Managing resin-buying risks

The volatility of resin prices poses myriad challenges to today's processors, who also have many more tools to help them manage the volatility and inherent risk, but negotiating, understanding, and implementing these tools can be difficult. Tom Langan is a risk management and trading consultant at WTL Trading and Mathelin Bay Associates. Self-described as a "trader, risk manager, and teacher", Langan has 20 years of experience in financial and physical commodity trading and risk management. Below, Tom and Phil Karig at Mathelin Bay share their insights into the various hurdles and risks resin buyers face, and what they can do to overcome them. 

Ability to pass along price increases to customers

Often caught in a squeeze between large petrochemical companies who will pass along price increases, no matter what, and large customers (often "Big Box"/Hypermarket retailers such as Walmart and Home Depot or Carrefour) who will not easily accept increases. If a manufacturer is unwilling or unable to pass along cost increases, the manufacturer could:

Volatility of resin prices

Resins are petrochemical products in a volatile energy price environment, so price volatility is a given. Unfortunately, contracts between plastics processors and their customers are often based on a model from a time when the speed and magnitude of resin price increases were much less than they have been in the last 5 to 10 years. Plastics manufacturers may live with resin price volatility, reduce it, or eliminate it. Without a change in either the pricing model with the customer or the way the manufacturer manages resin costs, price volatility can become a matter of survival for many manufacturers.

Reducing or eliminating price volatility, without changing the resins used or the products offered, often means hedging. Hedging done unwisely is costly and may create more problems than it solves. Hedging done wisely is smart business. It means establishing a set of rules (a risk management policy), understanding and identifying the right hedging instruments and strategies for the business, and obtaining management buy-in before executing any hedges.

Transparency of resin prices

Many other commodity markets are far more transparent than resins. Finding up to the minute prices for crude oil or gasoline, copper or lead, coffee or wheat, is simply a matter of checking the commodities page on a website such as Bloomberg.com.

There are a number of reasonably accurate and reliable market price surveys, such as CDI or CMAI, but these are often published no more often than monthly, are subject to after the fact adjustments, and don't often show the prices paid by large buyers after all discounts. As a result, manufacturers often feel they don't know the whole story on resin prices and can find themselves in the uncomfortable situation of attempting to pass along cost increases to their customers without really being sure how much of the underlying resin price increase will hold in the market.

The best overall hedging instruments are usually exchange-traded. Exchange-based prices are inherently transparent and fair. Unfortunately, the current markets for resin hedging instruments are neither widely accepted nor widely used in commercial transactions. This can leave resin manufacturers feeling as if they are experimenting, at their own risk, in markets that are not yet fully developed.

Many of these same concerns about transparency were an issue at one time in the markets we today consider to be among the most widely accepted and transparent, such as the energy markets.

Working capital

Outright physical purchases ("pre-buys") in anticipation of resin price increases can tie up a lot of working capital. There is also the risk that a large, wrong way guess on resin prices can leave a manufacturer holding a large inventory of depreciated raw materials. Prices can go down as sharply as they go up in a volatile market, and with as little warning.

Certain financial purchases, such as futures and swaps, may require large amounts of working capital in reserve to meet potential margin calls.

But there are lower capital alternatives in a resin risk management program. Options, for example, protect against higher costs, have limited downside price risk, and can accomplish the same goals with far less working capital than "pre-buys".

Second guessed

Being second-guessed is a constant risk in a market that combines volatility with a lack of transparency. The likelihood of being second-guessed is high if a manufacturer's resin purchase strategy is limited to "pre-buys'. Sooner or later, even the most skilled resin price forecaster is going to guess wrong. It is very hard to explain to a company owner or president that the rapidly depreciating Polypropylene filling every available silo and storage spot is offset by five successful, prior pre-buys.

A risk management policy that contains strict management approval and signature requirements is the best way to limit second-guessing. The use of lower cost financial tools, with limited downside risk, such as options, is also helpful since the total dollars at risk can be appreciably smaller.

Full Disclosure

Disclosure requirements can be an issue for public companies utilizing financial hedges. Providing your customers and competitors with detailed information on how you are hedging your purchases can cause problems, including trying to pass along resin price increases when your customer is aware that you are not actually paying the price increase.

One of the reasons for disclosure at public companies is to inform investors about the nature of the risk the company is attempting to mitigate. It also helps ensure that hedges are truly linked to physical purchases, and are not speculative trading positions well beyond the amount of resin the company might actually use.

Competitors review the public filings of their public competition, so it is important to always keep in mind the various audiences that will see the information and to work with the company's controller or CFO while preparing a public filing relating to a material hedging transaction.

Business security, job security

Running a business that is often squeezed between large suppliers and large customers can be a high stakes game. If your company depends upon guessing the direction of resin prices correctly one hundred percent of the time you may be taking a risk with the long term viability of your company.

If, as a buyer within a company, your job security depends upon guessing the direction of resin prices correctly one hundred percent of the time, start looking for another job now, because sooner or later you will be wrong.

What if no direct hedging instrument exists

Matching the hedge with the resin requirement can be a challenge where there is no exact (or nearly exact) hedging instrument available for a particular resin or resin grade. It is not necessary to match every purchased grade to the grade available in a hedging instrument. Various grades of HDPE, for example, while vastly different in performance, can often be linked to a single grade of HDPE that is traded in options or futures form.

Some resins, such as Polystyrene, are not currently available in a hedging instrument. There are, however, highly correlated feedstocks that are traded and can help mitigate a portion of the risk involved in purchasing Polystyrene. Various new resin contracts, including Polystyrene, are planned to be introduced over the next few years.

Counter-party credit risk

In other words, what happens if the organization that underwrites a transaction becomes insolvent or otherwise refuses to pay? Alternatively, what happens if a manufacturer agrees to purchase particular resin volumes at particular prices from a supplier based on an agreement with its customer --- and then the customer only buys when they are protected from resin price increases but refuses to buy when resin prices drop?

The safest strategy is to avoid counter-party credit risk or limit it through certain transactions with highly credit-worthy counterparties only.

There is no counter-party credit risk to sellers or buyers of exchange-traded instruments. The risk of non-performance by exchange participants is controlled by the exchange.

Internal credit departments or external agencies should monitor and pro-actively control counter-party credit risk.

If a customer cannot abide by a transaction in up markets or down, the manufacturer must decide whether they want to hedge all or part of their resin price exposure on their own and without the customer's support.

Capitalizing on spot opportunities

Resin suppliers or distributors will invariably bring forward spot opportunities from time to time that are more favorable than the hedged price for the same type product.

Most manufacturers do not hedge all of their requirements and leave some room to take advantage of the occasional spot opportunity.

Whatever the spot opportunity, it should always be approved within the broader risk management policy. This helps eliminate or limit second-guessing by other stakeholders within the organization.

If the spot opportunity is large and will take a relatively long time to consume, options may be utilized to protect the long position until the resins are consumed. A long resin position is as manageable as a short position and a good risk management program can deal with both, along with spot opportunities.

For more information, please contact us at Mathelin Bay