Options Give You Options

[This article is also posted on Plastics Today.]

To control resins costs for less cost, risk, and angst

Last time, I introduced readers to the resin cost control tools offered by Cargill ETM. IMO, the most advantageous of the tools are options – limited cost & low risk “insurance” against 1) higher resin prices before you lock in a purchase or 2) lower resin prices after you lock in purchase. The first involves price caps (call options); the second involves put options. Both are proven economically and strategically beneficial for buyers of commodities and equities. Thanks to Cargill ETM, resins buyers may now benefit from them.

Choices to match

Table 1 shows a range of transactions for buyers or sellers consistent with a given market opinion or concern. Clearly, options provide several more cost and risk level choices than the buy/sell/do-nothing choices without them.

Table 1

What’s the upside and downside for resins buyers of executing one of the above transactions? Table 2 is indicative. Most processors default to strategies A or B; strategies C, D, and E are available with options.

Table 2

The market isn’t the problem

Many processors blame the resins market and, in some cases, suppliers for resin price volatility and resulting costs that exceed expectations or hopes. A supplier says “It [when the discussion turns to price] becomes a combative environment that’s not very pleasant.”

Volatility is here to stay because resins are petrochemicals and driven by crude oil prices. That’s a fact which processors, until now, have had to live with, executing highly risky “fix or float” buying strategies that often lead to market frustration and angst. Now the market (via Cargill ETM and, perhaps, others) offers choices that enable processors to buy smarter and save money and trouble. The sooner processors learn and take advantage of those choices, the better for them and their customers.

Takeaway

Learn and position yourself to execute resin buying strategies C, D, and E above. Then spend more time making better products and meeting customer needs, and less time worrying and complaining about resins prices and profit margins.

Resins Price Caps Are Here!

This article is also posted on Plastics Today.

Along with the other right tools for you to control resins costs and secure profit margins

Last time, I discussed resins price caps – insurance against resin prices moving higher than an acceptable future level. Price caps would enable processors to control resins costs effectively and economically and give them valuable time to make better purchase decisions and, consequently, save up to 5 ¢/lb in average resins costs.

I had thought resins price caps were not available in the OTC or futures markets, so processors who wanted to cap their price risk needed to buy the next best thing: options in crude oil, which is highly – but not perfectly – correlated with resins. Happily, for processors in North America, I was wrong!

Cargill ETM

In response to Resins Price Caps, Cargill ETM (Energy, Transportation, and Metals)
informed me that they offer resin price caps and other risk management tools for up to two years ahead. The tools are financial only, but are precisely what processors need to manage resins costs and secure profit margins. In fact, they are the very tools I’ve been discussing in Profitable Plastics for months. In Cargill’s words:

Cargill ETM was formed in the late 1980′s in order to manage exposure in energy on a centralized basis throughout Cargill globally. The resin desk was started three years ago in order to address the nearly $1 Billion Cargill spends on packaging on an annual basis. Cargill also made the decision to offer 100 % correlated index based swaps and options to other end users – seeing this as a need in the marketplace. [Great minds think alike.J]

We’ve helped some of the largest consumers of resin in North America minimize volatility and achieve price clarity (and peace of mind) on their resin expenditures.

Tim Johanson, Director

What do Cargill resin price caps look like?

Cargill ETM offers price caps settled against IHS/CMAI, CDI, or PCW indexes for up to 2 million pounds per month for up to two years. An example, based on November IHS/CDI contract prices, for 1Q2013:

Strike price	Resin	Premium (¢/lb)
At the money	PE	4.5
	PP	6.25
5 ¢/lb out of the money	PE	3
	PP	4.25

The fact that Cargill offers price caps settled against the three most widely used market indexes enables most processors to offset the price risk perfectly in their contracted physical supply. Resins futures settle against PCW prices, so Cargill’s offerings are more advantageous to processors than what the resins futures market could one day offer.

Takeaway

The wait is over for processors who want to effectively and economically control resins costs, secure profit margins, and beat the competition. Cargill ETM has brought the future forward. Take advantage of it. Learn more about the cost control tools Cargill ETM provides and position yourselves to buy them as your risk management policy authorizes. Then spend more time making better products and meeting customer needs and less time worrying about resins prices and profit margins.

Upcoming

Cargill ETM, Plastics Today, and yours truly work together to make controlling your resins costs easier than you might think.

Resins Price Caps

This article also appears on Plastics Today.

Price Protection for Processors, Added Value for Suppliers

As discussed earlier, using the difference between a daily resin price (reported by PCW or TPE) and crude oil futures is a trigger for hedging forward resins purchases. The resin/oil difference (or spread) mimics the profit in producing the resin and, where commodities are concerned, profits typically normalize in a few weeks; so, spreads that mimic profits are good indicators of future price movements.

Time-to-wait saves 5 ¢/lb

A hedge is either a fixed-price financial or physical purchase or a protective purchase. (Doing nothing isn’t a hedge, but it is a valid decision based on the resin/oil spread.) What is a protective purchase? For processors, it’s insurance against resin prices moving higher than expectations or an acceptable level (e.g. the price required for a minimum profit margin). In crude oil and other commodities futures, insurance against higher prices are call options. For a premium (hence, insurance) related to the term and strike price of the option, a call option gives the buyer the right (not obligation) to buy a commodity at the strike price on or before the expiration of the option. Call options are preferred hedging tools of most risk managers because they limit (or cap) upside price risk for much less capital and risk than outright purchases. More important, price caps give a buyer time to wait coolly for a lower price since a price cap protects against the market moving higher while the buyer waits. In the volatile resins markets, I estimate such time-to-wait for a lower price could save processors 5 ¢/lb or more in resins costs.

Oil is good, resins are best

Resins call options are not available in the OTC or futures markets. So, processors who want to cap their resin price risk must buy the next best thing: crude oil call options. The good news is call options in crude oil futures and ETF’s are readily available and liquid, and they offer plenty of choices for the most capital-constrained and risk-averse processors. The not-so-good news is that, even though resins and crude oil prices are highly correlated (80-85%) over the medium to long term, they don’t necessarily correlate well in the short term (next week to next month). Resins price caps are best to manage short-term risk, but where can you get them? Call a friendly, service-oriented, and sales-driven supplier. He may provide them, to your and his benefit.

What might resins price caps look like?

Resins price caps would be similar to price caps in other commodities. I recommend a contract volume of 10,000 pounds and strike prices that settle against an average of daily prices over a calendar month. PCW provides daily prices that the CME uses to settle its calendar swap futures in polypropylene and polyethylene. If PCW prices are good enough for the CME, they should be good enough for OTC resin price caps. For the more adventurous and those with purchase contracts that settle against the more widely subscribed CDI monthly index, resins price caps could also settle against that index. However, being a one-time price and, therefore, more volatile than a monthly average, price cap premiums for a CDI-settled price cap would be higher.

Suppliers Benefit

It’s clear processors will benefit strategically and economically from resins price caps, but what about suppliers? Here’s a list of benefits:

• Additional revenue
  
• Selling covered calls and decaying assets
  
• Easy to manage
  
• Customer satisfaction
  
• Competitive advantage, new customers
  
• No credit risk (price cap premiums must be paid up-front)
  
• Leading edge reputation
  

Takeaway

Understand how price caps work and how they will help you control resins price risk and reduce costs. Then, contact your suppliers and determine their willingness to design and offer them at fair market prices that you can calculate or estimate. If your suppliers are not willing to work with you, contact other suppliers. You process resins to make a profit, and resins price caps will help ensure and insure that you do just that.

Resins Hedging Triggers

Also published on Plastics Today

Choices

As discussed earlier, the most effective means for processors to hedge forward resins costs are: outright purchases of physical supply or futures in polypropylene or polyethylene or protective purchases. Outright purchases means buying (locking in) forward prices to eliminate price risk; protective purchases means buying options in crude oil futures or ETFs to limit price risk. (Crude oil options are a proxy for resins options until they become available in the futures market, though processors could request resins options from their suppliers – to their mutual benefit.)

There is a third hedging choice that processors may take and most processors only take: do nothing. Do-nothing means purchasing physical supply for short-term processing needs only. It is considered the safe choice, but do-nothing actually equates to taking the position that 1) future resins costs will be lower than expectations (or low enough to still make a profit), 2) higher resins costs can be, sooner or later, passed through to customers, or 3) competitors are also doing nothing so it’s best to do nothing, too. Given the volatility of resins prices, do-nothing can be a good hedging decision, but having it as the only decision for the biggest cost component is hardly safe. It’s a disservice to customers, investors, and employees and leaves processors vulnerable to competition from processors who do more than nothing to manage risk. Which processor are you? Which one do you want to be?

Triggers

Like other business decisions, hedging decisions are best made dispassionately, not emotionally or by “gut feel”. For such decisions, price indicators or triggers are useful. Given the high correlation between resins and crude oil prices, it follows that resins prices relative to crude oil prices may provide such triggers: triggers to lock-in forward purchases, protect forward purchases, or do nothing. A resin price relative to crude oil could be a ratio or a difference. I believe the difference (or differential) is most informative because it reflects the profitability of the resin being produced by petrochemical companies and market forces tend to bring a resin’s profitability back in line with historical averages within a month or two.

Resins/Crude Oil Differentials

The following charts show daily price differentials between polypropylene and polyethylene (high-density) and front-month crude oil futures prices:

The charts show that polypropylene and polyethylene differentials to crude oil do indeed return to normal (e.g. historical averages) a month or two after straying from the norm. What does the future portray?

If resins futures are executable at the settlements listed on the CME, then it appears, relative to crude oil, polypropylene futures are a clear buy and polyethylene futures are neutral (protective purchases). Are they executable? Contact me to find out.

Takeaway

Basing resins hedging decisions – buy, protect, or do nothing – on differentials to crude oil reduces the guesswork. The less guesswork, the more rational decisions are made with the biggest cost component you have. And more rationality means lower costs, even if do-nothing hedging is your default.

Hedging Resins the Smart Way

Also published by Plastics Today.

Last time we discussed forward price curves as an important tool to predict future resins costs and the risks of those costs moving higher or lower. Forward curves for HoPP, LLDPE film, and HDPE are provided on a daily basis by CME using PCW prices. As of 9-24-2012, the curves look like this:

Why do I compare forward price curves for resins with the forward curve for crude oil? Here’s why –

Over nearly four years, price correlations are 80-85% between daily resins prices and front-month crude oil futures. They’re even higher (85-90%) in 2012.

Given resins are petrochemicals, of course their pricing will be correlated with crude oil. But the fact that the correlations are so high, means forward resins prices will track forward crude oil prices; i.e. the shapes of the curves will be the same. At this time, flat.

The Good News

The good news for processors is there are two effective means to hedge forward resins costs: resins futures for polypropylene or polyethylene purchases or crude oil for most any resin purchases. Using crude oil as a hedge empowers processors to choose low cost/low risk hedging alternatives: options. Options are the “smart way” to manage price risk. They may be used to limit upside price risk before locking in resins purchases and/or limit downside price risk after locking in purchases. Options-based hedging programs save buyers and sellers angst and money – lots of both. That’s why using them is smart.

The Forward Curve

Also published by Plastics Today.

As discussed earlier, the purpose of managing resin price risk should be to improve profit margins. For processors, improving profit margins means hedging resins costs consistent with product prices and risks. But how (and how best) to hedge resins costs? That topic will be much discussed in Profitable Plastics. For now, some front-end basics –

What is a resins cost hedge?

A resins cost hedge is protection against 1) financial loss in an existing physical purchase or 2) a higher price than acceptable in a future physical purchase. Hedges are usually financial, and cheaper and less risky, than outright physical purchases. Hedges should protect next month forward purchases, not short-term (current month) needs.

[Aside: Hedging is often associated with options since options were created as hedging tools. For a defined cost and limited risk, options allow buyers and sellers to create positions that exactly meet their hedging needs and market outlook.]

Accounting for Hedges

Resins cost hedges are alternatives to physical purchases; therefore, hedging gains and losses should be accounted for in the eventual purchase price of the resins they are meant to protect to arrive at a net purchase price. If an existing hedge cannot be linked to a physical purchase by the person responsible for the hedge, it’s speculation. Hedges are not speculation and speculation is not hedging! For some, speculation within approved limits is fine, but don’t blame hedging for a bad bet.

The Forward Curve

The starting point for a hedging decision is the forward curve. The forward curve is a monthly chart (as of a certain date) of expected, future prices for a commodity. The best forward curves come from an unbiased, well-informed source. For energy and many other commodities, that source is the futures market. What about resins?

Financially settled futures are available in polypropylene, linear low density polyethylene film, and high density polyethylene. [These are calendar swaps where the floating price for a contract month is equal to the arithmetic average of Petrochem Wire's daily closing price (FOB Houston) for the resin for each business day during the contract month.] The forward curves for those resins, alongside the forward curve in crude oil (converted to $/lb), are shown here:

Forward curves tell processors what resins costs to plan for and, depending on the level and volatility of the forward curves, whether or not hedges are warranted.

How may processors hedge resins costs?

If, after reviewing the forward curve, a polypropylene or polyethylene processor decides to hedge, are resins futures the only tool available? And what about PET, PVC, polystyrene, and other resins processors? What hedging tools are available to them?

Stay tuned.

Avoid the Restaurant Bind

Also published by Plastics Today.

The bind of rising ingredients costs vs. flat product prices to maintain sales —

Soaring Food Prices Put Restaurants in a Bind

(Wall St. Journal, 8-29-12)

Restaurant chains are in a pickle, caught between soaring ingredient costs and fears that raising prices will turn off their budget-conscious customers, who generally remain pessimistic about the economy.

Companies like McDonald’s, Buffalo Wild Wings, and Chipotle are taking different approaches to the dilemma. Some are trying to pass on rising costs to customers to avoid squeezing their profit margins. Others are holding the line on prices or emphasizing their existing low-cost menu items to keep consumers coming through the door.

The worst drought in decades has driven up prices for foods including corn, chicken and beef this summer.

“Restaurant operators are in a position where they don’t have much of a choice but to raise prices because they operate on such thin margins,” said Darren Tristano, executive vice president of restaurant consulting firm Technomic, Inc.

The pressure is greater on some chains than others. Fine and casual-dining restaurants can better stomach commodity-cost increases because of their higher-priced menus and ability to adjust portion sizes. “But when you’re McDonald’s, a lot of your products are priced to be ‘value’ offerings, so there’s not a lot of room to absorb cost increases,” Mr. Tristano added.

If you substitute ‘processors’ for ‘restaurant chains’ and ‘resins’ for ‘ingredients’ in the article, does it describe a dilemma your company could face? Has faced?

Advice for tomorrow: learn about and then implement a program to cap your resins costs.

Advice for today: stock up on cheeseburgers and buffalo wings before restaurants cry uncle.

Profit is the Thing

Also published on Plastics Today.

In general, businesses with commodity price risk (e.g. oil companies, transportation companies … and resins processors) manage that risk to achieve different objectives – cost certainty, budget or forecast targets, job and business security, competitive advantage, customer loyalty, etc. IMHO, the primary purpose of managing commodity price risk should be to secure and improve profit margins. Profits keep the doors open and people employed. Resins processing may be tons of fun, but profit is the thing.

For processors, managing profit margins means controlling (hedging!) resins costs consistent with the way revenues are generated: the timing and type of resin cost hedges should reflect the timing and nature of product sales. In simplest terms, what you do with one side of the operation should take into account what’s happening on the other side. (Think oil refinery and crude oil costs. Hedging crude oil costs independent of gasoline pricing isn’t hedging. It’s betting.)

Resins costs beyond immediate needs (i.e. medium to long-term) should only be locked in against fixed and certain product prices. If product prices need to be flexible to respond to competitive and customer pressures, then resins costs should be capped, not locked in. In other words, if you can’t easily raise product prices to offset higher resins costs and profit margins are tight, then capping resins costs is the right and most prudent hedging strategy. (How to cap resins costs will be a major topic in this column.)

Commodities costs are usually controlled (hedged!) with financial tools for reasons such as cost effectiveness, better buying decisions, capital constraints, etc. But financial transactions and the physical transactions they substitute for need to be in sync as much as overall cost control needs to be in sync with revenue flow.

Consider the generic processor:

Processors like the generic processor who focus on and manage margin risk will outperform and outlast competitors because they spend more time meeting customer needs and wants and less time worrying about profits.

Resin Processors Leave Themselves at the Mercy of Crude Prices

Adopted from a WSJ Article (23 FEB 2012)
America is pumping more oil out of the ground than it has in years thanks to a surge in onshore drilling. U.S. refineries are producing more gasoline and diesel than ever, and Americans’ gasoline consumption is at an 11-year-low.
So with all that supply and not much demand, why have gasoline prices risen high enough this year to resurface as a national political issue? The short answer, experts say, is that the global economy and geopolitics, not the U.S. industry or economy, are driving gasoline resin prices.
Gasoline resin prices will be most influenced by the price of oil, traded in global markets, not U.S. supply and demand.
The cost of crude typically accounts for a little more than half of the price of gasoline, with taxes and refining and transportation costs making up the rest. In January, however, crude made up 76% of the price of gasoline, according to the federal Energy Information Administration.
In the past, the price of U.S. oil at a key storage hub in Cushing, Okla., most directly influenced U.S. gasoline prices. But that price of U.S. crude, known as West Texas Intermediate, has strayed far below crude from other parts of the globe that is actually used by many U.S. refineries, particularly along the coasts.
Thus the price of oil from the North Sea, known as Brent, has become the benchmark most tied to U.S. retail gasoline prices. [Brent trades at a premium to WTI of $15 to $20 per barrel.]
Experts say that over the long run, increased oil production in the U.S. might temper global prices, and getting that oil to more refineries across the country could help bring down prices at the pump. But for now, U.S. prices remain tied most firmly to Brent, which is being driven mainly by factors such as China’s sharp economic growth, even as that has moderated recently.
Meanwhile, the unstable situation in the Middle East, especially the turmoil over Iran’s possible nuclear threat, has sent global crude prices surging. 
“There’s a war risk premium that is weighing heavily on the markets,” said Amy Myers Jaffe, senior energy adviser at Rice University’s Baker Institute.

Establishing a Resins Hedge Account

[This article is also posted on Plastics Today.]

In the roadmap for managing resins prices, I explained that risk management is a process whose purpose is to help achieve strategic and economic objectives (e.g. price certainty, increased utilization rates, hoped-for profit margins, etc.) Hedging is part of the process, and hedges should be executed after the objectives and a risk management policy are established. The risk management policy contains procedures and authorizations, and lists and prioritizes hedging tools and strategies. Hedges are typically financial, but physical transactions are also included.

For resins, hedging tools are exchange-based and over-the-counter (between counterparties), and need not be limited to fixed-forward purchases (a.k.a. “pre-buys”) that so many processors fear because of downside price risk. Exchange-based (and some brokered) transactions require a hedge account that may be fully funded or marginable.

What are some guidelines for setting up a hedge account? Greg Ogborn, Director of Purchasing at Sunny Delight, shares his expertise:

There are a number of brokerages where resins buyers or sellers can open a hedge account, but I’m hesitant to specifically recommend someone in this forum. That said, here are some guidelines to follow in establishing and transacting a hedge account:

1. Be sure the broker has an energy desk (e.g. FC Stone, Wells Fargo Advisors, and others)
2. Resins are traded OTC, and futures are ‘thin’. You need to work with someone who knows the players and can make a deal happen. Starting out, the thin market was my greatest challenge as I was accustomed to executing market orders in seconds on regular exchanges.
3. Resin brokers play a far greater role than simply typing bids into the computer (like corn, wheat, HO, and other commodities brokers) so not just any broker will do.
4. Transaction rates can always be negotiated, but it’s pointless to go with “cheap” if the broker has no contacts. Assuming the cheapest broker can get a deal done, it’s not likely to be at the best available price, so the cheapest broker may end up costing you more.
5. There are 3^rd party firms such as Accord Petrochemical or Houston Mercantile Exchange that serve in somewhat of a broker capacity, allowing you to get your bids in front of the largest possible pool. However, neither of them serves a clearing function, so if you use one of them you still need a clearing firm to oversee your account (e.g. margin requirements). If you can transact directly with a counterparty, you don’t need a clearing firm; however, that involves credit risk, so I don’t recommend it — unless you have a credit department (internal or external) that can monitor counterparty credit risk for large volume or longer term transactions.
6. An added complication for direct transactions with counterparties is the need for a Master agreement with each of them. For most buyers, Master agreements are burdensome.
7. In addition to brokered deals, if you want your trades to be on CME Clearport, you must register with Clearport. Forms are available on line.

Establish a hedge account following Greg’s guidelines. A hedge account empowers you to use a range of financial and physical tools to control resins prices. It doesn’t commit you to hedges; it simply puts you in position to execute them. Execution is up to the Risk Manager or authorized individual like your CFO. (See the roadmap.)

If you want to control your resins costs and achieve other key objectives, establishing a hedge account is an important first step. Based on the evidence, it’s a step that most processors won’t take, which makes taking the step even more advantageous for those who do.