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.

Long-term energy price and supply projections are always suspect. But for most manufacturers exposed to energy and resins price risk, it’s worth asking, “How low can natural gas prices go?” Consider these recent articles:

Low Gas Prices Spur New Chemical Plants (WSJ, 12-27-11)
The boom in low-cost natural gas obtained from shale is driving investment in plants that use gas for fuel or as a raw material to make chemicals, plastics, fertilizer, steel, and other products.

Shale-gas production volumes will depend on environmental-protection rules set by state and federal regulators. Many environmentalists say that the chemicals pumped into the ground to unlock shale gas are a threat to water supplies.
Shell plans to build an ethylene plant in the Appalachian region. Ethylene, produced from ethane in natural gas, is used to make plastics and other materials that go into an array of products. Dow plans to build two new chemical plants near the U.S. Gulf coast and upgrade or reactivate others as part of a planned investment of $4 billion over the next six years. Some of the chemicals will be exported to Latin America. [Aside -- exports? Interesting, given the effort by Dow and others to prevent natural gas exports by energy producers, discussed here.]

Natural Gas Ends 2011 below $3 (WSJ, 12-31-11)

U.S. natural gas prices fell to 10-year lows, underscoring how the nation’s booming energy business is becoming a victim of its own success. New drilling techniques have unlocked vast new stores of natural gas from shale formations and other so-called unconventional reservoirs.

Cheap gas hurts energy company profits. “American natural gas production growth is essentially useless at this time since you can’t make any profit on North American natural gas,” said EOG Resources. EOG plans to direct 90% of spending to oil production in 2012, drilling for gas only where it is necessary to hold on to acreage.

Most processors have fixed product prices due to customer constraints, competitive pressures, or both. If they don’t buy resins until ‘the last minute’ or manage price risk before they buy, then they’re ‘short the market’ through their fixed price products. [See Price Wise for 12-20-11.] How did that “strategy” work in 2011? How does it look in 2012?

As high correlations and this flowchart show, crude oil prices drive resins prices, but natural gas plays an important role affecting polyethylene, ABS, PVC, and other resins prices to different degrees. Whatever resins you buy, for 2012, from a risk management perspective, now is a good time to take some or all of your gas price risk off the table.

Managing price risk is smart business, and easy once the rules are in place and you know what you’re doing. Managing natural gas price risk is smart and even easier. At this time, it’s also very inexpensive. Calculate the natural gas price risk in your resins or energy consumption, then mitigate or eliminate it in 2012. You’ll be ahead of the game right off the bat.

With the caveat that I have no information on risk management activities at Dow Chemical or other chemical companies … based on the following articles, for Dow to simply complain about potentially higher natural gas prices rather than manage them is astonishing, particularly given the ease with which Dow (or anyone else) could manage gas while prices are at historical lows. Consider –
Natural Gas: Manufacturers Fear Higher Costs (Wall St. Journal, 12-22-11)

U.S. officials will soon weigh in on a fight between companies that want to export some of America’s fast-growing supply of natural gas and big manufacturers that oppose the exports because they rely on cheap domestic gas.

The battle, which pits manufacturers such as Dow Chemical Co. against energy producers like ConocoPhillips, shows how the boom in U.S. fossil-fuel production is upending markets and forcing policy makers into decisions they didn’t imagine facing just a few years ago.

Once seen as a likely significant importer of natural gas—before the boom in domestic shale-gas production provided enough to meet demand—the U.S. is now emerging as a potential supplier of the fuel to nations overseas thanks to the newly tapped sources in shale.

Companies are setting their sights on markets in Europe and Asia where natural gas fetches three to four times the price in the U.S. But Dow Chemical and others say allowing exports will crimp the supply available to U.S. users and drive up prices here.

To send natural gas across the oceans, companies must supercool the fuel to minus 260 degrees and convert it to liquid form so it can be loaded onto tankers. Building massive coastal facilities to make liquefied natural gas requires multiple permits from Washington.

The Energy Department is looking at whether exports will drain U.S. supplies and inflate domestic prices. The Energy Information Administration, part of the department, is expected to deliver its analysis in a few weeks.

Among those taking a hit would be chemical companies, which use natural gas as a raw material in car parts, bottles, cleaners, mattresses and other products.
Dow Chemical, one of the most outspoken critics of the export proposals, says the U.S. would be better off using its cheap natural gas for domestic manufacturing instead of exports.

“When natural gas is used as a chemical raw material, it creates eight times the value compared to other uses, and fuels higher-paying jobs, exports of finished goods and the vitality of the manufacturing sector,” Dow spokeswoman Kasey Anderson said.

Energy companies say there is plenty of natural gas in the U.S. to meet domestic demand and support exports at the same time. They say building the giant export facilities would create construction jobs and boost long-term employment by encouraging a faster rise in U.S. natural-gas output.

The Coal Age Nears Its End (Wall St. Journal, 12-23-11)

After burning coal to light up Cincinnati for six decades, the Walter C. Beckjord Generating Station will go dark soon—a fate that will be shared by dozens of aging coal-fired power plants across the U.S. in coming years. Their owners cite a raft of new air-pollution regulations from the Environmental Protection Agency, including a rule released Wednesday that limits mercury and other emissions, for the shut-downs.

But energy experts say there is an even bigger reason coal plants are losing out: cheap and abundant natural gas, which is booming thanks to a surge in production from shale-rock formations in the U.S. “Inexpensive natural gas is the biggest threat to coal,” says Jone-Lin Wang, head of global power research for IHS CERA, a research company. “Nothing else even comes close.”

For decades, coal produced more electricity than all other fuels combined, and as recently as 2003 accounted for almost 51% of net electricity generation, according to the U.S. Energy Information Administration. But its share has dropped sharply in the last couple of years. It fell to 43% for the first nine months of 2011, as natural gas’s share has jumped to almost 25% from under 17% in 2003. Despite that, gas prices have fallen.

Natural-gas plants are springing up around the country, from Connecticut to California. More are expected to crop up along natural-gas pipelines, especially in places like Texas where demand for power is outstripping supplies.

With energy markets flooded with cheap natural gas from shale rock, utilities have been idling coal capacity and running gas-fired plants harder. New EPA rules are also significant. Last Wednesday, the agency released its latest rule, requiring power plants to slash emissions of mercury, arsenic and other toxic pollutants within three to four years.

EPA’s Power Play (Wall St. Journal, 12-22-11)

The new rule may be the most expensive the EPA has ever issued, and it represents the triumph of the Obama Administration’s green agenda over economic growth and job creation. The rule requires power plants to install “maximum achievable control technology” to reduce mercury emissions and other trace gases. But the true goal of the rule’s 1,117 pages is to harm coal-fired power plants and force large parts of the fleet—the U.S. power system workhorse—to shut down in the name of climate change. The EPA figures the rule will cost $9.6 billion, which is a gross, deliberate underestimate.

The economic harm here is vast, and the utility rule saga—from the EPA’s reckless endangerment to the White House’s failure to temper Ms. Jackson—has been a disgrace.

For most people and companies, it’s easier to complain than actually do
something positive about the thing that bothers you. Are you like that when it comes to resin price volatility? The overwhelming evidence (e.g. the uniqueness of Sunny Delight’s risk management program) says yes. Why? I believe most processors are more than capable of learning and applying risk management tools. So the hurdle isn’t aptitude; it’s attitude.

I suppose if Dow chooses to complain about, rather than manage, natural gas prices – which are easier to manage than resins prices – processors have more room to complain. But complaining doesn’t solve anything, and it’s really lame when the solution is right in front of you. Don’t just complain like Dow. Change your attitude, and win.

Greg Ogborn, Director of Purchasing for Sunny Delight, shared some insights into how and why Sunny D controls its resins prices. Sunny D has a well-structured and coordinated risk management program whose primary objective is resin price certainty. It achieves price certainty using physical and financial tools (e.g. resins futures) that any processor can use, though it’s clear most processors don’t use them, given the low liquidity in resins futures and ongoing complaints about resin price volatility. Why? Are most processors willing to take more risk than Sunny D with resins prices? Ironically, yes, though they don’t look at it that way.

To maintain utilization and sales, it is very difficult for processors to pass higher resins costs through to their customers. That means most processors have a short resins market position. Their profit margins decrease as resins prices increase, and profit margins increase as resins prices decrease. Such a short position is a de facto bet that resins prices will stay the same or decrease from current levels – not a smart bet for such a volatile commodity and major contributor to COGS, is it? Sunny D doesn’t think so. If you do, consider …

• Did your short resins position pay off in 2011?
  
• Did you achieve your 2011 budget projections for profit margins?
  
• Do you think that same short bet will pay off in 2012?
  

Are you unnecessarily betting against resins prices for your profit margins? As Greg said, “We spend a significant amount of time developing our annual financial plans and those plans can be easily destroyed by a runaway resin market.” So Sunny D manages its resin prices. Join them, and leave the betting to traders.

Previously, I wrote about a risk management Roadmap. When it comes to resins risk management, Sunny Delight has already “arrived” at its destination and is reaping the rewards. I had heard Sunny D had a resins risk management program, but I didn’t know it was as advanced as this Q&A makes clear.

Greg Ogborn is the Director of Purchasing for Sunny Delight, and he took time out to answer some risk management questions:

1. Please tell our Price Wise readers about yourself and your role at Sunny D. I’m the Director of Purchasing for Sunny Delight Beverages Co. My team and I support all raw material and packaging Purchasing for 5 N.A. bottling plants
   
2. Unlike Sunny D, few processors hedge their resins price risk despite resin price volatility and the fact that resins comprise 50% or more of processing costs. Why is Sunny D different? We’ve always been involved in commodity risk management, from corn to diesel fuel to natural gas and electricity. Since resin is a major contributor to COGS; it’s been my mission since joining Sunny to find a method of effectively, economically managing this risk.
   
3. What are your Objectives in hedging your resins prices? Two words; price certainty. But not price certainty at any cost; we weren’t interested in paying 10 over the index; we wanted to own the index.
   
4. You work in cooperation with your Finance Department, which means your CFO is on board with your activities. Was it difficult to get your CFO’s approval and cooperation? No, our entire Senior Leadership has always been supportive of the program because they are seeking price certainty. We spend a significant amount of time developing our annual financial plans and those plans can be easily destroyed by a runaway resin market. That can’t happen anymore.
   
5. Does Sunny D have a Risk Management Policy that guides your hedging decisions? Absolutely and it is very well defined; starting with a Board of Directors Resolution authorizing the activity. It took time to develop and to get stake holder alignment, but is quite simple to administer. The key to all trades is alignment and concurrence; I can’t bid a pound without written approval from both the CEO and CFO.
   
6. What risk management tools (financial or physical) do you use to hedge your resins prices? We utilize the PCW/CME Clearport MBN (ethylene) and HPE (high density polyethylene) futures swap. We negotiated these indices into our bottle contracts so that we have 100% correlation between our futures position and our bottle price change. These are excellent derivatives for our needs, but the challenge is visibility and market liquidity; we need more of both.
   
7. When your hedge positions show a mark-to-market profit, are you encouraged to “take the money”? No, that action would be viewed as speculative.
   
8. What qualifications do you think a Risk Manager should have? Thorough understanding of the market & tools, but of equal importance; have a clear objective. Get over the natural desire to second guess your trades. If you have a plan, the plan works and you’ve executed the plan; you’ve succeeded.
   
9. Is there anything else you would like to tell our readers? Understand your liquidity. Establish your risk tolerance and determine what degree of market move your cash reserves can handle; keep your position within that tolerance.
   

That’s risk management! I hope Greg and Sunny D are willing to share more thoughts and information in future posts, but this brief Q&A is a window into “doing it right”. Sunny D controls the resins market to meet its objectives. Its costs, sales, and profit margins are not controlled by it. They have a ‘Cadillac’ risk management program and credit goes all the way to the top, but you don’t need a Cadillac to move in the right direction.

Risk management guards against or eliminates potential cost increases while securing profit margins and sales. Hedging is part of risk management, but risk management is a process that, implemented wisely, adds quantitative and qualitative value to your business. “Hedging” and “risk management” are often used interchangeably. The problem that causes is not just a lack of understanding of risk management. It’s that risk management gets a bad rap because hedging has a bad rap. Hedging has a bad rap because a few unqualified and careless individuals have hedged or overseen hedging activities and caused unnecessary and unexpected losses. Neither risk management nor hedging deserves a bad rap; that’s like blaming cars for accidents caused by drunk drivers.

With that introduction, if I worked for a processor who wanted to control resins prices, and increase sales and secure profit margins, I would follow this roadmap:

Specify Objectives

These are strategic and financial objectives, such as:

• Meet or beat budget or other profit margin expectations
• Limit or eliminate price risk in purchases and sales
• Secure and increase revenues

Write a Risk Management Policy

This step is critical but most often overlooked or bypassed. The RMP establishes responsibilities and authorization levels, hedging procedures, approved tools and strategies, hedge accounts and funding, reporting requirements, etc. to achieve the Objectives. At a minimum, the final RMP should have CFO signature approval.

A good RMP is well worth the time and effort. For example, it requires that hedges be analyzed correctly; i.e. not analyzed separate from the underlying physical positions they were designed to protect. Unfortunately, CFOs who aren’t involved in developing the RMP oftentimes define hedges as ‘good’ or ‘bad’ depending on whether or not they made money. Hedges can and often do make money, but their purpose is to mitigate risk and help achieve the Objectives. They are not trading positions to be analyzed on their own, and if your CFO doesn’t understand the difference, you should not open a hedge position until he does understand or at least signs off on the RMP.

The RMP may only be a few pages long, but ensures coordinated and successful implementation of risk management – and, therefore, hedging – activities. (See also Hedging Rules in Price Wise, May 31, 2011.)

Implement the RMP

Designate an experienced and trustworthy individual as Risk Manager. The risk manager’s responsibility is to implement the RMP. The most challenging part of implementation is getting things up and running smoothly. If someone in your organization doesn’t meet the qualifications, hire a risk manager for initial implementation and train an in-house candidate to take his place after an interim period. Once it’s up and running, you’ll be pleased with how easy and beneficial risk management is … like riding a bike.

All resins prices contain crude oil price risk. For propylene and derivatives, the extent of oil price risk (i.e. the price correlation) is over 90%, as you would expect looking at this Purvin & Gertz and CMAI upstream/downstream process chart, which shows the monomers only a few refining steps away from crude oil:

Interestingly, even resins with a less direct linkage in the production chain have a high oil price correlation, as shown here for high-impact polystyrene:

HIPS prices courtesy of Petrochem Wire

Crude oil feeds refineries, refineries feed petrochemical plants, and petrochemical plants produce resins. All resins market price surveys (PCW, CDI, Chem Orbis, etc.) keep a watchful eye on crude oil prices as they do their best to report fair and accurate resins market prices. But which crude oil benchmark best represents oil prices and, therefore, is the one resins buyers and sellers should watch most closely – Brent or WTI? More important, once deciding the best benchmark, how may processors manage their oil-based resins price risk? Are transactions in the scary futures market the only way? A couple of recent articles in the Wall St. Journal shed light on these questions.

Brent Is the One to Watch, Not WTI (WSJ, 17-Nov-11, excerpts)

A rise in the price of West Texas Intermediate crude futures isn’t good news for the global economy. But, it isn’t really the bad news that markets think either. The real crude price to watch is Brent, which has much more influence than WTI on oil prices in the rest of the world.

The disconnect between the price of WTI and the price of Brent has grown all year, mostly because the rise in the Canadian oil supply to North America led to a glut in WTI.

As WTI isn’t exported in any quantity outside of North America [yet], the glut had little direct impact on the world crude market and the correlation between the price of WTI and Brent is a lot weaker than it once was. The weaker correlation means that a rally in the price of WTI will affect the U.S. economy only, rather than the global economy as a whole.

Investing in Oil (WSJ, 19-Nov-11, excerpts)

WTI surged last week after the announcement of the sale of an oil pipeline running from Oklahoma to Texas. Other oil markets barely budged.

Enbridge said it would buy a 50% stake in a pipeline that brings oil from the Gulf of Mexico to Cushing, Okla., and reverse the direction that the oil flows, so that oil would be leaving Oklahoma instead of arriving. That will ease the glut of WTI, stored at Cushing—a glut that has been keeping the price of WTI far below that of Brent, the European standard. The price of WTI jumped on the news. For most of 2011, WTI has trailed Brent – at times close to $30/bbl. The spread is now less than $10/bbl.

Though Brent and WTI represent two similar types of oil, they are subject to different regional forces. Before the start of the year, Cushing already was facing price pressures caused by a glut of oil. At the same time, Brent crude, the European benchmark, was buffeted by supply disruptions due to unrest in the Middle East.

The “correlation” between the two crudes—their tendency to move in the same direction—has averaged 96% over the past two decades. On Nov. 15, it had fallen to 0.71, the lowest in at least 20 years.

Brent’s outperformance has reversed in the past month, partly because it no longer faces the supply disruptions it had earlier in the year. The economic turmoil in Europe has also reduced demand for oil, and as a result, Brent is moving sideways.

Those looking to bet that WTI will continue to rally should consider using the United States Oil exchange-traded fund [symbol USO], says an ETF analyst at Morningstar. The fund buys WTI futures contracts that expire in one month, sells them close to expiration, and buys new ones—a strategy known as a “roll.” The shortest-term futures contract is more sensitive to the spot price of a barrel of oil than longer-term futures. USO has gained nearly 15% in the past month.

An investor [or hedger] who thinks oil will appreciate over the long term should buy either WTI or Brent. The ETFs are USO, USL, and BNO.

ETFs trade likes stocks, with accompanying put and call options. Even most processors, who see the oil or resins futures markets like Dracula sees daylight, own stocks in their personal portfolios. So it would be relatively easy and comfortable for most processors to take a small step toward managing resin prices.

As ample evidence shows, oil drives resins prices. Plastics processors have been lucky in the last year or so that WTI crude oil prices have been suppressed by a supply glut at Cushing, OK. But the party will be over soon –

Oil Pipeline Reversal Pushes Up Prices (Wall St. Journal, 17 Nov 2011)

The sale of an oil pipeline running from Oklahoma to Texas upended U.S. energy markets, sending the price of crude surging above $100 a barrel. Enbridge Inc.—which bought a 50% stake in the Seaway Pipeline—announced it would reverse the direction of the flow, allowing more crude to move south from oil storage in Cushing, Okla., into the world’s largest refinery complex along the Gulf Coast.

Over the past two years, the U.S. has started producing so much oil that existing pipelines have been unable to move it to refineries. That has led to a glut of oil in the center of the country, keeping the price of American crude far below that of petroleum traded overseas.

That will change once the pipeline is reversed, a process expected early next year.

The U.S. requires companies hold a special permit to export oil from the Gulf Coast, but the restriction doesn’t apply to gasoline. With a new supply of oil headed to Gulf Coast refineries, exports of gasoline are expected to rise.

“It’s hard to overestimate the significance” of reversing the pipeline, said a lead industry economist at the EIA. He said it was the start of a process to reconfigure the U.S. pipeline system to carry increased domestic oil production to the Gulf Coast.

For decades, oil has been imported from overseas to the Gulf Coast, then either refined there or moved elsewhere in the U.S. for processing. The pipeline system was set up to move crude from south to north. But booming U.S. oil production and declining imports mean oil now needs to move from north to south.

Industry analysts don’t expect rising U.S. crude-oil production to translate into lower gasoline or diesel prices anytime soon. So much gasoline and diesel is exported from the Gulf Coast that U.S. customers compete with customers in Mexico and the rest of Latin America—and have to pay as much as these foreign users. The result is that all this new U.S. oil won’t significantly lower prices at American gas stations, unless global gasoline prices drop.

U.S. oil prices jumped 3.2% to close above $100 per barrel for the first time since June, settling at $102.59 per barrel. Prices are based on oil stored in Cushing. Traders confronted the prospect that crude oil flowing into that storage hub would soon find a new route to refineries on the U.S. Gulf Coast—and from there to buyers of petroleum products around the world.

Because of the glut in Cushing, the price paid for crude in the Midwest U.S. has been substantially less than European benchmark prices, such as Brent crude. This is expected to largely disappear by the middle of next year, as the Seaway pipeline change gets underway.

——————

For processors without a risk management program in place, either your margins or your customers are going to suffer under higher resins prices. (Good luck trying to pass along higher resins prices.) For processors without their heads in the sand, now you will have an even easier time of beating your competition.

In our previous episode, we learned that the CFO of Poly Wise challenged ‘old dog’ Ralph the Purchasing Manager to convert their polypropylene supply from an index price – which exposes Poly Wise to higher resins prices and offers little choice but to try to pass along higher costs to customers – to a fair and easily managed crude oil differential price. Ralph says he’s up to the challenge, though the CFO has his doubts and is willing to replace Ralph with someone who understands and appreciates the advantages of the new resins pricing paradigm.

Making It Abundantly Clear

To emphasize his point to Ralph, and the rationale for the new pricing paradigm to all his direct reports in Purchasing, Sales, and Finance, the CFO sends out the following email:

“As most of you are aware, Poly Wise is determined to switch from defense to offense on our profit margins so we can wrest control of our success from the market – particularly the resins market, the source of our biggest cost – to ourselves. In short, we are going to break the mold in plastics processing. The ‘old mold’ and its challenges for processors and customers are epitomized in the following excerpts from recent articles. Read these stories and be prepared to discuss them (particularly the highlighted parts) and the opportunities they present to Poly Wise at our staff meeting next week, where Ralph will also report progress on his efforts.”

Old Molds

Bemis Reports 3Q 2011 Results

“Food price inflation has driven grocery store prices higher in 2011, challenging consumers to stretch their grocery store dollars. Most of our customers experienced lower unit sales volumes in many of the product categories for which we provide packaging, and we expect this trend to continue through the fourth quarter.

At Bemis, we have responded to lower volume levels by reducing our workforce. In addition, we are undertaking optimization initiatives that will result in the closing of several small plants globally and leveraging our most efficient facilities and proprietary technologies over the next year. Efforts associated with these activities are expected to reduce fixed costs and optimize our facilities to create a manufacturing platform from which to expand in the future.”

Flexible Packaging Business Segment
“Raw material cost increases in 2011 have negatively impacted operating margins as a percentage of net sales, and lower unit volumes across most market categories have resulted in additional negative margin pressure.

We have addressed the raw material cost increases from the first half of the year with selling price adjustments, many of which were implemented during the third quarter. The benefits of these price adjustments were more than offset by the negative impact of generally lower unit sales volumes this quarter.”

Silgan Announces 3Q 2011 Earnings

Silgan Holdings Inc., a leading supplier of rigid packaging for consumer goods products, today reported third quarter 2011 earnings. “[The year ahead] is shaping up as an opportunity to showcase how our businesses perform in the face of multiple significant headwinds. We have experienced a stagnant U.S. economy and significant raw material inflation, compounded by an increasingly volatile European economy. Our metal container business benefited from the … timing of contractual pass throughs of increases in manufacturing costs. Our closures business suffered the negative impact of the delayed pass through of significant spikes in polypropylene resin costs.”

Costs Weigh on P&G Results

Procter & Gamble Co. produced solid sales growth in its fiscal 1^st quarter as it successfully raised prices even as some competitors held back, though higher commodity costs took a toll on margins. Costs will still pressure results in the current quarter, causing P&G to give downbeat guidance for its fiscal 2^nd quarter.

P&G indicated that it planned to spend about $1 billion before tax on restructuring this year, which includes cuts to stay lean. Some analysts have pressed for more and deeper cuts, but P&G instead wants to make the changes over time to address what it acknowledges are high overhead costs.

P&G in recent years has aimed to sell products across the price spectrum. With the higher-end consumer holding up better than lower-income shoppers, who continue to fret about unemployment, P&G has had more leeway to raise prices on its premium products.

Some competitors have held back on price increases for now, causing P&G to lose share in North America and Western Europe. P&G expects those competitors to follow soon with higher prices.

Appliance Sales Tumble

The world’s two biggest appliance makers, Whirlpool Corp. and Electrolux AB, are being battered from several directions. Stubbornly weak demand and stiff price competition led both on Friday to disclose dismal results. Whirlpool slashed its profit forecast for the year and said it will close two factories and eliminate 5,000 jobs, or 7% of its work force. Electrolux also will cut its production capacity, noting North American demand is 30% below its expectations.

Sales gains in Asia and Latin America are slowing and aren’t sufficient to make up for sluggish demand in the U.S. and Europe. Steel and other raw-material costs are up from a year ago. Price-cutting promotions have hurt profits without generating much new demand.

Whirlpool said it would limit price-cutting events this holiday season to about half as many days as last year. Executives said promotions aren’t doing much to create demand lately and only reducing proceeds. Whirlpool also said it hopes to push through price increases in January, the third such move within the past year. However, an analyst at Longbow Research says it will be hard to make price increases stick amid tough competition from rivals such as South Korea’s Samsung Electronics Co. and LG Electronics Inc.

In response to “recessionary demand levels” and higher costs, Whirlpool is consolidating production and eliminating its highest-cost factories. Whirlpool’s planned job cuts include 1,200 salaried positions. The company said its restructuring will lead to $500 million of charges, spread out over three years, and reduce annual fixed costs.

Takeaways

The CFO finishes his email with these declarative statements:

“We will not –

• Pass through higher resins costs to our customers because we will take control of those costs
• Leave ourselves exposed any longer to negative margin pressure

We will –

• Meet or beat our budgeted and forecast profit margins
• Help our customers control their costs and improve their profit margins
• Beat the competition handily
• All profit from our efforts

Please be on time and prepared to discuss the above at next week’s staff meeting.”

Ralph Calls Poly Bon

Ralph gulps after reading the CFO’s email. As reported last time, Ralph contacted several polypropylene suppliers and received a positive response from Matt, the Marketing Manager at Poly Bon. Ralph asks Matt if they can meet by the end of the week to discuss a polypropylene supply at WTL + 30 ¢/lb. Matt agrees.

To be continued …

In our last episode, we learned that after deciding to search for a supplier to provide polypropylene at the new resins pricing, Poly Wise switched from defense to offense on profits, telling their employees:

“Profits keep us in business and you employed, so we all need to work together to secure and improve profits. We are attempting to change the pricing structure of our polypropylene supply to give us control over our biggest cost, but we also want your ideas. In return for your ideas and their successful implementation, you will share equitably and handsomely in the profits.”

Poly Wise follows up with specifics on its profit sharing program:

“We have two reward levels under our profit-sharing program: 1) Everyone Shares and 2) Key Contributors. Our objective is to meet or beat our budgeted 10% gross profit margin. The more we beat it, the more money we all make. Key contributors (employees whose ideas we adopt that lead to higher profits) will make even more.”

Poly Wise is overwhelmed with the positive response of its employees and the mood lifts. [Profit sharing is far more effective at improving employees' moods than cookies, absurdly recommended in this otherwise insightful WSJ article on improving morale in the work place.]

CFO Steps In

In moving from defense to offense on profit margins, Poly Wise takes the additional step of putting its CFO in charge of the Purchasing and Sales Departments. The aggressive but fair CFO calls in Ralph, the Purchasing Manager: “Ralph, you have been tasked with finding a long-term polypropylene supply for us at WTI futures plus 30 ¢/lb. We want to be able to control our polypropylene costs against our product prices so we can increase margins and sales while helping our customers control their costs. We’re tired of resins prices and the market controlling our profitability. You have a crucial role in this effort, but I’m concerned about this email you wrote to me a few months back:

In today’s world of such volatile resin prices (cost swings like we’ve never seen before), hedging is too risky. Public companies can make up excuses to shareholders as to why the “hedging strategy” did not work, leading to under-budgeted margin results or (most likely) losses. In plastics processing, no company can afford NOT to pass along resin cost increases immediately to customers. The real issue is communication between our Sales Department and customers’ Purchasing Departments. Our customers need to understand any type of price protection or the unwillingness to accept a justifiable increase not only puts our health/existence at risk, but theirs, too.

“That approach doesn’t cut it anymore, Ralph. We can’t just pass along higher resins costs to our customers when we want to, and that’s not our Sales Department’s fault. We’re losing customers despite not passing higher resins costs along to them. Worse, our profit margins are weak. We need to change. You need to change.

Carrot and Stick

“I’ve teed this up for you, Ralph. Learn about the new resins pricing paradigm and find us a polypropylene supplier at WTI plus 30 ¢/lb so we can all benefit – you, in particular, as a potential key contributor. But I want results, Ralph, and if you can’t do this, I’ll find someone who can. Given our new profit-sharing program, that won’t be too difficult.”

Ralph Steps Up

Ralph is an “old dog” but he’s not dumb. After 28 years in the plastics industry, he actually enjoys the challenge by his new boss, the CFO, and is determined to learn this “new pricing paradigm” stuff. He reads previous articles on Price Wise while the CFO provides backup for Poly Wise’s WTI + 30 ¢/lb bid to polypropylene suppliers:

Poly Bon Steps Up

Ralph contacts many polypropylene suppliers, including Big Oil Chemical Companies for whom Ralph thinks a polypropylene price at a differential to crude oil makes the most sense – Exxon, Chevron, Conoco, BP, and others. Ralph is somewhat surprised when his first response is from Matt, the Marketing Manager at Poly Bon.

To be continued …