London Metal Exchange goes plastic

The LME today (27 May 2005) launched two new futures contracts for polypropylene (PP), which is used in bags and bottles, and linear low-density polyethylene (LL), mainly used for car fenders. The contracts offer companies a new financial tool to help manage their price exposure to fluctuating polymer prices.

PP prices rose 80 per cent in 2004, reaching a record high in December. Prices have since fallen by about 24 per cent. LL prices rose 57 per cent last year.

Producers have responded by pushing through rapid monthly price increases in an attempt to recover their profit margins, said David Paul, global head of LME plastics at Refco, a futures broker.

“However, a feature of the plastics industry is that the ability of the converters and the consumer industries to pass on these price rises is limited by end-user fixed price contracts that have long terms, typically one to three years,” he said in a statement published on the LME’s Internet site. “This has brought into focus the need for a means of managing price volatility and subsequent margin risk.”

The contracts will be useful all along the plastics packing supply line, including primary producers, converters and logistics companies. The contracts aim to reduce the extreme cyclical pricing volatility the industry has suffered for over 40 years, Paul said.

Plastics pricing has been affected by the cost of raw materials, supply and demand, and the increasing globalisation of industries converting or consuming plastics. Currently, the ability of the packing industries to adjust prices has been restricted by the lack of transparency in base costs globally.

Packers face little opportunity to adjust the selling price of finished products due to plastic raw material prices, Paul said. The industry typically operates on fixed price contracts or at best a narrow band of flexibility within the contract to adjust prices. Supplier contracts are usually negotiated by month or at best quarterly, leading to less pricing consistency.

The plastics futures contracts being offered are designed to minimise price exposure through hedging a company’s raw material price risk and locking in fixed forward prices. These work by securing a forward purchase price and obtaining a long-term fixed purchase price if the supplier is not in a position to offer a fixed price. Raw materials, mainly oil, natural gas and naphtha – represent 55 to 65 per cent of the final product cost.

Plastics produers have a history of long pricing cycles. Prior to the second quarter of 2004, the market had been struggling at the bottom of a long cycle.

Margins for producers have been poor and investment in new capacity was primarily in Asia and the Middle East, the LME said in a statement. Extreme oil and gas price increases during 2004 created an even more severe margin squeeze down through producers and at both converter and consumer levels.

“It is this marked effect on margins, which the rapid price increases have brought about, that have focused organisations’ minds on the possibility of hedging via the LME,” Paul said.

The two contracts offered by the LME will be recognised as global base marker grades typically sold into the market. These grades will establish global prices on the exchange and will allow for the pricing of more specialised grades to be priced at a premium to the base price.

The creation of plastics futures contracts will also create a change in the industry in the way prices are reported globally and regionally, the Paul said.

“Today prices are discovered via telephone poll by companies such as ICIS-LOR, Platts and CDI calling buyers and sellers and interpreting the inputs,” he said. “This approach is recognised as being far from ideal and the published market prices to be, at best, indicative.”

In the plastics industry, agreements between buyers and seller have to a large extent been based on these indicative prices, leading to a lack of transparency. The introduction of an exchange-derived price for a base marker grade will remove this uncertainty, he said.

Many companies who are considering using the plastic futures contracts to hedge are already using futures for other volatile commodities such as aluminium, copper, oil, gas, cocoa, and sugar.

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