Hedging Your Bets
By Cheryl C Lewis -- Purchasing, 7/16/1998
Purchasing professionals in the chemical processing industries now have a way to manage raw-material price volatility. During the past two years, several companies have begun to offer price risk management--hedging--tools for commodity chemicals and plastics. These tools provide companies with a method to reduce volatility in raw-materials costs.Commodity chemical and plastics prices can swing sharply, often with little or no forewarning. For example, ethylene prices in the U.S. have ranged from a low of 19.5(cent)/lb to a high of 30(cent)/lb since January 1995, according to the results of Purchasing's monthly transaction price survey. During the same time, blow-molding-grade high-density polyethylene tags hit a low of 29.5(cent)/lb and peaked at 49.5(cent)/lb.
This volatility can have a major negative impact on companies. In some cases, budgets can be blown apart. That is especially true when an unexpected rise in raw-material costs occurs. Price swings can also reflect on financial issues, such as cash flow and debt management. Sometimes, a customer wants a fixed price for a set period of time, so raw-material price increases are difficult or impossible to pass on. And even when an increase can be partially or totally passed on to customers, it can damage an otherwise good customer relationship.
If done properly, hedging can reduce price volatility in a big way. It can be used to manage cash flow, maintain working capital, meet a particular customer's pricing needs, and/or improve a company's financial leverage. "By managing exposure to unpredictable prices, companies can extract themselves from the commodity price game and capitalize on their unique competitive advantages," says Enron Capital & Trade Resources on their Web page, www.ect.enron.com.
Brand-new CPI tool
Price risk management is a new concept for the chemical processing industries. Companies called "market makers" only recently began offering these services. They include Enron Capital & Trade Resources, a subsidiary of Enron Corp.; Koch Chemical International, a subsidiary of Koch Industries; Louis Dreyfus Plastics, a subsidiary of Louis Dreyfus; and Shell Chemical Risk Management (SCRiM), a subsidiary of Shell Oil Co.
Koch and SCRiM offer commodity chemical and plastics price risk management services. Louis Dreyfus Plastics provides plastics hedging services. Enron Capital & Trade Resources (ECT) has been providing energy price risk management tools for almost ten years. In 1995, ECT introduced price risk management to the petrochemical and plastics industries. ECT also offers similar financial products for pulp, paper, packaging, and weather.
Currently, the business is in its infancy. "In the first 18 months or so, we were in a developmental stage, doing a lot of educating," says Ed Moody, Koch Chemical International's marketing manager. "In the last six months, people are more familiar with our product, so business has picked up substantially."
Hedging marketers expect strong growth. "We believe the market is going to be successful," says Jack Perini, vice president of SCRiM. "This is a tool that all producers and consumers of these petrochemicals are going to have to understand."
SCRiM executives point to the growth in natural-gas hedging. "Ten years ago, nobody hedged natural gas," says Gene Kenyon, president of SCRiM. "Now, at least everybody looks at it." At some point, the need to use the tool will be there.
Kenyon offers a hedging success story. For years, silver prices were in the doldrums. Last year, however, silver tags started to run up. When a reporter asked Kodak what they had done about their silver purchases for photographic film, Kodak reportedly said that they did not expect the run up in prices to have a traumatic impact on them, because they had been hedging 50% of their silver purchases.
Now, chemical and plastics producers and buyers are beginning to look at hedging. "Business is great for an emerging market," says Doug Friedman, Enron's director of petrochemicals and plastics risk management. He estimates the current demand for risk management at 80,000 tonnes/month in the U.S. "Companies that are exposed to changes in raw-material prices but are unable to pass them through are the most interested," says Friedman.
Who's involved?
Hedging in the CPI is usually a team effort, involving senior management, usually the president of the company; the chief financial officer (CFO); and purchasing. "The requirements of this activity aren't really centralized in any one group," says SCRiM's Perini. "They all have to have an oar in the water to run this thing."
It's a multilevel, multifunctional transaction. "Each player brings different skills and needs to the table," says Enron's Friedman. The CFO provides the financial background. He understands the mechanics of the financial transaction and knows what the company's position is in relation to foreign exchange risks, interest rates, and loans.
In the CPI, purchasing plays a strong role in hedging. "In most other markets where companies hedge, it's usually done at the corporate level," says SCRiM's Kenyon. "Here [in the CPI], purchasing is much more important to the decision."
Why? "Purchasing understands the markets and pricing," says Koch's Moody. Buyers know the raw-material markets, track raw-material pricing, and are familiar with price indices.
In the CPI, a hedging deal hinges on a price index, sometimes called a price basket. In general, the financial companies are using some of the more popular indices in the industry, including indexes from Chemdata and cmai.
Purchasers should be aware that a "customized" price index might best meet theirs needs. "Purchasing's role can also be to find the index or combination of indices that have the best correlation with respect to price movement to the price they pay for the physical material," says Perini. "That's where you make the hedge more efficient and more effective."
When to use it
Hedging isn't about making money. It's a strategic and tactical business tool. Most of the pay out is on the financial end of the business. "The key benefit to hedging is the reduction of price volatility because it helps companies manage their cash flow better and more predictably," says Koch's Moody. With less price volatility, companies can leverage and manage debt more effectively.
Others agree. "Stability is appreciated by bankers," says SCRiM's Perini. "Banks will loan you more or allow you to increase your debt-to-equity ratio to give better leverage to your shareholders if you can show some semblance of stability in your cash flow."
Hedging can also help those companies who either want a strict budget or who are tied to a strict budget. These tools can help a company bid on a new piece of business that includes a fixed price contract. "You have the opportunity to get pinched, so a use of this tool might be to bid on a piece of business that otherwise you wouldn't go after, because it's too risky," explains Perini.
Some companies--particularly in consumer products--want strict budgets. When companies miss budget, the first thing cut is advertising. "Hedging helps these companies meet budgets and continue to promote and do things that add value to their business," says Perini.
Debunking the misconceptions
Misconceptions exist about hedging. Some raw-material buyers believe they shouldn't hedge when prices are falling. But in some cases, cash flow or other factors can make hedging work well in a falling market. Example: If a resin is selling at 40¢/lb but prices are forecast to fall to 30¢/lb in one year, the buyer many want to hedge at 35¢/lb. Such hedging approaches can help buyers meet larger goals of the company.
Some buyers also focus solely on price. "I've tracked their prices, and I haven't found any that make money," says a purchasing manager. "They are one-tenth of a penny to 5¢/lb above my price." SCRiM's Kenyon responds: "If he can get a better price than the published market price, he should continue to do that, but it's still going to have variability in it. What we offer is the ability to stabilize that."
The important point is that buyers understand their own internal strategies and objectives before getting into a hedging situation. Why? "People want to take care that their hedge minimizes their exposure rather than exaggerates it," says Enron's Friedman. Sometimes, companies may want outside help in analyzing their goals and strategies for risk management. One company that offers this service is Charles River & Associates, Boston, Mass.
SCRiM advises that companies getting into hedging start out small. "The idea is to start with small volumes and short time frames," says Perini. "You don't want to pay the full price if you've been ill advised or are not equipped to deal with it." Over time, companies can begin to experiment with different tools and move to higher volumes.
In coming years, commodity petrochemical and plastics price risk management are likely to become part of the overall risk management portfolio of many companies in the CPI. And purchasing professionals will play an increasingly important role in setting up, running, and reviewing successful hedging activities because of their market knowledge and pricing expertise.
Financial risk management objectives
Tactical--Usually 12 months or less
* Protecting budgets
* Achieving minimum required cash flow
* Fixing revenues, costs, or margins
* Competitive advantage
Financial performance
Locking in advantageous prices
Gaining market share via price structures
Strategic--Usually longer than 12 months
* Financial
Down-cycle protection
Tax issues
* Altering of production mix
* Project financing
SOURCE: ENRON CAPITAL & TRADE RESOURCES
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