January 11, 2019 | Chemicals Blogs
These days, volatility is synonymous with resins — the feedstock for packaging films — as crude continues to play a significant role in determining resin pricing in the market. Not only has the oil market seen two complete price cycles over the past couple of years, the uncertainty has not decreased one bit. A slight movement either on the supply side, or a geopolitical shift, has an immediate impact on oil pricing, making the marketplace even more dynamic. Given the uncertainty, what should large buyers do to shield themselves from volatility? Not only do they need to stick to fixed contracts on the back of volatility, they also need to work with a strong pricing mechanism that will significantly reduce the risk.
|Hedging — Long-Term, Fixed-Price Contract||
||No revision for the contract period|
|Long-Term Pricing With Price Revision||
||Every time the index breaches the agreed percent volatility|
||Based on the day’s monomer/polymer pricing|
Index-Based Pricing Contract
Fixed contracts are signed with a list of preferred suppliers. Usually, not more than two to three depending on the resin type and volumes involved. Prices are linked to an index, usually the month-end resin prices (any suitable index in the market — ICIS/CDI/Platts/IHS). Other aspects that are usually fixed are the quantities, the cost of extrusion and frequency of deliveries. Pricing is revised every month depending on the frequency of delivery, and the resin index for that specific month is used as a base for the calculation.
Hedging — Long-Term, Fixed-Price Contract
When the raw material prices are expected to witness a significant increase, customers usually hedge the pricing based on the present market prices and sign a long-term contract at present prices. This is usually effective when the demand forecasting is accurate and robust. In this case, the customer forecasts its demand for the contract duration and signs a forward contract to hedge its risk and the supplier/converter procures the necessary quantity of resins and produces films from it for the entire duration of the contract. The same pricing is used across all deliveries. However, there is a downside to hedging if the hedges are not carried out correctly, or if the market shows extreme volatility. For instance, in 2015, some of the long-term hedges in the resins space led to some unexcepted losses due to the sudden drop in oil prices and companies were not able to recover from them. Hence, it is important to understand the downside to it and create alternative plans if things go wrong — an additional cover to one’s risk mitigation plan.
Long-Term Pricing With Price Revision
A long-term pricing/volume is predetermined in the contract with a revision clause in place to protect both the parties in terms of severe fluctuations in the market. The ceiling is usually set at a number between 3 percent and 7 percent depending on the volumes and base resin under consideration. For example, if the price of the resin drops by about 2 percent in any given month, no revision is carried out. However, if the difference is of more than 7 percent, the prices are revised effective immediately.
Customers who do not have a robust demand forecasting in place usually operate more in the spot market. The pricing is set based on that day’s resin pricing in the market, which is usually driven by the monomer pricing. Spot buys can be very expensive when one is dealing in an uncertain marketplace coupled with exposure to severe volatility. The spot-buy options are usually beneficial in cases of ad hoc purchases apart from the volumes defined in the contract and/or during force majeure situations. Most of the larger firms usually tie up about 90 percent of their volumes into contracts and rest 10 percent is dealt in the spot market to take advantage of the market pricing at any given instance.
Other Contractual Best Practices
Usually, a supplier has a price clause inserted into the contract if the buyer does not meet the promised volumes. Something like this is in place to protect the supplier’s interest.
|% Reduction in Volume Promised||Overall Price Increase|
Conversely, a buyer could look at inserting a similar clause to include better discount structures if they exceed the promised volumes. Usually, a 60-day notice is given to the supplier either way.
Overall, lower resin prices should translate to lower pricing for plastic films. In most of the existing contractual relationships between a customer and a supplier, this does not seem to be the case, resulting in a huge loss of opportunity. According to a recent survey, only 35 percent of all contracts had an automatic price adjustment clause based on an index and while remaining 65 percent didn’t, and amongst the ones who had a price adjustment clause, quarterly price adjustments were used rather than monthly.
Overall, procurement needs to ask itself this question — how competitive are the prices we are paying against the relevant indices existing in the market and what are our peers doing? If one has answers to both these questions, one is well positioned in this category.