Transparent Plastics

The London Metal Exchange Ltd. (LME) is the world’s largest nonferrous metals futures market and has been formally established for more than 130 years. It is owned by its membership, which includes most of the world’s well-known banks and financial institutions. As such, it is run on a nonprofit basis and earns revenue through member subscriptions, levies and the sale of real-time market information to major price vendors, such as Reuters and Bloomberg.

A consultant with a long history in the plastics industry approached the LME in 2003 regarding plastics pricing. Having conducted extensive research, the exchange noted the similarities in the supply chain between nonferrous metals and plastics and the shared industries in which the materials are used. Thus, in May 2005 the LME launched futures contracts for polypropylene (PP) and linear low-density polyethylene (LLDPE). Initially offering global contracts with delivery points worldwide, the LME introduced regional contracts in June 2007, with delivery locations specific to each contract in North America, Europe and Asia.

The LME provides three core offerings that are interdependent: hedging, pricing and delivery of physical material. We refer to the industry that readers are part of as the "physical industry," or "physical market," and the financial paper market as the "futures market."

Pricing references in the polymer industry currently are derived from telephone polling of buyers and sellers.

The LME price is independently discovered on exchange as a result of the buying and selling of futures contracts. It is similar to an auction where bids (buyers) and offers (sellers) are placed in the market. It is therefore a much better reflection of actual prices being paid and is anonymous, as LME members transact on behalf of their clients.

The price discovered from this buying and selling activity represents a transparent "benchmark" price for a marker grade for the product in question. In the case of PP, for example, this would be a 12-melt homopolymer injection-molding grade without additives, e.g. slip and anti-block.

For PP we also have allowed 3.5 raffia, 20-melt and a 25-melt homopolymer injection-molding grades to be deliverable at par with the 12-melt price.

The deliverable grade of LLDPE is 0.8-melt butene blown film and blending grade. All deliverable grades are without additives to improve long-term storage.

These grades were selected because they represent the bulk of product produced and consumed globally. They are considered commodity grades where price movements in these grades are reflected by similar price movements in other grades of product. This allows grades with high correlation to the LME-specified grades to be hedged using the LME futures contracts. The price correlation with more highly specified grades would not be very good and it would not be possible to hedge those grades.

Prices are discovered on the LME’s open outcry trading arena, known as the Ring, during five-minute trading periods. Trading during a small time frame focuses the available activity in the market into one place at one time and results in a better reflection of prices in the market.

The LME contracts trade up to 15 months into the future. It is currently possible to buy and sell contracts that mature up to December 2009. Where forward contracts are traded, the LME publishes the forward prices, known as the closing prices or evening evaluations everyday. These give an indication of prices market participants are prepared to buy and sell at in the future. It is not a forecast, as many people believe, but is based on actual forward bids and offers in the market.

We publish official prices daily based on the prices discovered in the official plastics ring at 12:20 each good business day and the closing prices that are discovered in afternoon trading and are published around 6 p.m. London time.

A futures contract is "an agreement today to buy or sell a standard quantity of a specified asset at an agreed price for settlement on an agreed future date."

A "hedge" or futures market position is usually equal and opposite to an existing physical market transaction. It creates an equal and opposite cash flow to offset the impact of price movements, essentially leaving the hedger with a fixed price.

We are providing industry with the ability to manage the risk that the price of PP or LLDPE may go against you. The downside of this is that if the price moves in your favor, the opportunity cost of hedging is that you lose the advantage of the beneficial price. If the agreement with your customer is for a fixed price, then, regardless of the movement, you will have locked in the price and your margin.

To hedge you would first have to determine whether the LME price correlates well with the price of the product that you are buying or selling.

Then you would need to incorporate the LME price as the base price in your normal purchase and/or sales agreements. The LME price is a benchmark price for a certain grade in an LME warehouses in specific locations. When incorporating the LME price in sales/purchase agreements, it is usual to add premiums or differentials for alternative grades, additives, delivery to customer works etc. Note: your existing business relationships do not change.

The LME price would tend to represent "not quite" prime material being stored for a period of time. Recyclers would probably apply a discount to the LME price when pricing their products for sale and purchase if the correlation was high enough. Where post-production scrap is used rather than post-consumer scrap, then the correlation is likely to be higher.

There are numerous advantages to using the LME market, depending on the individual organization’s needs and abilities.

By hedging a portion of your business, you essentially demonstrate to financial participants in your business, namely your bank(s), that you are able to better manage the volatility in your market and provide greater confidence in your ability to lock in your future profits. This is particularly beneficial when involved in project finance and trade finance activities. In addition, LME warrants (a bankable bearer document for a specific parcel of LME registered material in an LME approved warehouse) can be sold and converted into cash at market prices within a matter of days. LME warrants can, therefore, be used as collateral against a loan and can result in competitive interest rates from your bank.

From an accounting perspective, hedging activity, access to a transparent reference price and the availability of forward prices make it easier to forecast cash flow and profit and loss. Investment decisions can be made with greater confidence.

The LME approves recognized producer grades of material that meet the LME specification. These "brands," as they are referred to, are deliverable against an LME futures contract. The LME also approves locations and warehouses where delivery can take place. These are always in foreign or free-trade zones to remove the distortion of various countries’ import duties and taxes on the LME price.

The physical delivery aspect to the market ensures the futures market price stays linked to the physical market price, a phenomenon known as price convergence. The LME price stays linked to the physical market through market participants’ ability to make or take delivery as a last resort. It is actually more expensive to make or take delivery through the delivery mechanism, but it is an option.

If the LME price starts to diverge from the physical market price, then physical traders that buy and sell material regularly will see an opportunity to buy LME specification material from the physical market and deliver into the LME market system and thus realize a higher price. This activity reduces the LME price back into line with the physical market price.

As buyers or sellers of recycled material, if there is a high price correlation between LME grades and recycled product, then hedging should be possible. Assuming the material trades at a discount to the LME price, then a differential to account for any differences in price between the LME specification and the hedged product would be deducted in the sales/purchase agreements, and hedging should be possible on that basis with the LME price embedded in the contract.

The difficulty will come if you wish to make physical delivery of product against a futures position, as you are only able to deliver grades that meet the LME specification and are LME approved.

Progress on the plastics contracts is being made, but with any new futures contract it takes time for the market to become familiar with the new concepts that are being introduced.

Ultimately what you are looking for is certainty in an increasingly uncertain world.

The author is LME plastics development manager and can be contacted at Robert.Sheldon@lme.com.