24 October 1994 00:00 [Source: ICB]
Calls from buyers to stabilise the price swings transmitted from feedstocks and intermediates seem to have fallen on deaf ears. Analysts have suggested spreading the risk through futures contracts, a strategy industry has rejected in the past but which is slowly being accepted as the financial way forward.
By John Baker
THE RECENT sharp increases in prices for petrochemicals feed-stocks and intermediates has squeezed margins on downstream products, putting the spotlight once again on the volatility of markets and the risks inherent in the chemicals cycle. Small wonder the topic of the desirability of more stable pricing patterns and mechanisms to ease the risks from sharp price swings reared its head at the recent EPCA meeting in Monte Carlo.
Dieter Bender from Bayer and Paul Parniere of Renault, representing the buyers of the industry, pleaded for more consistent pricing from suppliers, buy were met with very little positive reaction. One approach which has been discussed before is to spread the risk through the use of derivative instruments such as futures contracts. These have proved an increasingly effective and well used tool in the oil and gas energy sector, where traded volumes are large.
But the chemicals industry obviously feels unhappy with the concept and despite encouragement and advice from financial and banking consultants has yet to be convinced that futures trading has much to offer the petrochemicals sector. Indeed, the one attempt to set up a futures contract for naphtha in the late 1980s-early 1990s fell by the wayside as too few people supported the initiative, led by the International Petroleum Exchange (IPE) based in London.
The argument against futures is that the traded market in petrochemicals is too small and does not have enough liquidity to support futures trading. In the naphtha scheme, around 30 companies and traders initially pledged their support, but in the end, because of lack of interest or understanding, only a very few actively traded - the most notable support coming from ICI.
Understanding and experience are obviously key to the success of any further moves to futures as a tool to smooth financial exposure to fluctuating prices. Stefan van Riet of the energy derivatives group at Lehman Brothers feels there is potential. Speaking earlier this year at a Lehman seminar for chemical clients he explained that commodity price risk should form an integral part of the wider risk management process in each firm.
'The cost of raw materials such as naphtha or ethane is a significant percentage of total operating costs for a chemical producer and these are highly volatile. Heightened awareness and increasing desire to manage financial risks (price or cost volatility) suggest that these commodity prices will become easier to hedge.'
Van Riet points out that forward markets, on exchange or over the counter, have been developing in some energy markets since the beginning of the futures contracts in 1978. 'Where 15 years ago no hedging was done or even contemplated in the energy sector, this has now become standard practice, both by producers, refiners and end users'. Currently efficient markets can be found for instance in crude oil, fuel oil, gasoil, jet fuel, gasoline and natural gas.
'To some extent similar markets have been developing slowly in the prompter periods for naphtha and propane . . . and tentative deals are being looked at in some of the other petrochemicals products such as benzene and ethylene.' But as van Riet points out, a large part of the feedstocks and base products for the chemicals industry are still very difficult to hedge. What, he asks, would it take to develop the market for these products further. And in answer he proposes:
Van Riet is not alone among the financial community to recognise the potential of derivatives in the chemicals sector. But despite such advocacy, industry remains very reluctant. The IPE is still keen to broaden its activities from the oil and energy markets into petrochemicals. but evidently has learned its lesson from the now-moribund naphtha attempt. Now it is taking things a little more cautiously, but at the EPCA meeting it did demonstrate a new computer-based trading system that could eventually lead to the type of hedging van Riet envisages.
Initially, explains Derek Butters of Petroleum Economics (PEL), acting on behalf of the IPE, the system is being offered to the chemicals market as a screen-based physical trading system. It will be tested first for futures trading on petroleum products, such as unleaded gasoline.
Butters is hoping to set up an industry working group of interested parties over the next year to identify the right commodity to introduce the first trading on and to establish the contract terms. Initial discussions have suggested benzene or methanol could be suitable candidates, but hdPE has also been suggested, although here there would be difficulties as to what base grades to use as the benchmark.
The advantage of the system for chemicals, explains Butters, is that it will be much easier to set up contracts for trading where the number of participants in the market is relatively small. 'It will therefore be ideally suited to petrochemicals and derivatives where there is a reasonable level of physical trade and where risks caused by price volatility need to be managed'.
The system is relatively straightforward and essentially mimics electronically what is done today by phone and notebook. Buyers and sellers would each have a personal computer terminal linked by phone line to the IPE central computer. Sellers would log in their offers on to the system, and buyers would enter their needs.
A deal can be concluded onscreen and the information relayed to the respective partners for paperwork to be raised, etc. Transactions are guaranteed by a central clearing house thus eliminating counterparty default. A service charge is levied in the form of deposit payment and margin calls are levied to guard against default.
The power of the computer allows the market to be analysed in depth and for the history of transactions to be followed. In this way, the market becomes more transparent to all users -some, especially traders, might say too transparent -but this is not seen as a particularly insurmountable objection.
The benefits of the system are that traders interact directly with one another; anonymity is maintained; and full price disclosure and amount of interest at different price levels is provided.
As users gain experience and confidence with physical trading on the system. Butters believes they will be more open in future to using it with forward and eventually futures trading. Buy he admits that getting sufficient interest in the startup of the system will not be a trivial exercise. Besides the question of transparency, Butters has found people wary of the impersonal nature of the system. Also, traders have expressed the feeling that the system makes it easier for them to be bypassed.
But the general reaction, despite the somewhat mixed reception, is that the industry will eventually move towards the use of such systems. To get the first trading off the ground IPE requires around 20-30 participants to give the required level of trading and an ongoing activity of bids and offers. It is planning to demonstrate the system again later this year, perhaps at the next EPL. Come! This way the futures lie.
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