Polyethylene Pricing Separates From Fundamentals

By John Richardson

Linear-low density polyethylene (LLDPE) pricing in China has become increasingly divorced from industry fundamentals as a result of the growing role of the Dalian Commodity Exchange’s futures contract, claimed a Singapore-based polyolefin trader late last week.

And the contract is setting the physical market, resulting in Dalian performing a similar role that of NYMEX on the price of crude as result of very easy lending conditions, a petrochemicals consultant added today.

Financial as well as polyolefin industry players have become heavily involved in Dalian, the trader added.

The big growth in LLDPE volumes traded last year -as this chart from my fellow Paul Hodges illustrates – was supported by the huge surge in banking lending in China.

 

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The contract is also being used by polyolefin traders to make money through pure one-way speculation and as a means to hedge risk in the physical market, the trader said.

“Buyers are using the contract to hedge, although I have seen little evidence of producers trading on the exchange.

“Everybody seems to be using the exchange as an indication of sentiment and if they are not actually setting pricing off Dalian, they are using it as a guide.”

But the consultant added: “I believe that Dalian is, in fact, setting the physical market as PE becomes more speculative.

“It has come to play the same role as NYMEX for crude oil, meaning that the contract often moves on sentiment and speculation rather than on fundamentals.”

Assessing the pricing outlook for PE now involves looking at comparative margins on real estate, equities and other futures contracts in metals and agricultural commodities, the trader continued.

“It’s not just about looking at supply and demand fundamentals anymore,” he said.

“Financial and chemicals industry player will look at margins across all the different futures contracts, and in equities and in real estate, to decide where the best returns lie and flip their money accordingly. I have to do the same to figure out PE price direction.”

China’s huge increase in lending has had comparable effects on the physical market with polyolefin traders, and traders in other chemicals and polymers, sometimes only buying a particular cargo in order to get their hands on credit in order to speculate elsewhere.

This has led to some chemicals and polymers cargoes being sold at below cost because sufficient profits have been made in other commodities.

“It’s also worked the other way round – i.e. somebody raising credit through buying another commodity because his main objective has been to speculate in polyolefins,” added the trader.

So go figure this: You have an increasingly speculative physical PE market which is so divorced from the fundamentals that there’s a bigger need to hedge. The problem is that one of the major hedging mechanisms – the Dalian contract – is also highly speculative!

The multi-million dollar question now is whether China’s decision to tighten liquidity through raising the reserve requirement for commercial banks will reduce the amount of froth in the PE market and across commodities in general – both for physical cargoes and on futures exchanges.

As Paul Hodges also noted last week, several fiscal tightening measures have already taken place which could reduce trading volumes in both the Dalian LLDPE and polyvinyl chloride (PVC) futures contracts. We will look at relationship between physical PVC pricing and the futures contract in a later post.

LLDPE trading volumes so far this year are down by 27.77% on January 2009, according to the exchange’s website today.

This might make a successful launch of a major futures contract in polypropylene (PP) – rumoured to be under evaluation in China this year – problematic.

PP producers are reportedly jostling for position to get their grades accepted under this planned contract in order to support physical sales.

If a grade made by only one producer is traded through a PP contract, a hedger could be more likely to also buy physical volumes of that grade as, in theory, hedging should work more efficiently.

But China constantly loosens and tightens credit and so, even if Dalian becomes less relevant this year, it might well come back.

There are also indications that the Chinese government wants to make exchanges such as Dalian more sophisticated in order to set its own global benchmark prices for commodities.

“It no longer wants to be just the price taker from exchanges such as NYMEX. It also wants to be the price setter,” said a Shanghai-based chemicals industry observer late last year.

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