Implement margin management strategies using risk management tools such as futures, options and swaps to capture higher profits and beat the competition
By and large, chemical producers choose not to manage price risk in their feedstocks or products and, therefore, choose to let the market determine their profit margins.
They are betting (speculating!) that the market will reward them with good profit margins and they will outlast – though not outperform – their competitors.
How is that bet working lately? Based on recent announcements, not well for Dow Chemical, Berry Plastics or Shell.
Chemical producers need to take a proactive approach in order to see higher margins Copyright: alamy
US-based Dow Chemical has announced that it is separating its chlorine and derivatives businesses for future transactions.
Chemical producers need to take a proactive approach in order to see higher margins
These businesses, with annual sales of around $5bn (€3.7bn), include chlor-alkali, epoxy resins and chlorinated organics.
US-based consumer packaging company Berry Plastics initiated a cost reduction plan in November, which will result in five plant closures.
In December 2013, Anglo-Dutch energy company Shell decided not to build a $12.5bn gas-to-liquids (GTL) plant in Louisiana, US. Shell CEO Peter Voser said the uncertainty of long-term oil and gas prices made GTL “not a viable option” for Shell in North America.
PROFIT MARGIN CONCERNS
The decisions by Dow, Berry Plastics, and Shell have one thing in common – they are a result of concerns about future profit margins. With increased competition from Asia, Dow probably expects margins in bulk chemicals to be low and wants out.
Berry Plastics expects lower margins in its business due to slow economic growth in 2014.
Shell sees a potential tightening in margins for its GTL project, with lower diesel fuel prices and higher natural gas prices.
The companies are taking action on their margin concerns by leaving the business (Dow), consolidating (Berry), and dropping a major project (Shell).
Will their competitors be forced to make similar decisions? Perhaps. But such decisions would be less likely – and less forced – if producers managed profit margins using one or more of the strategies presented here.
The charts of historical values of the margins for ethylene and propylene show that – like the outright commodities themselves – the margins are volatile. So much money is riding on those volatile margins!
What margins do the chemical producers building new ethane crackers and PDH units expect? If they expect $0.30/lb and they could capture $0.35/lb on future production, would they take it? Why wouldn’t they take it? Would concerns over their competitors capturing higher margins by doing nothing stop them? How about $0.40/lb?
Regardless of expectations for margins, the chemical producer who is proactive (e.g., selling highs, protecting against lows) will not bemoan unrealised expectations later on.
It can beat expectations. Being proactive about margins means implementing margin management strategies.
MARGIN MANAGEMENT STRATEGIES
Three margin management strategies – A, B, and C – are presented in the table. A is an outright forward sale strategy.
B and C involve the use of options. “Do nothing” is standard operating procedure for chemical producers.
■ Set profit margin target and floor (e.g., $0.35/lb and $0.20/lb) and update as market conditions warrant.
■ Specify percent of future production that may be sold at target and protected at floor (e.g., 65% and 30%).
■ Scale into positions (e.g., execute no more than 20% at one time).
■ Specify how far forward future production will be managed (e.g., 3 months to 1 year).
For oil refiners and GTL projects, implementing margin management strategies is straightforward with futures and futures options. Oil refiners may execute gasoline or diesel fuel crack spreads and crack spread options. GTL project owners need only execute transactions on the spread (or options on the spread) between diesel fuel and natural gas prices.
For bulk chemicals producers, futures markets alone do not provide the means to implement margin hedging strategies.
Over-the-counter (OTC) transactions are required. For OTC transactions, agreements with credit and trustworthy counterparties must be established.
BEAT THE COMPETITION
For the chemical producer that implements margin management strategies, if the profit margin target is above the average, then the producer will outperform the competition. If the profit margin floor is above the market low, then the producer will also outperform the competition.
Regardless of the strategy, the probability that the producer who manages profit margins will outperform the competition is greater than zero – much greater depending on the target, floor and strategies adopted.
The probability is zero if the producer does nothing. Zero is safe, but most investors invest in companies on the expectation that they will outperform their competitors. Margin management strategies empower chemical producers – and other commodity pricessensitive businesses – to do just that.
TAKE CONTROL OF PROFIT MARGINS
If you’re a chemical producer, what target profit margin would you choose? What floor would you choose? Take control of your profit margins, exceed expectations for yourself and your investors, and beat the competition stuck on the “do nothing” strategy.