However, this change will probably weaken the influence that oil prices have in the determination of plastics prices in the future. The relationship between oil prices and plastics prices is now very strong, and therefore the spectacular volatility experienced by oil and energy markets was fully inherited by the plastics markets. This relationship usually strengthens when the market tightens and weakens when it eases. Correlations between price movements in oil and polyolefins have been very strong during the last few years, some 80 per cent compared to 30 per cent a decade ago. Oil prices are expected to remain very volatile and above $100 a barrel for the foreseeable future, with a likely skew to higher levels.

The highest marginal cost of polyolefins production is given by oil-products based crackers and it is expected to remain so in coming years. Price levels are expected to vary in line with energy price levels, but the new intermittent flow of low-cost product across the world, trying to break into fresh markets, will distort the regional supply picture and add uncertainty to the price behaviour of polyolefins. This will almost certainly mean increased volatility for the plastics markets.

Both volatility and price levels for most commodities have sharply increased in the last five years. Business planning becomes increasingly difficult with market uncertainty, as a company’s cost and price advantages can be quickly reversed by changing market conditions. The harmful effects of price volatility are also unevenly distributed across value chain participants.

Polyolefin producers suffer a serious mismatch between the pricing mechanisms used to trade their feedstocks and their final products. Increased price volatility at both ends further distorts margins control and the commoditisation of the basic polyolefins markets experienced in the last decade limited their pricing power.

The conversion industry, another margins industry, relies on rudimentary stock-piling mechanisms as a way to mitigate price movements. Volatility severely increases their financial risks; an ill-timed purchasing decision may have dramatic consequences. End-users usually get the worst deal as they ultimately bear most of the risk. They tend to sell at fixed prices over a long period and suffer from volatility on the cost side. As prices of energy and industrial commodities outpaced inflation over recent years, end-user profits were severely impacted and the experience served to remind them of their massive financial exposures to raw materials and energy markets. Some of these raw materials have well-developed derivatives markets like oil, electricity or aluminium. An opportunity to develop a sound tool to manage plastics price volatility arrived last year via the LME.

The LME’s North American, Asian and European regional futures contracts for LLDPE and PP celebrated their first anniversary on 25 June 2008. The futures contracts’ correlation with the physical regional markets is one of the Exchange’s biggest achievements so far. Acceptance has been far from universal to date. Nevertheless, the LME option appears to be the only rational and economically sound way of managing price risk in a sector suffering from increased levels of volatility.

Sebastian Castelli
LME Ringsider enewsletter
Autumn 2008