Barefoot In The Ring: Plastics Futures

When the London Metal Exchange [LME] launched it first two plastic futures contracts on May 27, 2005, it was, at last, possible to trade "barefoot" (plastics with no additives) in the ring (on the LME).

You could have traded plastics futures in China back in the 1990s, but you would certainly have had to wear galoshes: Trading on the Chinese markets was eventually suspended "due to rampant speculation and irregularities."

Now, however, you can trade plastics futures not only on the LME, they are also traded on China's Dalian Commodity Exchange and India's National Commodity and Derivatives Exchange (NCDEX). The Dubai Gold & Commodities Exchange is, after some delay, expected soon to launch its own plastics futures contracts. And rumors still swirl of NYMEX's plans for a plastics contract.

Why futures in plastics? In the words of the LME, plastic futures contracts "enable the plastic industry to hedge against volatility in plastics prices."

The Plastics Industry

Plastics are everywhere. Consider, just for example, the food, packaging, medical, building and automotive industries: all are huge industries, all rely on plastics. The thermoplastics market is, consequently, itself, huge, worth in excess of $200 billion, on par with the market in nonferrous metals.

Of thermoplastics today, the primary demand is for polyolefins (polypropylene [PP] and polyethylene [PE - made up of LDPE, LLDPE and HDPE]).[1] Together these now account for some 62% of global commodity plastics consumption. And in case you are wondering what they are used for, polypropylene is used, for example, in bottles and bags, and polyethylene is used in anything from consumer packaging to car fenders, and from water tanks to crates.

FIG 1.

Source: CMAI

The major factors affecting the prices of these polymers are: the prices of the ethylene and propylene feedstock, crude oil prices and prices for naphtha and natural gas. In addition, prices are affected both by regional and global supply and demand and geopolitical factors.

The plastics production chain is, essentially, three-tiered.

Business	Material/Product	Pricing Frequency	Pricing Reference
Refineries and Producers (Integrated & Non-Integrated)	Crude Oil, Natural Gas, Naphtha & Ethane Ethylene and Propylene	Intra-day Weekly/Monthly	IPE, NYMEX and OTC ICIS & Platts
Converters/Fabricators	PP and PE	Weekly/Monthly	ICIS & Platts
End User	e.g., Automotive, Consumer Durables and Packaging	Model Years, Catalog Years and Annually	Competition and Intermediaries

Source: LME & NCDEX

In 2007, the world's largest polyolefin producers (in order of size) were: ExxonMobil (XOM), Dow (DOW), Basell (privately held Dutch company that is the world's largest producer of polypropylene and advanced polyolefins products) and INEOS (a large "tightly held" private chemicals company headquartered in the U.K.).

FIG 2.

Source: Borealis

Plastics Futures

When the LME first launched its two plastics futures contracts back in 2005 (one for PP, the other for linear low density polyethylene [LLDPE]), they were both global contracts, i.e., any material on warrant for the relevant product can be delivered in settlement of the futures commitment.

At that time, there was really no fully functioning spot market in these plastics. So, although trading got off to an enthusiastic start, interest in the contracts subsided over the following couple of years.

At the end of June last year, however, the LME launched three additional regional contracts - for Asia, Europe and North America - to better reflect "...the variations in the use and trade of plastics around the world." This is observable, not least, in the significant variations in volatility regionally.

FIG 3. Volatility In Yearly Average Polyolefins Prices (%)

Source: SGCIB Commodities

At the same time, the LME "launched the facility for ‘spot' trading."

Following these changes, it appears that the LME has quite successfully addressed both the global/regional and pricing issues.

Correlations for Asian prices on a weekly basis (while the LME prices daily, ICIS prices are weekly) are now both very robust and above 95% for both PP and LLDPE.

For European LLDPE, weekly price correlation, too, is both robust and near the 95% level. For European PP, however, weekly correlation is currently running around 70%.

Finally, weekly correlations for US prices have been 95% for both LLDPE and PP.[2]

At the end of April this year, the LME plans to make additional changes to the plastics contracts, aligning them further with existing models of their successful metals futures contracts. In addition to a change relating to actual physical delivery of the plastics (the move to a FOT [free on truck] basis), there will be some easing of requirements vis-à-vis branding and shelf life.

Investing In Plastics

For anyone with an interest in plastics futures, setting aside for the foreseeable future both the Indian and Chinese exchanges, the LME provides the most obvious platform.

While for many, the lack of a full year's price data for the new regional contracts may be a problem, on the basis of those that are available, the news is encouraging. I think it would be fair to assume that, once the year is up, and if the price correlations remain as strong as they have been, we will see a commensurate deepening of the market and increased liquidity. (We are already seeing OTC-type monthly average deals with the open interest registered on the exchange.)

Apart from providing the chance to diversify further into two different varieties of another commodity, the prices of both PP and LLDPE have risen significantly over the past nine months or so.

FIG 4. Price History For Cash Buyers Of North American Polypropylene

Source: LME

FIG 5. Price History for Cash Buyers of North American Polyethylene

Source: LME

With regional and global contracts, LME plastics futures can already offer arbitrage opportunities. According to the LME, following the contract changes to take place in April, its "members expect more clients to take advantage of the opportunities presented by price differentials between North America and Europe."

In addition, as noted in a recent edition of the LME's publication the ringsider, there has been interest both in naphtha to LLDPE spreads in Asia and Europe, and propane to PP spreads in the Americas. But, as the LME is also quick to point out, although "...it remains difficult to show correlations between naphtha and other feedstock prices and olefins...the LME data can be used to follow the differentials one step back up the feedstock chains."

As the market deepens, liquidity increases and usage becomes more accepted, possibilities may well arise either to hedge elements of the major chemical companies' exposures to polyolefins, or, indeed, to use plastics futures to achieve proxy exposure to these elements. Only time will tell.

Conclusions

The market in plastics futures is still young. As with any new market, it will take a while to develop. Of all such futures currently traded, those available on the LME are the most established.

Liquidity is a vitally important characteristic of any truly successful market, and currently the market lacks this element for success. Now that both the regional and spot pricing aspects have been resolved by the LME, a further year's worth of trading and a full year's worth of price data for the regional contracts should mark a milestone from which liquidity can develop further.

A successful launch of plastics futures in Dubai and, if or when it comes on the NYMEX, will demonstrate continuing confidence in the fundamental notion of plastics futures.

The road will most probably be a long one, but as Mr. McGuire so forcefully impressed upon Ben in The Graduate: "There's a great future in plastics. Think about it. Will you think about it?"