Chemical companies can hedge to improve profit margins

By: Tom Langan

Hedging in the chemical industry has gotten a bad rap. But there are good reasons and ways to hedge to lock in profits in a volatile raw material environment.

To begin, it is important to distinguish between risk management and hedging. Risk management is a programme or policy whose purpose is to guard against or eliminate unacceptable market risks, such as higher costs, lower revenues and weak profit margins.

A well-designed and implemented risk management program adds quantitative and qualitative value to an organisation, particularly one whose profits are linked to volatile commodities such as petrochemicals.

Hedging is part of risk management, and – despite its negative reputation – can be highly beneficial to an organisation if hedges are executed within the approved boundaries and strategies of a good risk management policy.

This article discusses how to establish a good risk management policy and hedge to stabilise and increase profit margins, and outperform your unhedged competition.


HEDGING’S NUMEROUS BAD RAPS

Hedging has an undeserved bad reputation. Some reasons for this are:

1. Hedges are executed before a risk management policy is approved by key decision makers.

2. Hedges are analysed separately from the underlying physical position they were designed to protect. As a result, hedges are seen as speculative and adding risk.

3. A hedge is one-sided. For example, locking in the purchase price of a feedstock before locking in the sale price of the product the feedstock produces. Such a hedge only applies to one side of the profit equation and the longer the time between the fixed price purchase and the fixed price sale, the higher the market risk – in this case, the risk to margin. The margin risk increases because profit changes from the difference between two floating prices to the difference between a fixed and floating price.

4. The hedger hesitates when a good purchase or sale opportunity arises and decides to wait for more favourable prices. Given the volatility in commodity prices, the market often reverses direction and prices move against the hedger. This sometimes leads to “panic hedging”, leaving a sour taste for hedging despite indecisiveness creating the situation.

5. The hedger does not understand or use options alongside or as an alternative to futures and swaps. Options limit risk for a limited cost, and they provide several hedging choices for less cost and risk than swaps and futures. Given their limited risk and cost, they are also very helpful in overcoming the indecisiveness in #4 above.


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FEAR OF HEDGING

“Chemical producers want to capture all the upside profit of low natural gas costs. In a bullish market – with low gas costs and high chemical/polymer prices – they don’t want anything to hinder performance versus their peers,” said Joseph Chang, global editor of ICIS Chemical Business. “Fear of underperformance regarding hedging is something the CEO of a chemical producer mentioned years ago in an investor presentation.”

This reason for not hedging is related to bad rap #3 above. Chemical producers are wary of locking in the cost of a feedstock (eg, ethane) and allowing the revenue side (eg, ethylene) to float with the market.

As bad rap #3 points out, such a hedge, though well-intentioned, increases margin risk and can backfire in a volatile market. But the problem is not hedging – it is the one-sidedness of the hedge.


GOOD REASONS NOT TO HEDGE

There are good reasons not to hedge, but they do not include the reason given above.

They are:

1. A producer can easily pass through higher commodities costs to customers. Customers have few supply alternatives.

2. A producer’s margin is so wide that it can absorb higher costs or lower revenues for however long it takes for the market to turn around.

If those circumstances apply to you, congratulations! For others, there are many good reasons to hedge.


GOOD REASONS TO HEDGE

Ask risk managers the purpose of hedging and responses vary depending on risks and objectives: cost control, budget and forecast certainty, reduced volatility, smoother earnings streams, job and business security, competitive advantage, customer loyalty, etc.

All good reasons, but I contend the primary reason to hedge should be to help meet or beat profit margin expectations.

Producers need to turn a profit reliably, and investors want them to exceed profit expectations. That means the producer should manage risk on both sides of the profit equation.

Cost hedges should mirror how revenues are generated – that is, costs should be locked in against fixed priced sales, and costs should be limited against floating price sales.

As discussed in bad rap #3, locking in costs (hedging with futures or swaps) against floating price sales or floating costs against fixed priced sales increases margin risk. That has led some chemical producers to avoid hedging altogether. Mistake!


RELYING ON THE MARKET

The market does not owe you a profit and certainly not a consistently high one. The un-hedged chemical producer risks low profit margins due to high raw materials costs that may not be recoverable for various reasons in the sales price of its products.

Sometimes taking this risk pays off – other times it does not, with negative consequences. In either case, the un-hedged producer is dependent on the market and, therefore, betting (speculating) on profit margins. Ironically, some producers think hedging is speculation (bad rap #2).

Many companies are investing heavily in facilities to use shale gas-based ethane and propane to produce ethylene and propylene. Are they all relying on the market to reward them with profit margins that justify such massive expenditures?


BENEFITS OF MANAGING MARGIN RISK

The benefits of wisely managing profit margin risk (balanced hedging) are many, but most important are meeting or beating profit expectations and outperforming competitors.

Managing margin enables producers to spend more time and energy on improving operations and increasing sales, and less time worrying about the bottom line. Being proactive about profit margins by balanced hedging of forward sales and purchases puts the producer in control of margins rather than the market, reducing risk and capturing profits at the same time.

Balanced hedging of feedstocks and products helps producers meet or beat profit expectations, outperform the competition, reduce risk, and free resources to improve operations and increase sales.

HOW TO HEDGE

Anyone can hedge – not everyone can manage risk. To best manage risk and avoid unnecessary hedging mistakes (like bad raps #1-5), take these pre-hedging steps:


SPECIFY OBJECTIVES

These are strategic and bottom-line objectives, such as:

1. Meet or beat budget or other profit margin expectations

2. Reduce or eliminate price risk in purchases and sales

3. Secure and increase revenues


IDENTIFY RISKS

1. Identify market risks that could hinder or prevent achieving the objectives

2. Identify and prioritise ways to ­manage risks. This means identifying hedging instruments strategies, markets (futures and over-the-counter), and creditworthy counter-parties


ESTABLISH HEDGING RULES

The Rules specify what to hedge, how far forward to hedge, approved and prioritised hedging instruments and strategies, procedures and authorisations, when hedges may be closed, reporting requirements, etc. Rules should be clear and concise, and approved by upper management.

The Rules are rules, not guidelines. They must be followed and should only be changed as agreed and approved by the same managers who approved them in the first place.


WRITE A RISK MANAGEMENT POLICY

This step is critical but is often overlooked or bypassed. The Risk Management Policy (RMP) makes the Rules official. Depending on the risks to be managed and the extent they will be managed, the RMP may only consist of a few pages, but it ensures successful implementation of risk management and, therefore, hedging activities.

The RMP should have chief financial officer (or equivalent) signature approval before any hedges are executed.


IMPLEMENT THE RMP

Designate a qualified and trustworthy person as Risk Manager. The Risk Manager’s responsibility is to implement the RMP. This is where hedging is done!


USE OPTIONS

Understand and use these effective, limited-cost hedging tools. Options open up a wide range of hedging transactions to match market expectations and reduce risk. Without options, hedging transactions are limited to buy or sell, now or later – i.e. futures and swaps only.

Options also provide leverage with little capital and risk. For example, the purchase of a near-the-money option requires much less funding than an outright purchase of a commodity, and the premium paid for the option is the only capital at risk for the buyer.


PETROCHEMICAL OPTIONS

Currently, options in petrochemicals must be transacted in the over-the-counter (OTC) market. Options in crude oil and natural gas, the source and source-to-be for petrochemicals, are available and heavily traded in the futures market.

Tom Langan is a commodities risk management consultant at Oahu Capital Group (Asia) Pte. Ltd.


HEDGING ETHANE, ETHYLENE, POLYMERS AND OTHER COMMODITIES

The decision to hedge or not is an ongoing issue that corporations struggle with. Many believe they are charging as much as the market will bear for their finished product, and that coupled with making their operating expenses as lean as possible, is more than enough in terms of managing profit margins.

However, an often overlooked segment of a corporation’s profit margin is the financial risk from volatile commodity prices. These include the price of natural gas for BTU generation, the prices of ethane and ethylene for a chemical producer, the prices of polymers as they relate to packaging costs, and the price of diesel fuel as it relates to fuel surcharges that most everyone in the supply chain is exposed to.

All these risks can be controlled (eliminated or reduced) by using liquid and efficient markets that help transfer those risks from the producer/consumer to the marketplace.

We work with clients to help them understand their risks to commodity price movements, and then construct hedges to reduce those risks. While the decision to hedge or not is at times a struggle, Cargill believes in two key principles:

■ A properly constructed hedge will always reduce risk, and;

■ Market movements are unpredictable, and choosing not to hedge is choosing higher risk.


HEDGING INDECISIVENESS

Consider the chart on petrochemical and crude oil prices. Businesses that were not hedged over the past few months, and had exposure to higher PP and PE prices, did not foresee the recent rise in price levels, which was caused by an extraordinary amount of feedstock supply issues and cracker outages in the marketplace.

The most recent price spike caused a material negative impact on many bottom lines, and has compressed profit margins for those who were not hedged.

The graph is a stark reminder of the volatility in commodity prices. Yet we have found that for those exposed to such volatility, the greatest challenge is execution when hedging opportunities arise.

After prices have decreased, buyers often wait for still lower prices, only to be disappointed when the market reverses and heads back up. After prices have increased, sellers often wait for still higher prices, only to be disappointed when the market reverses and heads back down.

Such indecisiveness when opportunities arise lead to panic hedging when the market reverses. Panic hedging leads to more costly results and hard feelings toward hedging itself (bad rap #4).

Whether you are a producer, processor or consumer, our advice is to minimise opinions on market direction, and dispassionately and actively hedge profit margins consistent with your objectives and risk management policy.


CLOSING THOUGHT

Chemical producers that are spending billions of dollars to process shale gas-based feedstocks should not wait years to realise possible high profit margins when new facilities are completed.

Rather, chemical producers can manage to capitalise today on the ­expectation of those high margins through forward market transactions, capturing profits and protecting against the possibility of ­margins eroding before new facilities come on line.


About the author: Tom Langan is Risk Manager - Refining & Petro Chemicals for Oahu Capital Group (Asia) Pte. Ltd. Tom has over 20 years of experience in commodity, options trading and risk management. He has developed and implemented risk management programs for electricity, natural gas utilities, oil companies and plastics processors.

 

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