MANAGEMENT

Despite a perception of complexity, the process for creating an OTC price hedging program is well established, with many pieces already in place

Paper Company Hedging Programs Uncomplicated to Design, Implement

By David W. Cox

Price volatility in pulp and paper markets can wreak havoc on the financial performance of producers and their customers. Both groups have tried to “hedge” their exposure to volatility through several strategies (e.g., vertical integration, long-term contracts, etc.). Pulp or paper product-based financial derivative markets offer companies—both producers and purchasers—the opportunity to hedge their exposure (Pulp & Paper, March 1998, p. 59).

In financial terms, hedging means entering into business activities that tend to have risk exposures opposite to those that a firm faces in its normal course of business. As a result, the firm’s net exposure is reduced. For example, manufacturing firms are exposed to the risk that their normal operating income might be interrupted in the event of a fire. To hedge this risk, companies purchase fire insurance, anticipating that income from the insurance policy will offset such interruptions. As a result of purchasing insurance, the net exposure of the firm to lost revenue is reduced.

Similarly, pulp and paper producers (and their customers) can purchase derivative products—the equivalent of price insurance—allowing the companies to obtain a predetermined and/or fixed price for a product over a contractually specified period of time. This type of price hedging is used extensively to manage price risks in other price-sensitive commodities. And since price-hedging contracts are typically settled with a bank-like counterparty for cash (rather than through a transfer of product), the contracts can be entered into and managed well away from the existing producer-customer relationships.

This approach allows producers to “lock in” a specific level of profit by financially converting a portion of their production into an annuity. Alternatively, firms can selectively eliminate their exposure to certain types of price risk (e.g., pulp cost) or lock in a specific difference between inputs and products (e.g., the price difference between pulp and LWC, or between OCC and 42-lb kraft linerboard).

ENTERING THE OTC MARKET. Hedging strategies can use either standardized forward or option contracts, which are traded through an organized exchange, or custom-designed “over-the-counter” (OTC) contracts. Before entering the OTC derivatives market, a firm must develop a program for pricing and executing (i.e., entering into) contracts, as well as managing its portfolio of OTC contracts (Figure 1).

Several components need to be considered in designing long-term, fixed-price contracts, including price, volume, and term. Mutual credit provisions must also be established, as should corporate policies that govern contract execution and administration. An International Swap & Derivatives Association (ISDA) agreement with one or more counterparties must be negotiated, and a transaction closing and ongoing hedge program administration plan must be developed.

Finally, some general corporate housekeeping, such as amending corporate bylaws, may be required. While completing these elements might seem to be a daunting, time-consuming task, most companies find that the bulk of the work is already in place, supporting other business activities.

ISDA AGREEMENTS. The standard ISDA contract is identical to the contract currently used by corporate treasuries to manage currency and interest rate hedges (with the firm’s banks acting as the counterparty). Because these agreements use a standard format, very little time is required to create a “Master Agreement,” which is required to support product-based derivative trading. A separate agreement must be reached with each prospective counterparty that a firm intends to trade with.

For companies that do not have experience with ISDA contracts, a local commercial banker can be a good information resource prior to negotiating a Master Agreement. The banker can help explain the agreement, as well as help identify the types of loan covenants which may be affected by the agreement. The commercial banker can also help identify legal counsel that has experience with such agreements, as well as knowledge of any necessary corporate housekeeping.

A Master ISDA Agreement is not an agreement to trade. Rather, it is simply the set of guidelines—a framework—that will govern future transactions with a particular counterparty. A critical element (“Annex”) in the ISDA agreement is the Credit Support Annex. Credit thresholds and posting provisions are outlined in the Annex. It specifically describes the allowable credit limits of each of the agreement’s parties for all transactions executed under the Master agreement.

With the Master ISDA Agreement in place, trade transactions can be executed. The confirmation of transactions—which specify the product (e.g., newsprint, pulp, linerboard), the settlement index (Pulp & Paper Week, RISI, Pulpex, etc.), the price, the duration of the transaction, and the settlement frequency (e.g., monthly, quarterly, etc.)—become addenda to the Master agreement.

DETERMINING A FINANCIAL SETTLEMENT METHOD. The terms of the “Financial Settlement Method” describe how the buyer and the seller of an OTC agreement pay (“settle with”) one another over the life of the transaction. Several issues must be resolved to adequately describe the method.

Identifying a published price index. Most transactions are settled quarterly, based on a published price index. The most common indices for settling pulp, packaging, or paper financial derivative contracts are Pulp & Paper Week or RISI (Resource Information Systems Inc.). For example, in RISI’s Paper Trader, Table 21 is used to indicate the average transaction or market price for newsprint. RISI historical data is available on disk for the pulp, packaging, and paper market dating back to 1980. Typically, when a relevant published price index is later revised, adjustments are made retroactively.

Understanding basis risk. Basis risk is the difference between the actual transaction price for a commodity (e.g., newsprint) and the relevant published index price (Figure 2). Since index prices are “averages” comprising both discount and premium transactions, such differences are common in paper markets.

Before entering into hedge transactions, firms need to analyze the historical relationship between the proposed settlement index prices and the firm’s actual average transaction (purchase of sale) prices. Systematic differences should be considered in designing the hedging strategy.

Establishing credit thresholds. In the Credit Annex of an ISDA agreement, the trading parties provide one another with a specific amount of “threshold credit.” If either party exceeds their established credit limit, that party will be required to post collateral (normally a standby letter of credit) to increase their credit position. In some cases, counterparties are required to post collateral at the beginning of a transaction due to their low credit rating. Credit requirements for specific transactions are based on the price, volume, and term of the transaction and historical price volatility.

Price monitoring. Once an ISDA agreement has been executed, firms should establish a systematic hedging program that meets specific objectives. The plan should identify price levels, volumes, and terms of future hedging transactions. By following a well-defined system, the firm can measure quantitatively the effectiveness of its strategy, as well as the likely costs and benefits on changes to the strategy.

David W. Cox is a vice president at Enron Capital & Trade Resource Corp., Houston, Texas, and author of the book Risk Management for the Pulp and Paper Industry.