Hedging may not yet be widely used in the P&P industry, but a growing number of companies are reaping the benefits of risk management tools
By Tom Bruce-Jones
Deriving value from the future
In 1997, the pulp and paper industry was revolutionized with the introduction of price risk management mechanisms, allowing the sector to hedge its exposure to the volatility and unpredictability of its infamous cycles. The sector now has the chance to protect its revenue base and cash flow from the cyclicality and price volatility that has plagued the industry over the past few decades. The risk management company, Enron, was a pioneer in introducing these tools to pulp, paper and packaging companies. The company now has a global pulp and paper trading book with notional values of around $4 billion, equating to nine million tons across all the paper grades.
While the sector's shares have witnessed huge growth during the course of this year (mainly due to investor confidence in cyclical stocks), the question still remains whether companies are maximizing the shareholder returns that could be achieved. When looking at the sector, investors tend to adopt selective investment strategies as they are anxious to ensure satisfactory returns on equity. Price risk management tools are just one method of achieving these goals, but analysts are becoming increasingly strident in their arguments as to why companies should be more proactive in managing risk.
Prices can be quoted for any commodity, from raw materials through to finished goods, which are published in a transparent and industry accepted index (for example, PPI, Risi, Euwid, PIX, etc). There are three basic types of contract, which can be used individually or in conjunction with each other - fixed price swaps, floor contracts and cap contracts.
Swaps are privately negotiated financial contracts in which two parties agree to exchange, or swap, different price streams over a predetermined period of time. Swaps allow for strategies designed to protect against market price fluctuations, giving producers and consumers the ability to manage margins, control variable costs and proactively offer customized pricing to customers. These contracts enable producers and consumers to lock in the price of raw materials and/or final products. Used in concert with a physical contract, swaps effectively alter the price structure of the contract, converting it from a floating price to a fixed price. In short, the settlement is financial and physical products are not exchanged. For each month of the transaction's timeframe, the difference between the two prices is determined and payment is made to the appropriate party.
In the pulp and paper sector, swaps can be used to protect a paper producer from rising NBSK (northern bleached softwood kraft) prices. For example, a large woodfree producer, may be worried that the current increase in pulp prices will be difficult to pass on to its customer base in view of the tough market conditions in A4 copier grades. This situation makes it impossible for the producer to maintain its margins. In order to hold on to its margins and gain competitive advantage, the company decides to enter into a two-year price swap agreement. The swap effectively fixes the price of NBSK at $570/ton on a monthly volume of 1,000 tons, using for example the PIX index (see figure).
During the life of the swap, the producer continues to purchase NBSK from suppliers of its choice at floating market prices (ie using a price index). At the same time, the woodfree producer and a risk management company exchange payments on a monthly basis equal to the difference between the fixed swap price of $570/ton and the index price for NBSK. For example, if the index price for NBSK is $600/ton in a given month, the paper company will receive $30/ton. However, if the index price is $550/ton, the producer will owe $20/ton to the risk management company. The net effect of combining the swap cash flows with actual purchases of NBSK is a fixed price of $570/ton.
Swap transactions can also be used to protect the margin between rising raw material prices and stable finished goods prices. For example, a non-integrated producer of lightweight coated paper (LWC) is interested in managing the margin between NBSK pulp and LWC over the next three years. The company is concerned that NBSK prices will continue to rise in the foreseeable future and squeeze margins to the point of jeopardizing the company's annual profit plan. To reduce this threat, the producer enters into a swap with a risk management company which locks in the spread between NBSK pulp and LWC at Euro 300/ton on 1,000 tons per month of LWC.
During the life of the swap, the LWC producer continues to purchase pulp from suppliers and sell paper to customers of its choice at floating market prices. At the same time, the producer and the risk management company exchange payments on a monthly basis equal to the difference between the fixed spread of Euro 300/ton and the prevailing floating price spread. For example, if the floating spread is Euro 200/ton in a given month, the LWC producer will receive Euro 100/ton on 1,000 tons per month. However, if the floating spread is Euro 400/ton, the company will owe Euro 100/ton to the risk management company. The net combination of the swap cash flow and cash flows related to physical purchases of pulp and sales of LWC is a fixed margin of Euro 300/ton.
Pulp and paper producers also have the opportunity to use floor contracts to protect themselves against potential downward movement in the markets. For example, a BHKP (bleached hardwood kraft pulp) producer may anticipate that the recent price rise announcements will be accepted, but the company is concerned that the prices will come under sustained pressure from consumers and that mothballed capacity may be recommissioned over the next year. To protect itself against a sharp price reduction during the next 12 months, the producer buys a one-year BHKP price floor to cover 80,000 tons. The floor price is set at Euro 475/ton and costs Euro 10/ton. The total premium payable by the pulp company is Euro 800,000 (80,000 tons x Euro 10/ton).
For each month, during the life of the floor contract, the producer continues to sell BHKP to its market customers at prevailing market (floating) prices. The risk management company receives an upfront Euro 10/ton premium from the producer for the Euro 475/ton price floor valid for the one-year period. If the floating price for BHKP is greater than the Euro 475/ton floor price, there is no financial transaction. The effective price that the producer receives for its BHKP is the floating market price, minus the premium. If the floating price drops below the Euro 475/ton floor price, to Euro 460/ton for example, the producer will receive the Euro 15 difference from the risk management company. In this instance, the pulp company's effective price for BHKP is Euro 465/ton - the Euro 475/ton floor price less the Euro 10 premium for the first month. In short, the price floor has established a minimum price of Euro 465/ton with full upside potential at a known cost of Euro 10/ton.
Another type of contract that a paper or pulp company can use to protect itself against upward market movements is the cap contract. For example, a large woodfree producer may want to develop business with a customer that has difficulty passing on price increases due to the tough competition in the markets. In order to protect itself from rising NBSK prices, the company purchases a three-year cap on NBSK at $600/ton for 2,000 tons per month at a cost of $15/ton. As with the previous types of contract, the producer continues to buy NBSK from its regular suppliers at market prices. The risk management company receives an up-front payment of $15/ton for the $600 price cap. If the market price for NBSK moves above $600 in any given month during the contract, the risk management company will pay the difference to the paper producer. If prices fall below $600, the paper company enjoys the lower market prices for its raw material. For a known cost, the producer has ensured that it will not have to pay over $600 for its NBSK.
Speculation or value creation?
The risk management tools outlined above are not speculative tools and companies are not jeopardizing their strategic positioning within their particular sector by using them. In fact, by not entering into these types of mechanisms, companies are automatically assuming a speculative viewpoint, gambling on the direction of future price movements. The rationale should be that these tools allow companies, both producers and consumers, to dampen or even remove their exposure to such business risks.
Producers and consumers are increasingly keen to enter into long term physical contracts, for example over three years. As soon as there is any movement in either direction in market prices, these contracts invariably become null and void as one party attempts to drive prices higher or lower. Risk management specialists can provide long term financial contracts which guarantee pulp and paper companies that prices are locked in over the term of the contract.
There is also a widely held notion that the introduction of risk management is a threat to jobs. The argument runs that fixed prices for a proportion of tonnage will render the seller/buyer's job useless and superfluous to an organization's requirements. This could not be further from the truth - the more aggressive and proactive the seller is to secure prices above the published index, the higher the net price per ton, allied with a hedge transaction. And vice versa for the buyer. As a result, financial instruments should be seen as an enhancement of collective and individual responsibility and place greater influence on these respective positions.
Entering into risk management contracts is the joint responsibility of senior management, in liaison with the purchasing or selling departments. Understanding these products and their implications to the company should be the responsibility of each level in the decision-making process. Abdicating this responsibility to lower levels of management creates fear and mistrust if the mechanisms are misunderstood.
A common misconception is that these type of contracts are physical supply agreements. They are in fact financial contracts. The risk management company does not supply physical products, nor does it affect existing buyer/seller relationships. The risk management company does not need to be aware of the actual selling or buying prices that pulp and paper companies have negotiated, nor does it need to know their customer or supplier base. These hedging instruments simply overlay the existing day-to-day business of companies.
The contracts are underwritten by the International Swap and Derivative Association (ISDA) master agreement and are negotiated between two parties. They are confidential and not transparent to the market. There are no fees or commissions payable to enter into a contract with a risk management market-maker, nor are there any hidden costs. The only instance where money is payable is if the counterparty wishes to implement a cap or a floor, as described above.
The timeframe of the contract and the number of tons a company wishes to commit to is entirely at its discretion. Price risk management is not an all or nothing proposition. Some companies may wish to hedge between 5-10%, while others prefer to commit upward of 50% of their exposure. The size and scope of the Enron trading book clearly suggests that pulp and paper companies are recognizing the value of these mechanisms and that risk management will be increasingly utilized to generate investor confidence and bring stability to cash flows. These tools may not suit the needs of every company, but can the majority afford to ignore these innovative mechanisms and risk their competitive advantage?
Tom Bruce-Jones is the manager of Enron's Pulp, Paper and Packaging group in Europe