Reducing the Volatility

“If I could only count on getting X number of dollars for my recovered fiber, then our company could . . .” is the lament of many in the scrap paper business. Commodity prices for OCC, ONP, SOP and other grades have recovered strongly over the last year but are whipsawed daily as regional and international forces of demand and supply affect the market.

In fact compared to market pulp, typically regarded as the most volatile of all products produced by the pulp and paper industry, recovered grades are the true grand-daddies of price instability. Typically prices for these grades change at least 40% year over the year.

For anyone running a business depending on recovered fiber prices, this extreme price volatility can make life either a feast or famine situation.

Consider the fate of a large company processing more than 300,000 tons of OCC yearly. While prices for OCC averaged nearly $130 per ton in 1995, they peaked at over $200/ton early in the year and fell below $40 per ton by year’s end. Since then, prices have averaged between $50 and $75 per ton, with price spikes over $110 per ton occurring in 1997 and 2000. Considering this dynamic, cash flow attributed to the sale of OCC can vary from $12 million to more than $40 million on an annualized basis.

Until recently, the only way to manage through these changeable price circumstances was to ensure you held enough idle cash made in good markets to tide the business through difficult markets (or alternatively had an accommodating lender).

What may not be recognized by those in the recovered fiber business is that this type of price volatility is also typical for many commodities like metals, agricultural products, natural gas, and electricity. For this very reason financial instruments, called derivatives, were created in the early 1980’s to provide predictable pricing for both buyers and sellers. Today the value of derivatives traded worldwide through financial markets for all types of underlying products exceeds $60 trillion, far overshadowing the value of stock market transactions by a factor of 10.

By engaging in longer-term financial sales of recovered fiber using a financial derivative structure called a “cash-settled swap,” our example collector above can turn scrap paper into a revenue source with a predictable cash flow for one to several years, thereby avoiding the fluctuations of the spot market. A swap structure is defined by the specific grade, a time duration (one, two or more years), a monthly volume, a firm price and a price index. The price index serves as the benchmark against which cash changes hands monthly or quarterly between the buyer and seller of the swap, offsetting price volatility in the underlying markets.

A Typical Hedging Example

For our collector above generating 25,000 tons per month, hedging 5,000 tons per month at a price of, say $100 per ton, for three years guarantees a cash flow of $500,000 for every month of the three year period. This hedge requires the swap seller (our collector above) and buyer (perhaps a paper mill) to exchange only cash–no OCC deliveries occur.

Thereafter if the current month’s market price is, say $75 per ton (as measured by the index chosen for the swap), then our collector receives $25 per ton from the swap buyer, in effect “topping up with cash” the $75 per ton he gets from his OCC sales to his usual customers. Alternatively if the monthly price is over $100 per ton then a cash payment flows to the swap buyer.

The net effect is that both swap seller and buyer get a fixed price for the duration of the swap, regardless of where the current spot market is. Hence, both parties can run their businesses counting on a cash flow based on a hedged price.

Importantly, derivatives do not interfere with the existing relationship between a recovered fiber buyer and a seller; rather, they are a separate transaction typically involving a new counterpart.

Financial intermediaries, (brokers, banks and market makers familiar with these commodities) offer services to price, structure, and transact commodity-based derivatives.

The growth of derivatives for fiber and finished products of the pulp and paper industry has been rapid since their inception only a few years ago. Growth is expected to be robust as more companies now understand these tools and the benefits of managing their exposure to price risk.

Are Fluctuating Prices an Unnecessary Evil?

Of course, in an ideal world stable prices are preferred, with only one important qualification, all things being equal. Prices constitute the important signal system in a market economy. Can resource allocation in an economy be carried out with stable prices? The experience of the planned Soviet economy tells it cannot. In a market economy we have to accept that price moves are a fact of life.

Financial derivatives are a prudent mechanism to manage price, consequently allowing buyers and sellers alike to make better decisions for their businesses, manage their risks more effectively, and ideally resulting in a competitive advantage flowing to those who learn to use them most effectively. RT

Gary Helik is director of the North America pulp and paper division and Jeff Mehan is director of the pulp and paper division at Tradition Financial Services, Stamford, Conn. They can be reached at (203) 351-9557 or pulppaper@tfsbrokers.com .