Off the Paper Roller Coaster
When it comes to predicting prices in the pulp and paper market, it seems as though we are lost in a maze, hoping for a magical crystal ball that predicts our future. The pulp and paper industry is indeed on of the most financially volatile businesses out there, but thanks to some financial strategies, paper specifiers no longer have to try to predict market fluctuations and run the risks associated with guessing incorrectly.
A volatile scenario
Since 1991, 40lb. No.5 stock prices rose and fell an average of eight times a year, varying between two and 13 percent with each fluctuation. It seemed impossible to predict these variances; we were simply at the mercy of the market. Now, there's a solution to the seemingly insurmountable problem having to be reactive, rather than proactive, in the face of market changes. Financial risk management strategies—also known as hedges—take a lot of the guesswork out of managing pulp and paper prices. While these strategies don't help paper makers and consumers predict price variances, they do neutralize the risk of price volatility. They are flexible, easily tailored to each customer's needs, and outline the agreement duration, how much product it covers and how large a price swing will kick the agreement into effect.
Types of solutions
There are several strategies for protecting your business during tumultuous paper market times:
Fixed-price swap: Swaps are privately negotiated financial contracts by which two parties agree to swap different price streams over a predetermined period of time. They protect against market price fluctuations by enabling
producers and consumers to lock in the price of raw materials and/or the final product. A paper producer that worries final product prices will drop too low may enter into a swap agreement that ensures it will be reimbursed by a bank-like third party if the price drops below a certain rate. Conversely, these agreements stipulate that if the prices should rise above the rate, the paper producer must reimburse the counter-party. Either way, the net effect is the same: The producer never winds up paying more or less than the price agreed upon. Production costs and profit margins are easily predicted and managed.
Fixed-price swaps aren't solutions exclusive to paper producers; paper buyers can initiate these types of agreements to protect them from market pressures, as well.
There are no fees or premiums assessed in a financial swap, and only money—never actual paper—changes hands between the two parties. Swaps convert a floating price to a fixed price, guaranteeing stability. After a period of time determined at the agreement's negotiation (typically between one and 10 years), the swap expires.
Caps and floors: Caps allow businesses know the maximum cost they'll pay for a product if the price rises, but it still allows them to benefit if there is a downward price movement. Floors allow businesses to protect themselves against drops in product prices, but also allows them to benefit from price increases.
Collars: Collars combine a price cap with a price floor, which reduces the cost of protection by establishing a range within which prices will fluctuate. For example, a price floor provides full protection against falling prices, while affording unlimited benefits should prices rise. Price collars are a price- effective alternative to a straight cap or floor.
The greatest benefit of these price management strategies is that companies can set firm budgets for the year, knowing that their expenditures will remain constant. They ensure stability in a market that can be anything but stable. It's important to note that these financial risk strategies work in tandem with, but independently from, paper supply chains. Publishers, for example, can retain their current suppliers and existing paper contracts while participating in these price-stablizing programs.
Risk management programs start with a contract. Reputable paper price risk counter-parties will review the details of the agreement with the participant. The pulp and paper industry relies on International Swap & Derivatives Association (ISDA) agreements, a standard contract used globally to manage multiple commodities, including interest rates, currency and oil. The ISDA governs the transaction, but precise transaction terms are negotiated separately and are formalized as addenda to the master agreement.
Market prices are determined by one of several third-party indices, including Pulp & Paper Week, Pulpex and Resource Information Systems (RISI). For example, Enron Industrial Markets uses RISI, along with other indices, to determine market prices when it is negotiating a price-management agreement. This market price represents the floating price that is swapped out of. The fixed, hedge prices are set based on global market information, supply and demand forces and cross-com-modity values. Once a party is involved in the hedge, financial contracts are settled monthly or quarterly, by whomever owes money to the other participant.
Financial price management strategies remove the speculative aspect of transacting in the pulp and paper industry. Producers and consumers retain the freedom and ability to make choices that will prove beneficial to their business. Each company determines how much paper expense risk it wants to eliminate and at what level a hedge makes economic sense.
The pulp and paper market will always fluctuate, but stability is no longer inconceivable. Take charge of your paper budgets and explore how hedging may make sense for you.
For more information on current market prices and price risk management strategies, visit www.clickpaper.com, or e-mail Wendy.King@ Enron.com.