Summary
The economics of PVC have always been complicated; much more complicated than polyolefins. Several years ago as China undertook a rapid expansion in the PVC capacity, they introduced a very old concept which has further complicated the market.
Analysis
The Dalian Exchange in China will begin hosting a PVC futures contract (http://www.dce.com.cn/portal/servlet/ServletGate?op=forward&cur_page=DCEPage&target=en_infodetail2&dc=About+us&column=ROOT%3E%B7%C7%D2%B5%CE%F1%3E%CD%F8%D5%BE%3E%D3%A2%CE%C4%3EAbout+us%3EDCE+News&infoid=1240389372100&infotype=CMS.PHOTO_NEWS) on May 25th (http://in.reuters.com/article/oilRpt/idINPEK14898620090515). Shanghai Chlor-Alkali, the largest PVC producer in China, has announced that they will participate in the market, hedging 70% of their spot volume. China has become the largest market for PVC in the world – the largest producer and the largest buyer. Why is the futures contract needed and will it “work?”
The economics of PVC have always been complicated; much more complicated than polyolefins. Generally, PVC is produced from ethylene and chlorine. On the surface, while they are roughly in equal volume in the compound, the cost of ethylene in PVC is about 3.5 time the cost of chlorine. So, ethylene is the price driver, right? Well, this doesn’t account for the coproduct caustic soda produced with the chlorine, which has been the profitable side of the pair for the past several years. In fact, right now, integrated PVC producers can sell the plastic at a loss and still show a profit due to the coproduct caustic soda produced. Complicated!
Several years ago as China undertook a rapid expansion in the PVC capacity, they introduced a very old concept which has further complicated the market. VCM, the precursor to PVC, was first produced about 120 years ago from acetylene and HCl (hydrochloric acid). Acetylene can be produced from calcium carbide, essentially coal. The process lost out to the ethylene route due to its high cost of power required. In modern times, the acetylene route has been discouraged because of the mercury catalyst used in the process and other environmental reasons. But China has lots of coal to make very cheap electricity and lots of coke building up in the stacks to make acetylene.
Following the acetylene route to VCM eliminates the need for ethylene and the sensitivity of PVC costs to naphtha (to produce ethylene) and oil prices. In addition, the acetylene based VCM plants could be established in the interior of the country near coal (where industry is sorely needed), far from ethylene crackers or ports where ethylene is imported, and nowhere near chlorine production. Chlorine is very difficult and risky to move, HCl is easy. The plants could be relatively small, sized to serve the nearby market, and cheap. The PVC product is of slightly lower quality than that produced by the ethylene route, but the cost is about $200 per ton lower, based on the cost of carbide. This is quite a cost advantage as PVC is currently trading at $740 per ton, CFR, China. As a result of these tradeoffs, now 65% of China’s PVC capacity is acetylene-based.
Shanghai Chlor-Alkali does not use the acetylene route. They are the largest exporter of PVC in China, so they are sensitive to price shifts and sensitive to the spot market. Their spot volume of PVC is clearly a natural long position. The assertion in the article is that they will hedge 70% of their spot PVC volume suggests that they perceive a very high value at risk.
So, just how would you hedge PVC? Globally, ethylene is the driving cost factor. So oil contracts to capture the changes in naphtha? Not all ethylene is produced from naphtha, actually, it may be right around half of the feedstock used. Much of the rest is closer to ethane – so natural gas contracts to reflect changes in ethane? Both oil and gas futures prove to be miserable hedges for PVC. Besides, this leaves you with a naked position relative to acetylene-based PVC. Consequently, the PVC futures contract seems to be a good idea. Will it be successful?
The number 1 reason for the development of a futures contract is to make money for the exchange. Aside from this, a futures contract may be deemed successful if it is liquid. Liquidity has two components in futures trading: First, the price changes in the market are reflected in price changes in the contracts, and, traders can readily buy or sell contracts whenever they’d like, at a fair market price. There have been many attempts at futures contract and derivatives for plastics. Middle Eastern exchanges are planning more, in fact, probably by year’s end. However, none have been successful, with the possible exception of the LME European polyethylene and polypropylene contracts which have demonstrated consistent liquidity. Why?
With a natural long position, Shanghai Chlor-alkali will hedge by taking the other side, a short position in the futures contract. Essentially, they will buy PVC in the futures contract market. From whom? The first thought would be large buyers of PVC. They would be motivated to hedge their short position by selling PVC in the futures market. Personal experience is that it is all but impossible to convince converters that they need to hedge, or that they have the resources to do so. The next thought on counterparties would be PVC traders. These contracts may have some value to them, but they are constantly buying and selling PVC, constantly on both sides of the transaction. Finally there are speculators. Speculators can become very active in these tertiary types of contract, especially in Asian markets. There are many very active contracts in products like natural rubber on the Tokyo Commodity Exchange, for example. Yet, futures contracts in ethylene on the Bursa Malaysia collapsed very quickly a few years ago.
Finally, the futures contract itself is further complicated because it is transacted in Yuan. Globally, PVC is traded in US dollars per ton, including imports to and exports from China. So the futures contract pricing will have to include real forex factors, as well as the polymer itself. This may restrict participation in the contracts to those understand or can hedge the Yuan/USD/home currency rates.
The new PVC futures contract on the Dalian Exchange would solve one of the trickiest hedging problems in the petrochemical business, if it is successful. And if hedging PVC is a problem. But, as China’s influence as a PVC importer wanes and as an exporter waxes, who would really benefit from an active futures contract in PVC, besides the exchange?
