Dubai hopes to outshine LME with plastics futures

 

Plastics traders and consumers are hoping the launch of a new plastics futures contract in Dubai will offer a useful hedging tool and greater price transparency, ensuring success where London's LME has so far failed.


Soaring prices and recent high volatility have prepared the ground well for an exchange-traded pricing mechanism in the Gulf, which has half of the world's petrochemical projects.

Large plastics producers who are integrated into the oil and gas industry may be slow to adopt the new contract, but dealers say smaller players, more exposed to volatility, will be keen to use the Dubai Gold and Commodities Exchange's (DGCX) contracts.

"Integrated plastics producers who don't buy oil from the open market are less concerned about the effect of feedstock prices on their margins, and they think hedging can restrict profits," one industry executive said.

"But those who are not in the active Middle Eastern and Asian regions, and are desperate for margin stability, especially in this extremely volatile market, will want to use the DGCX contracts."

Plastics come from oil products naphtha and ethylene but cannot be hedged properly on oil futures exchanges as these markets do not always move in the same way.


The bourse hopes to launch four contracts next month in low-density polyethylene, high-density polyethylene, linear low-density polyethylene, and polypropylene.

For each grade, there will be three regional contracts: Northeast Asia, Southeast Asia and the Middle East.


NICHE

"The exchange is fulfilling an important niche that will represent the very large increase in local capacity in the Asian and the Middle East regional physical markets," said David Paul, Barclays Capital's global head of petrochemicals and plastics.

"Hence they are going to operate in an area trading a large number of transactions representing physical liquidity. This all bodes well for the future of the contracts."

Trading in polypropylene and linear low-density polyethylene futures on the London Metal Exchange (LME) started in May, 2005, but volume has been low so far. One difficulty those contracts have faced is "basis risk": differences between LME prices and prices in the underlying market at futures monthly settlement.

The model adopted by the LME relies on the assumption that -- whatever the differences between prices on forward futures contracts and the physical markets -- prices will converge when the contract expires, allowing traders the possibility of delivering physical lots of plastic to cover futures positions.

However regional differences between the prices of plastics has sometimes eroded the correlation between the LME price and underlying market, preventing full convergence and hampering delivery of physical plastic when the futures contracts expire.

But DGCX says it has avoided this problem by developing different regional contracts so that futures prices can reflect the regional price differences in the physical market.

"DGCX has learned a lot from the experience of LME and has been spending time with traders, producers, and converters, so they have made the contracts more reflective of the market needs," Paul said.

The petrochemicals market in the Middle East is expected to increase capacity by 2012 to 29 million tonnes from 12 million, the Gulf Petrochemicals and Chemicals Association says.

FLEXIBILITY

As the new capacity comes on stream, analysts say oversupply will force prices lower, squeezing margins for producers.

"Hence producers may consider using the exchange to protect themselves from the prices falling by hedging forward (selling forward production at today's attractive prices and then delivering into the DGCX warehouse in the future)," Paul said.

Traders said Dubai's contracts should give packagers, processors and converters in the three regions, who previously based contracts on opaque prices in specialist publications, more flexibility to trade in and out of positions.

"DGCX contracts are different and that differentiates itself from LME ... (they are) ingenious and specific to each region," said Pradeep Unni, assistant vice president of Vision Commodities Services DMCC.

"Financial markets, investors and broking industry in the Middle East at large are quite optimistic about the contracts ... and if the futures price quotes are consistent with the prevailing market quotes, then there would be greater interests from markets," Unni added.

Analysts and traders said the plastics futures market was likely to take time to build liquidity.

"Just like the launch of any other product, the exchange will see volumes building up slowly, but once there is enough liquidity the industry's players may start trading the contracts," said Joe Dewhurst, global Chemicals analyst at UBS. (Reuters)
 
 
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