Financial Risk Management In Action

September 19, 2001

Financial Risk Management in Action An aromatics case study

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ommodity petrochemical companies may not be able to predict forward product pricing, but they can use tools like futures to reduce the impact of price fluctuations on bottom-line performance. Some leading companies—including Dow Chemical and Shell Chemicals—are already using financial derivatives to reduce risk and improve margins, but for others the first step is to see these powerful and complex tools in action. No doubt there is a learning curve associated with sophisticated products like futures, but the potential reward—improved margins and profits—is hard to ignore. The commodity petrochemical industry’s complex In the following case study, Clif Curproduction base—with many processes generating a rin of online chemical exchange number of products and by-products—makes it parCheMatch.com shows ticularly difficult for companies to match supply and how a mixed xylenes demand while also meeting price and profitability targets. manager at Aromatics Both Aromatics Chemical Company and Pete’s Chemical Company, a mixed xylenes business are subject to the unique fictional aromatics proconstraints of aromatics production and markets. It ducer subject to realtakes 2.2 gallons of toluene as feedstock to make world prices and marone gallon of mixed xylene and one gallon of benket dynamics, uses zene. While each of these chemicals have relationClif Currin futures to reduce the ships to each other, they also have their own supply and demand fundamentals. company’s financial risk from DecemLike others in this complex industry, Pete is both a ber 2000 to June 2001. The net results consumer and producer of petrochemicals. As such, are more stable margins, stronger profmarket fundamentals that may be beneficial to one its and improved shareholder value. of the chemicals he uses or produces may also have

Complex processes, complicated markets

Background

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Pete is the manager of the mixed xylene business for the Aromatics Chemical Company. The company operates a Mobil Selective Toluene DisProportionation (MSTDP) unit, which uses 100,000 barrels/month of toluene to produce mixed xylenes and benzene. During the first eleven months of 2000, the business environment was poor and the MSTDP operation did not fully recover cash costs. But early in December, the markets were looking better. Pete’s analysis of

a negative impact on other chemicals involved in his business. More specifically, Pete is a consumer of toluene, a high-octane component in gasoline that tracks the gasoline market. Toluene prices increase when gasoline demand is high and octane is in short supply. Pete is a producer of mixed xylene, which is used to make paraxylene, a raw material for polyester resins and fibers. These in turn are used to make beverage bottles, apparel, carpet, and many other common household products. Pete’s business also produces benzene, a coproduct of mixed xylene production, which is primarily used in the production of styrene. Styrene is used to make polystyrene, which ends up in packaging, housewares, furniture, appliance parts and electrical components. Benzene has many other uses as well, including cyclohexane for nylon production. Because each of these chemicals responds to its own supply and demand fundamentals, Pete is exposed to volatile margins. Unfortunately, this led to many sleepless nights for Pete.

Special Advertising Section Figure 1 the fundamental supply/demand projections indicated that mixed xylenes would be strong in the first six months of 2001. Even so, Pete was concerned about his inability to project profitability.

Historical Margin of Producing Xylene and Benzene from Toluene via MSTDP 0.40

0.30

The Risk

0.20 Variable Margin, $/gal of Xylene

In December, as Pete assessed the coming year, his margins looked to be about average, based on physical market prices and variable margins throughout 2000 (Figure 1). He expected 2001 to be a stronger year for mixed xylenes because inventories were low and demand for polyethylene terephthalate (PET) was growing despite the weakening economy. Although the toluene price was an unknown, Pete expected demand to increase with the beginning of the gasoline production season. Pete was concerned, however, about the outlook for one of his products. Benzene demand was falling and along with that, its price. His research suggested that demand in Asia/Pacific was slowing and both benzene and styrene inventories would rise. So despite good mixed xylene fundamentals, his margin was at risk. Pete was looking for a way to manage some of these unknowns and hedge his margin, not to mention get a better night’s sleep.

0.10

0.00

-0.10

-0.20

-0.30

Figure 2 Benzene and Gasoline Forward Curve

The Evaluation

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A CH EM IC AL WEEK ASSOCIATES Custom Publication September 19, 2001

1.50 1.40

1.40 1.35

1.30

1.36 1.33

1.33

1.30 1.26

Price, $/gal

1.20

CME/CheMatch Benzine Futures Strip on 12/5/00

1.10 1.00 0.90

Unleaded Gases Futures Strip on 12/5/00 0.83

0.80 0.76

0.77

0.78

Feb-01

Mar-01

0.82

0.81

0.80

May-01

Jun-01

Jul-01

0.70 0.60 Jan-01

Apr-01

Figure 3 Projected MSTDP Margin 0.40

0.30

0.20 Variable Margin, $/gal of Xylene

The first thing Pete did was look at the options available for getting some kind of certainty regarding his toluene costs In November, toluene was trading at $0.15/gal above unleaded gasoline, which was slightly lower than 1999’s average of $0.16/gal. To check his opportunities for forward pricing, Pete logged on to CheMatch.com and found an offer to sell 30,000 barrels/month of toluene at the price of unleaded gasoline plus $0.19/gal for 12 months, beginning January 2001. Although the $0.19/gal differential was expensive relative to the prior year, Pete thought he could work with that price if he could also lock in an attractive forward price for benzene or xylene. Pete then looked at the forward prices of the CME-Chematch Benzene futures contract, which was trading on Chicago Mercantile Exchange’s GLOBEX2 electronic matching engine. He accessed the information directly from CheMatch.com and compared that to future unleaded gasoline prices (Figure 2). As the chart shows, the markets believed benzene would weaken relative to unleaded gasoline. The spread in the nearby month, January, was $0.64/gal and gradually dropped in the other months to a more historic norm of $0.46/gal. This was in line with Pete’s opinion but he wondered whether locking in these prices would secure an acceptable margin. To accurately project a margin, he would also need a forward mixed xylene price, which he did not have. So Pete decided to run a scenario to see one possible outcome. First Pete calculated what his toluene price would be if he bought the $0.19/gal differential to unleaded gasoline and locked in his price based on the forward curve in Figure 2. He then used the CME-Chematch forward benzene strip for his benzene pricing. Finally, he assumed the mixed xylene price would remain at the current level. The results of Pete’s work are shown in Figure 3. The margin under this scenario looked good for the first four months of the year and better than average for the next two months. Pete knew, however, that he had made the assumption that mixed xylene pricing would remain constant. But since that was highly unlikely, he decided to examine that assumption.

Jan-00 Feb-00 Mar-00 Apr-00 May-00 Jun-00 Jul-00 Aug-00 Sep-00 Oct-00 Nov-00

0.10

0.00

-0.10

Historical Projected

-0.20

-0.30

Jan-00 Mar-00 May-00 Jul-00 Sep-00 Nov-00 Jan-01 Mar-01

May-01

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Special Advertising Section Figure 4

Aromatics Dynamics 1 gal Benzene

1.1 gal Toluene

MSTDP Process

1.1 gal Toluene

1 gal Mixed Xylene

Table 1

Toluene, Benzene Pricing

Jan-01 Feb-01 Mar-01 Apr-01 May-01 Jun-01

Toluene Purchase Price ($/gal) 0.95 0.96 0.97 1.02 1.01 1.00

Benzene Sale Price ($/gal) 1.40 1.36 1.33 1.36 1.33 1.30

Over the previous year, the mixed xylene contract price to toluene spot price differential averaged -$0.02/gal. The mixed xylene Pete produced actually commanded a premium, however, because of the purity of its paraxylene component. The relationship of his mixed xylene value and the contract price had still been fairly stable, though, and he felt the basis risk was minimal. The current differential of toluene to mixed xylene was close to the average at -$0.03/gal. Based on history, the chances of the mixed xylene price falling or rising relative to toluene were roughly the same. However Pete’s research into the fundamental supply and demand balance suggested that mixed xylene would be stronger than toluene. In that case, the price difference would improve his margin. With that in mind, he formed a strategy.

The Strategy

Pete decided to split his margin risk into two components, as shown in Figure 4. First, he was at risk for the price spread of benzene to toluene. If the price spread fell, his margin would decline. Based on his analysis of the fundamentals and the forward pricing available he decided to hedge this risk. His second risk was that the mixed xylene to toluene price spread would fall, which would also reduce his margin. Since he believed that mixed xylenes values would increase relative to toluene, he wanted that part of his margin to remain exposed to the market. Because of this strategy, he knew his total margin might be larger or smaller than the projected margin in Figure 3, because he was still exposed to some toluene and mixed xylene price risk. His strategy, then, was to lock in a forward price for his actual purchases of toluene, and to hedge his benzene prices with futures contracts.

Execution In the afternoon, Pete again went to the CheMatch.com exchange and negotiated against the toluene posting priced at unleaded gasoline plus $0.19/gal. He countered with a six-month term beginning January 2001 for 50,000 barrels/month at the offered price differential of $0.19/gal. He also requested locking in the toluene price for all months based on the corresponding month closing price for unleaded gasoline futures for 12/5/00 (Figure 2). His counter offer was accepted by a toluene producer Pete had done considerable business with in the past. Still on CheMatch, Pete accessed the Chicago Mercantile Exchange and hedged his benzene price by selling 46 CME-CheMatch Benzene futures contracts (46,000 barrels/month, the amount of benzene made from 50,000 barrels of toluene) in each of the first six months of 2001. Table 1 shows the prices Pete locked in. If, as Pete thought, benzene prices did fall, he could offset (buy back) his benzene futures contract for less than he sold them for, and use the profit from that transaction to help compensate for the lower cash benzene price.

Results Pete’s market assessments proved to be correct. In January the physical (cash market) benzene contract settled at $1.37/gal, so when Pete offset his January CME-CheMatch Benzene futures contract he paid $1.37/gal versus his previous Jan. 01 sale at $1.40/gal (Table 1), netting him a financial gain of $0.03/gal. In the physical market he sold benzene at the $1.37/gal contract price, but when he added his financial gain of $0.03/gal from his futures hedge, his effective price was $1.40/gal, just as he planned. He calculated his margin using the $1.40/gal benzene price and the $0.95/gal price he locked in for toluene in January, and calculated a margin of almost $0.21/gal of mixed xylene. How much had the futures hedge helped? Pete recalculated the margin had he not hedged. The physical benzene price was $1.37/gal and the spot toluene physical price was $1.08/gal. Using these prices he www.chemweek.com

September 19, 2001 A CH EM IC AL WEEK ASSOCIATES Custom Publication

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Special Advertising Section Figure 5 determined that the operation would have made only $0.03/gal on mixed xylene. Hedging the January benzene to toluene spread represented approximately $350,000 of benefit (($0.21/gal-$.03/gal) x 42 gal/bbl x 46,000 barrels/month)—a successful hedge indeed. As the months progressed, Pete continued to track his strategy’s performance. Figure 5 shows the results of his plan. The strategy to lock in the benzene to toluene differential using futures and physical forwards met his objective and significantly improved his profitability. The strategy to hedge the six months improved his profitability by over $3.3 million. Pete wanted to summarize how each “leg” of the hedge contributed to overall performance, and developed Table 2.

Actual Hedge Performance 0.60 0.50 0.40

Variable Margin, $/gal of Xylene

0.30 0.20 0.10 0.00 -0.10 -0.20 Historical As Hedged No Hedge

-0.30 -0.40 -0.50

Jan-00 Mar-00 May-00 Jul-00 Sep-00 Nov-00 Jan-01

Mar-01 May-01

Table 2 Hedge Components, Results Toluene Hedge Price

Toluene Hedge Price

Conversion to Xylene Basis

Toluene Hedge Advanatage

Benzene Futures Price

Benzene Contract Price

Benzene Hedge Advantage

Total Hedge Benefit

($/gal of xylene)

($/gal of xylene)

($/gal of toluene)

($/gal of toluene)

($/gal of xylene)

($/gal of xylene)

($/gal of xylene)

Jan-01

$0.95

$1.09

x 1.1 =

$0.15

$1.40

$1.37

$0.03

$0.18

Feb-01

$0.96

$1.10

x 1.1 =

$0.15

$1.35

$1.40

-$0.05

$0.10

Mar-01

$0.97

$1.08

x 1.1 =

$0.13

$1.33

$1.15

$0.18

$0.31

Apr-01

$1.02

$1.23

x 1.1 =

$0.23

$1.36

$1.10

$0.26

$0.49

May-01

$1.01

$1.22

x 1.1 =

$0.23

$1.33

$1.17

$0.16

$0.39

Jun-01

$1.00

$0.95

x 1.1 =

-$0.05

$1.30

$1.13

$0.17

$0.11

Pete had also clearly benefited from buying toluene at the hedge price instead of market price. In January this was a $0.14/gal advantage. Since Pete hedged 1.1 gallon of toluene for each gallon of mixed xylene, he converted his figures so he could compare the costs on a gallon-to-gallon basis. ($0.14 x 1.1 = $0.15). The benzene contribution was based on the advantage of selling benzene at the futures price in December instead of the monthly physical contract price. No conversion factor was needed as he hedged one gallon of benzene for each gallon of mixed xylene. Different aspects of his strategy came into play at different times. The toluene leg, which protected him from rising feedstock costs, was the most significant factor in January and February. While the benzene leg protected him from a lower sale price in January, he gave up some opportunity in February as the benzene market rose. He was satisfied, though, as his risk profile was much lower. In March and April the benzene leg was the major contributor to his hedge. It protected him from the dramatic fall in the benzene contract price that was the result of lower demand and high inventories, which was precisely what he was concerned about in December when he formed this strategy. By assessing his needs, understanding relevant market fundamentals, and using the risk management tools available to him, Pete was able to significantly impact his bottom line. —By Clif Currin, Vice President, Over-the-Counter Products and Derivatives, CheMatch.com All historical data provided by DeWitt & Company Inc.; MSTDP economic model by Chemical Data Inc.; All figures and tables by CheMatch.com.

If this article has raised questions you’d like answered, please don’t hesitate to contact: Clif Currin CheMatch.com tel: 1-713-681-8140 [email protected] www.chemweek.com

Chicago Mercantile Exchange Inc. www.cme.com email: [email protected]

CheMatch.com www.chematch.com tel: 1-888-525-1000

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