Protective clauses in Polyethylene purchase contracts can help manage unplanned shutdowns

In collaboration with Saravanan Vaithi, Senior Research Analyst -- Chemicals

Polyethylene, a versatile polymer, is widely used by major industries -- right from packaging to automobiles. On an average, packaging polymers account for 4-10% of the total spend in a Consumer Products Group (CPG) company.

Polyethylene (PE) markets have been witnessing structural changes since the start of this decade. The evolution of shale based and coal based ethylene has reduced the polyethylene production cost by 75% and 40% in the U.S. and Chinese markets respectively.

Overall, emergence of non-conventional feedstock is expected to increase the global ethylene capacity by as much as 50 million MT in 2018 from the 2013 levels, and this is likely to increase the excess supply situation in PE markets.

However, from procurement point of view, all these positive developments in the feedstock markets have not fully benefited the buyers of downstream products made out of such polymers.

Incidents like plant outages and force majeure have impacted the PE supply and are pushing prices to higher levels. For instance, U.S. PE prices were trading at historical highs owing to plant outages during Q3 2014- Jan 2015. And due to this, buyers who had contracts with low cost feedstock producers in the U.S. were charged more than the buyers engaged with high cost feedstock producers in Europe and Asia.

This trend is also occurring in the European market since the beginning of this year. For instance, European PE prices increased to historical high levels in March-May 2015 against the backdrop of lower crude oil and naphtha prices.

Similar to what happened in the U.S. markets, a series of plant outages and force majeure announcements have pushed up the PE prices in Europe too, resulting in a steep increase in resin spend. And those PE buyers, who were expecting lower crude oil prices and as a result engaged in spot buying, were short-changed.

Force majeure and unplanned shutdowns are beyond buyer's control. And procurement teams can mitigate such unforeseen events by devising a contract that reduces the impact of unexpected, unplanned shutdowns.

Procurement managers can consider effective use of contract clauses such as "destination diversion" and "arbitrage" in their purchase agreement. These clauses are widely used in LNG purchase agreements due to high price volatility and variances in regional prices. Prevalence of similar conditions in the PE market has now necessitated use of such contract clauses.

For instance, polyethylene buyers, who cater to manufacturing locations across various geographies, can look for inclusion of "destination diversion provisions under specific conditions" in their contracts. This can help them to manage supply shortages in a region by diverting excess supplies from other regions.

Polyethylene buyers may also include clauses supporting the use of arbitrage opportunities in their existing purchase agreement. Inclusion of arbitrage clause under specific conditions can help buyers to make use of lower prices prevailing in other markets to offset high prices in their home market. Also, a well framed contract based on extensive quantitative factors may limit the impact of any unforeseen supply shortages.

Capacity rationalization in Europe, emergence of non-conventional feedstock, uneven trend in end use markets are likely to increase the volatility in resin prices. Such rising uncertainties and unexpected opportunities necessitate the need for innovative contract practices.