In recent years, much has been written about how important it is that financial market participants fully understand the nature of their relationships with counterparties. We agree that this is critical: Unless a market participant has informed itself as to exactly where its counterparty’s responsibility ends, it cannot easily assess where its own responsibility begins. These materials describe the economic terms of a number of derivative transactions. Derivative transactions involve a variety of significant potential risks, including risk of adverse or unanticipated market developments, risk of counterparty default, risk of illiquidity and other similar risks. The specific risks presented by a particular transaction necessarily depend on the nature of the transaction and your circumstances. Your company should not enter into any financial transaction unless it fully understands the potential risks and rewards of that transaction and has independently determined that the transaction is appropriate in light of its objectives, experience, financial and operational resources, and other relevant circumstances. Please bear in mind that in proposing transactions or discussing market opportunities with you, Enron is acting as a potential arm’s-length counterparty, and not as your company’s financial advisor.
1400 Smith St. Houston, Texas 77002-7361 888-367-6641 http://www.enron.com/lumber
Lumber and Panel Products MANAGING PRICE RISK
OPPORTUNITIES TO MANAGE EARNINGS INNOVATION — As the world’s leading energy company, Enron has
developed expertise in commodity risk management. Enron provides a
way for producers and consumers of lumber and panel products to make more money and save more money with a long-term strategy. A Fortune Magazine survey has named us the most innovative company in the United States five years in a row. We provide our customers cost-saving solutions unavailable to them through traditional suppliers. VALUE — We are a provider of price risk management services, energy and financing to the industry’s producers and consumers. We are not a bank. We are a source of solutions and long-term liquidity in the market. FLEXIBILITY — Price risk management does not have to be an all-or-none proposition. Producers and consumers need only apply price management at a time and at a volume that make sense. Enron can provide you with that flexibility. SIMPLICITY — You do not have to change any aspect of your relationships with your current suppliers or customers to take advantage of these services. EXPERIENCE — Enron is actively making long-term prices in lumber and panel products. Enron manages the world’s largest book of long-term fixed price natural gas and wholesale electricity contracts. Other core trading businesses include crude oil, plastics, weather, steel and pulp and paper. TRUST — Enron is a reliable, committed, long-term partner.
Enron provides long-term fixed prices for lumber and panel products. For producers and consumers of lumber and panel products, managing prices has been virtually impossible — until now. Producers and consumers of lumber and panel products are focused on manufacturing, distribution and building, and frequently deal with price fluctuation. Unfortunately, few have the time or the tools to solve or dampen price fluctuation. Some industry participants feel that obtaining a long-term fixed price for their production requirements is a bet on the market going up or down. In the lumber and panel products business, not unlike the natural gas business, it is well known that nearly all of the industry’s participants speculate about where prices are going. Nearly all are wagering their companies’ profits based on this speculation. It seems that the one certainty for the lumber and panel products business is an unpredictable future.
To combat this instability, Enron has developed several tools that enable you to dampen or even eliminate your exposure to these business risks. Experience has taught us that, if offered the opportunity to lock in prices at reasonable levels, both producers and consumers are willing to take advantage of it, as long as they know that the contract will be supported over the long term. Enron provides this support through a proven contract structure. Our basic financial contract is the International Swaps Derivatives Association agreement (ISDA). In 1999, over $20 trillion in notional amount was structured through this agreement.
BASIC TOOLS: Swaps are privately negotiated financial contracts in which two parties agree to exchange, or swap different price streams over a predetermined period of time. They are financial over-the-counter instruments that can be customized to meet a particular set of needs. Swaps allow for strategies designed to protect against market price fluctuations by enabling producers and consumers to lock in the price
SWAPS Swaps Help Lumber Company Lock in Profits Despite Uncertain Market Conditions Lumber Co., a producer of WSPF, is interested in managing the price of 2x4s during the next nine months. The company is concerned that market conditions could deteriorate more than expected and squeeze margins to the point of jeopardizing the annual profit plan. To reduce this threat, Lumber Co. enters into a swap with Enron, locking in its profit margin with a price of $270/MBF on 1,000,000 BF per month of 2x4 WSPF, or 30% of monthly production. This price gives Lumber Co. the margin and confidence that the 2x4 production will meet its financial target.
of raw materials and/or final product. By locking in prices, companies gain control over variable costs and revenues inherent in their businesses. There is no fee or premium for a swap. Used in concert with a physical contract, swaps effectively alter the price structure of the contract — converting it from a floating price to fixed price, for example — and provide protection against adverse price movements. In exchange for this protection, the ability to capitalize on beneficial price movements is sacrificed. In short, the industry can use swaps to eliminate price volatility, giving producers and consumers the ability to manage margins and proactively offer customized pricing to customers. The typical swap transaction involves the exchange of a fixed price for a variable, or
During the Life of the Swap: • Lumber Co. continues to sell 2x4 WSPF to customers of its choice at floating market prices. • Lumber Co. and Enron exchange payments on a monthly basis equal to the difference between the fixed price of $270/MBF and the prevailing floating price. • For example, if the floating price is $220/MBF, Lumber Co. will receive $50/MBF on 1,000,000 BF per month. However, if the floating price is $320/MBF, Lumber Co. will owe $50/MBF to Enron. • The net combination of the swap cash flow and cash flows related to physical sales of 2x4 WSPF is a fixed amount of $270/MBF. • Lumber Co. has stabilized a portion of their operating margin with the swap, giving the company the ability to achieve key performance targets.
floating, price. Settlement is financial in that cash changes hands; physical product
How Swaps Protect Homebuilders From Rising Lumber Prices Home Co., a national homebuilder, is preparing their annual budget. They discover that the company’s inventory cannot absorb increases in lumber prices, but it is impossible for Home Co. to pass on lumber price increases. On the other hand, customers don’t necessarily expect lower prices when lumber prices fall; they simply want to pay the agreed-upon price for their house. To serve its customers while protecting its margins, Home Co. enters into a 1-year price swap. This price effectively fixes the price of 2x4 WSPF at $275/MBF on a monthly volume of 500,000 BF, or 60% of anticipated monthly usage. During the Life of the Swap: • Home Co. continues to purchase 2x4 WSPF from suppliers of its choice at floating market prices. • Home Co. and Enron exchange payments on a monthly basis equal to the difference between the swap fixed price of $275/MBF and the floating price for 2x4 WSPF. • For example, if the floating price for 2x4 WSPF is $325/MBF in a given month, Home Co. will receive $50/MBF on 500,000 BF. However, if the floating price is $225/MBF, Home Co. will owe $50/MBF to Enron. • The net effect of combining the swap cash flows with actual purchases of 2x4 WSPF is a fixed 2x4 price of $275/MBF. • The swap enables Home Co. to build with full confidence that the margin on those homes is protected from fluctuating WSPF prices.
Fixed Price (Swap)
does not. Each month during the life of the transaction, the difference between the $ per MBF
two prices is determined and payment made to the appropriate party.
$550 500
Market Index Price
450
Price Counterparty Pays
400 350 Highest & Lowest Price Counterparty Pays
300 250 200 150 100 50 Month 1
Month 2
Month 3
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Swaps can be based on a flat price or, as illustrated left, an escalating price.
Price swaps are typically used to fully convert from one price exposure to another — from floating to fixed, for example. Like swaps, caps and floors provide price protection, but they have the added advantage of providing benefit from favorable price movements. They are commonly thought of as a “price guarantee”
BASIC TOOLS:
CAPS, FLOORS & COLLARS in that, for a premium, you are entitled to full price protection when prices move past a specified level. A price cap protects against rising prices without sacrificing the benefit from falling prices. Floors are the opposite of caps: they protect against falling prices but retain upside potential should prices increase. When a customer buys a price cap or floor, the full cost of the protection is predefined — it is equal to the premium paid for the cap or floor. There are no potential future costs related to price movements.
Mixing Basic Tools to Create Custom Protection By combining the basic instruments — swaps, caps and floors — it is possible to create customized, costefficient price risk management structures to fit nearly any situation. The number of variations is limitless; here are a few of the more popular structures. Price Collar Collars are created by combining a price cap with a floor to reduce the cost of protection by establishing a range within which prices will fluctuate. For example, a price cap provides full protection against rising prices, while affording unlimited benefits if prices fall. If you are willing to give up the benefit when prices fall below a specific floor level, the premium paid for the price protection can be reduced or eliminated altogether. If it is not necessary to retain unlimited benefit from favorable price moves, price collars are a cost-saving alternative to a straight cap or floor. • A producer of lumber or panel products interested in protecting against a price decline while retaining benefit up to a certain level would enter into a collar that results in payment from Enron if prices fall below the floor and, conversely, payment to Enron should prices exceed the cap. • A purchaser of lumber or panel products concerned about rising prices, but needing to maintain the advantage should prices slip to a certain level, would establish a collar whereby Enron pays if prices exceed the cap and the company pays if prices fall below the floor.
Participating Swap Created by combining a swap with either a price cap or floor, the participating swap establishes a fixed price while positioning the company to share in some percentage of beneficial price moves either above or below the swap-fixed price. The cost of the cap or floor is embedded in the swap-fixed price, so there is no premium paid for the cap or floor. Commodity Price Conversion Swap By combining two swaps on different commodities, the price of one commodity can be linked to the other. For example, a mill equipped to make only OSB, but that sells product into a market that competes with plywood, is at risk if plywood becomes the cheaper sheet. The producer can use a commodity conversion swap that links OSB prices to plywood prices, putting the company on a more equal footing with its plywood competitors.
$ per MBF $550 500 450 400 350 300 250 200 150 100 50 Month 1
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Month 5
Price collars are less expensive to implement than a floor or cap and can be tailored to meet many of the pricing requirements of both producers and consumers.
