RISK MANAGEMENT: Hedging paper bets

Dec 01, 1999 10:30 PM  By

Locking in paper prices with a third party can stabilize costs

Anyone remember the 50%-plus paper price increases of 1994-95? Catalogers Miles Kimball and Lillian Vernon certainly do. That’s why they’re now proponents of paper hedging: a risk management practice that allows them, via a third party, to lock in paper prices for several years, thus protecting them from any sudden price increases.

Catalogers’ paper costs “often equal or exceed total operating earnings,” says Mike Muoio, chairman/ president/CEO of $150 million gifts and home decor cataloger Miles Kimball. “Paper hedging lets you limit your risks and control costs.”

The two most common types of paper hedging are fixed-price swaps and collar hedges. In a fixed-price swap, a cataloger negotiates a fixed price for paper with a financial risk management company. If the market price of paper rises above the fixed price, the third party reimburses the cataloger for the difference between the fixed price and the market price. Conversely – and this is where the cataloger takes a risk – if the market price falls below the contracted fixed price, the cataloger pays the third party the difference.

The fixed price is based on market paper indices such as Pulpex and Resource Information Systems Inc. The risk management firm will then add basis points (with 100 basis points equaling 1%) to the price, and this becomes the contracted price. Contracts range from six months to 10 years, but most run for three to five years.

A collar hedge differs in that the agreement covers a price range (say, $980-$1,020 per ton) rather than a fixed price (such as $1,000 per ton).

The paper hedging contract is distinct from any paper buying contracts. Hedging and buying “are separate transactions,” says Richard Randall, chief financial officer of $250 million gifts cataloger Lillian Vernon. “One is a financial transaction with a third party; the other is with a paper supplier.”

A 72% increase in paper prices and a 50% drop in earnings in 1995 convinced Miles Kimball to sign a five-year fixed-price contract with Enron, a Houston-based financial risk management company. “There’s a direct tradeoff between paper prices and earnings,” Muoio says. “We didn’t want to take that risk anymore.”

Lillian Vernon decided to negotiate a four-year collar hedge, also with Enron, in early October. “We might not be saving any money, but we’re taking some of the risk out of the equation,” Randall says. “A collar is our insurance policy against a highly volatile commodity market.”

Enron, which adds 15 basis points, or .15%, to the market price, is also hedging its bets, of course, by striking similar (but lower) fixed-price arrangements with paper suppliers – some of which may be the vendors used by their catalog clients.

Catalogers may opt to hedge only a portion of their paper purchases. For instance, Miles Kimball is hedging 65% of its overall paper buys; Lillian Vernon is hedging only 40%.

“We recognize that if paper prices were to plummet, we would not benefit,” Muoio says. “But these are prices we can live with, and we felt that 65% of what we use should be covered. We’ll tolerate the ups and downs on 35%.”