Pulp friction - New futures on recycled paper off to slow start

With sustainability the word of the decade, a futures contract on recycled paper might seem like a bright idea. And it may well be – eventually. But a recently launched effort to start such a market is having trouble getting off the ground, showing the challenges ahead in the movement toward more sustainable commodities.

Pulp futures soar in Shanghai More than 20 million futures on wood pulp were traded on the Shanghai Futures Exchange in March, setting a record for the two-year old contract and capping a huge increase in trading activity since the start of the year. CLICK BELOW IMAGE TO ENLARGE The pulp contract, which is based on prices of softwood pulp delivered to Chinese warehouses, was launched in November 2018 and immediately attracted interest from local market participants. Several exchanges in other parts of the world had attempted to develop futures on pulp during the 1990s and 2000s, but until now none have been successful. Paper industry analysts in other parts of the world have cautioned that much of the volume is driven by retail speculators. Even so, the market's rapid growth has impacted pricing in the physical market. China is the world's largest importer of wood pulp and many international players now look to the SHFE as an important signal for the direction of prices. Over the last several months pulp prices have shot up due to a combination of strong demand, disruptions to supply, and speculative trading, according to analysts at Fastmarkets. Although the SHFE market is only open to local players, the high prices set on the exchange have put pressure on spot market pricing in other parts of the world as companies shifted supply to the Chinese market. The launch of the SHFE pulp futures market was a "game changer," commented Fastmarkets in a recent report. "Volumes were impressive right from the start, with over 400 million tonnes of pulp traded in the first year. Increasingly, the price of pulp on both the domestic resale market and the offshore import market are following developments on the exchange."

On paper, a recycled paper contract looks like a good bet. All kinds of businesses use recycled paper and as the world pivots towards greater use of recycled materials, demand is sure to grow. There is already a sizeable market for bulk shipments of used cardboard and other paper collected out of the trash, which can be used to replace virgin wood as the raw material for making paper products. Its price is also highly volatile, which creates risk for companies buying and selling this commodity. And there are well-established benchmarks for tracking the prices of used paper as it moves from waste collection to paper manufacturing.

Enter Norexeco, a commodities exchange based in Norway that focuses on pulp and paper markets. Last October, the exchange launched a cash-settled futures contract based on an established benchmark, the PIX OCC 1.04 dd index. The index tracks European prices for old corrugated containers, the industry term for used cardboard, which makes up the largest part of the vast stream of paper that flows through the recycling industry.

Although Norexeco is not well known outside its niche in the forest products industry, it has attracted several banks and brokers that are active in commodity markets. Broker-members of the exchange include not only local players such as Skandinaviska Enskilden Banken but also Goldman Sachs, Morgan Stanley, and StoneX, a nonbank futures broker that specializes in commodities.

Clearing is handled by European Commodity Clearing, a unit of the European Energy Exchange of Leipzig, which in turn is majority owned by Deutsche Börse. Banks that clear Norexeco products include ABN AMRO Clearing Bank, Banco Santander, Raiffeisenbank and UniCredit as well as Goldman Sachs, Morgan Stanley and StoneX. A number of major end users are also involved in the market. Trade members of the exchange include Ekman & Co, a Swedish forest products company, UPM-Kymmene, a Finnish forest industry company, and Sappi, a Belgian papermaker.

Timber has long been a significant part of the Norwegian economy – most of the lumber used to rebuild London after the Great Fire of 1666 came from Norway. Even today, wood products, particularly paper, are an important part of Norway’s foreign exchange, amounting to 11% of export revenue. But it has always been a very cyclical industry, with huge fluctuations in price and no central market. Stein Ole Larsen, the exchange's founder and CEO, says he sees an opportunity to provide the pulp and paper industry with a better way to discover prices, similar to what exchanges provide for other commodities.

Recycled paper isn't the exchange's only product. It also offers futures on several types of pulp, the wood mash that is turned into everything from boxes to tissue paper. In June, it launched several more contracts based on the prices of pulp futures traded on the Shanghai Futures Exchange. Although that exchange is open only to market participants in mainland China, its pulp futures market has become an important center for price discovery not only for the Chinese paper industry but also the many companies around the world that ship pulp to China. In effect, Norexeco is aiming to become the offshore alternative to the Shanghai contract, similar to the role that the Singapore Exchange plays in the iron ore market.

A quiet launch

However, eight months after the launch of the OCC recycled paper contract, Larsen's dream of a clearer price signal doesn’t appear to be much closer to reality. The contract is listed on the exchange's trading platform, but very few if any trades are taking place.

Why the lack of support? Market watchers say a few factors may be holding back adoption.

For one thing, there are mechanical issues. Fastmarkets, the price reporting agency that publishes the OCC PIX 1.04 dd index, has designed it to be a pan-European price, but the exact value of a ton of cardboard depends on the country where it is sold and its quality. That is an issue for potential users, according to Lauma Kazusa, head of financial and marketing reporting for Suez Trading Europe, the trading arm of the European waste giant. She explained that the PIX price fix is closest to the German market trends, and Norexeco’s contract does not have a clear mechanism for making adjustments to address this concern.

Another issue is the structure of the recycling industry. The waste collection companies that gather used paper materials are not directly exposed to the fluctuations in the price of recovered paper, according to Quint Feenstra, a commodity broker at Freight Investor Services, a broker-member of the Norexeco exchange. Their business model is based on fixed margins; whatever price they receive for selling the scrap paper is passed through the municipal authorities and commercial enterprises from which they collected the material. That reduces their need to hedge risk, he said.

“For this futures market to become liquid, I believe first the price risk for recycled paper should be with those who sell it," explained Feenstra. "How the market is organized now is that these collectors source the material from industry, municipalities, etc., against a fixed margin of their sales price, so no matter what the market price does, these collectors make a guaranteed fixed margin."

In effect, the price risk is passed through to the businesses and local governments that pay the waste collection companies to take away their trash. But these entities also lack the motivation to use futures to hedge their price risk. "For these players, the recycled paper is almost as a waste product to them. The industry has already accounted for the material in the production process, and municipalities often get paid to collect this material. They are just not concerned with the price they get for the material."

In the short run, the most important factor may be very simple: the price of recycled paper is currently very high, and umbrellas are a tough sell when the sun is shining. Lockdown life sharply reduced the use of paper and paper products in commercial and industrial sectors this winter, which means that there have been fewer boxes and packages to pulp this spring. At the same time, the explosion of home deliveries means that the demand for paper packaging remains strong.  

But there is a longer-term structural problem too, even when this anomaly ends:  in normal times, Europe almost always produces much more recycled paper than it can use. "We’re extremely good at setting targets, [and] we’re reasonably good at collecting the material to meet those targets," Kazusa explained. The trouble is… we collect a lot more than we need, and that’s always been a problem."

Education will be key

Others advise patience. Fastmarkets analysts wrote in a December report that they expect the recycled paper futures ultimately will follow the same path as scrap market futures. The London Metal Exchange launched steel scrap futures in late 2015 and the contract has gradually gained momentum over the last several years, with steel producers and consumers using the contract to hedge their risks.

There are also signs that some paper companies are starting to explore the new contract, according to Kazusa at Suez Trading.

"My gut feeling is some buyers are testing the contract,” said Kazusa. "The price projections follow the market sentiment each week."

Looking ahead, Larsen argues that education of its target customers is Norexeco’s biggest challenge. Companies that make or use recycled paper accept volatility as a fact of life. Teaching industrial producers and consumers of recycled paper that they now have a safer alternative may take a while, he said, particularly as, unlike pulp users, they have not had exposure to an OTC contract.

"It's going to take some time to actually change their behavior when it comes to risk management," Larsen said.