Commodity risk management: Evaluating the Spread between SHFE and NBSK pulp futures

Defining an arbitrage between the adjusted SHFE-NBSK pulp spread using a mean reverting technique

The global pulp trading market has seen increased volatility generated by adverse weather conditions, regional political tensions, logistics bottlenecks, and labor influences amid the Covid-19 pandemic.

To combat volatile market conditions, Norexeco, a paper and pulp exchange based in Norway, launched two China-inbound pulp futures contracts in June 2021. These new futures contracts are a great supplement to its existing portfolio of Europe pulp futures contracts, European recycled paper OCC, and a Shanghai pulp contract.

The two China import pulp futures contracts are cash-settled against NBSK (Northern Bleached Softwood Kraft) ) CIF China and BHKP (Bleached Hardwood Kraft Pulp) China Net prices published by a commodity price-reporting agency Fastmarkets.

Fastmarkets’ NBSK CIF China market assessment captures the physical seaborne price for products exported from Canada and Northern European to China. The price was first published in 2001 and updated every Friday. China’s Shanghai Futures Exchange (SHFE) also lists a softwood pulp futures contract that started trading in 2018.

Why trade NBSK Fastmarkets futures contracts

Futures provide financial tools to hedge risk exposures. If pulp producers are worried that the price is likely to fall, they can sell in the futures contracts to lock in their sales price and fix profit margins at pre-determined levels.

The hedging principle also applies to the pulp buyer. If the pulp is expected to rise, buyers might buy in the futures market to lock in purchase costs.

Cross futures hedging

Opportunities might exist to arbitrage these futures contracts and lock in the logistics costs or mispricing.

The following graph shows SHFE pulp futures settlement price and Fastmarket’s NBSK CIF China price over four years. A conversion was applied to the SHFE settlement price by deducting 120 yuan transportation cost, 13% value-added tax, and then converting to US dollar for comparison. A daily estimate of the Fastmarkets price assessment was created for this analysis.

After the adjustment, we found that SHFE futures and NBSK CIF China were highly correlated at 95% since 2019. Of these three variables (mispricing, transportation, and VAT), transportation and mispricing are the most likely to deviate.

The spread between SHFE and NBSK CIF China prices constantly changes but converges to a mean.

A tool to measure spread convergence

One efficient way to capture the mean reverting tendency of the adjusted SHFE-NBSK spread is to use Bollinger bands.

Bollinger bands are two standard deviations of the price series around a defined mean. When the adjusted SHFE-NBSK declines to the Bollinger low (2 standard deviations below the 20-day moving average), the SHFE is undervalued relative to the NBSK, likely due to higher transportation costs or mispricing.

When the adjusted SHFE-NBSK rises above the Bolinger band high (2 standard deviations above the 20-day moving average), the spread has contracted and probably expresses limited demand for the seaborne product.

During the past 12 months, there have been four occurrences when the spread dropped below the Bollinger band-low. There are several situations where the declines in the adjusted SHFE-NBSK spread continued below the Bollinger band low before hitting a short-term bottom.

During the past 3.5-years, there were 52 occurrences when the adjusted SHFE-NBSK spread was either above or below the Bollinger Band Range. Using this technique, commercials and traders can determine if there is an arbitrage opportunity to trade the SHFE-NBSK spread.

The bottom line

We can identify scenarios when a market anomaly exists by creating an adjusted SHFE-NBSK spread from an underlying two-price series with a 95% correlation coefficient.

Using Bollinger bands to find situations when the adjusted SHFE-NBSK spread declines below or rises above the specified range, we can identify conditions when the price series is likely to revert to the mean. Traders and commercials can use the techniques to trade the Fastmarkets NBSK futures contract in conjunction with the SHFE futures contract to capture arbitrage opportunities in the pulp market.

If you are interested in more information, please get in touch with our Risk Solutions Team.

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