Early in May, the Chicago Mercantile Exchange (CME Group) moved the first steel billet swaps cleared by a U.S. exchange, the latest expansion of risk-management tools in global iron and steel. The CME confirmed that it cleared 6,000 tonnes in one trade and 3,000 tonnes in another. The broker of the first trade was Freight Investor Services Ltd., and it was split over the third and fourth quarters of 2012, which equates to 1,000 tonnes per month from July to December. Deutsche Bank AG confirmed another partys involvement but declined to comment.
Steel is widely considered to be the last major global commodity to be actively traded under both physical-delivery and cash-settled contracts. The CME Group and the London Metal Exchange introduced contracts in late 2008 and early 2009. Total volumes and the number of contracts and participants have grown slowly, but both exchanges say they are pleased with the progress and are developing new instruments.
The CME Group started with an indexed contract against Midwest hot-rolled coil, while the LME offered billet contracts and stuck with its tradition of physical business. The CME billet contract marks an important expansion for the market, but it also presents a more direct challenge to its competitor across the Atlantic, which is evaluating a financial steel offering but is a year or two away from bringing anything
Separately, other exchanges are being developed with the intent of adding new hedging vehicles. The entire global enterprise has had its growing pains, not the least of which was the collapse of brokerage MF Global at the end of 2011. MF Global was not directly tied to any of the exchanges, but it was an active participant in steel hedging and its withdrawal from daily business was a blow to the market financially as well as psychologically.
Steel is one of the last commodities that does not have a derivative contract, said James Oliver, senior director of metals for CME Group Inc., owner of the CME. One of the primary challenges is that there are so many types and grades that it is difficult to determine against which of them to settle a contract. When it comes down to what mills actually produce, steel is a finished product and not really a standard commodity. Another problem is that it is difficult to store because it rusts so readily.
For all those reasons, the CME Group chose to lead with a financially settled contract rather than on a physical-delivery basis. Once the contract was on the market, however, it has been a huge educational challenge, first to let the industry know that these tools are available and then to show them how to use them, Oliver said. The steel industry has been around for decades, through good times and bad. They have survived, but it is a very cyclical industry.
The CME Groups full portfolio of contracts is integrated into what the exchange calls a virtual steel mill. We have Midwest and European (hot-rolled coil) as well as billet, and also ore, coal, scrap, freight and (foreign exchange markets) on one platform, he said. It gives industry participants at all levels the opportunity to hedge inputs and outputs to the extent that they need to.
Still, Oliver acknowledged that the educational challenge remains. I go to conferences, and one of the things I hear people talk about the most is volatility, he said. They wonder what to do. But they already hedge zinc and nickel. Eventually, they will become comfortable doing the same with steel up and down the supply chain.
Just a year ago, the LMEs physical steel billet contract earned the Best Product Innovation award at AMMs Awards for Steel Excellence. Since then, the LME has introduced swap contracts for all nonferrous metals except cobalt and molybdenum, and hopes to have a steel swap ready before the end of this year.
The CME Group and the Singapore Mercantile Exchange also are in the process of developing new instruments, both physical and financial, to increase volumes and liquidity in risk management. But the established global markets are increasingly being challenged by newer exchanges.
While the growth in steel and iron hedging opportunities are accelerating, the growth is coming from a relatively recent start. The reasons are many and varied, but chief among them are the vast number of grades and types of steel, the reliance of big mills on long-term contracts, and the fragmented, national or regional nature of the business. All of those factors are changing with increasing velocity, and the outlook now is for growth in physical and financial contracts and exchanges, perhaps for several years, followed by consolidation as the global industry coalesces around the contracts and exchanges that are most economical and effective.
The LME steel contract is relatively new, having been introduced in 2008, Chris Evans, head of business development for the LME, said. But we have had a long association with the steel market through our trading in zinc and nickel. The LME was founded in 1877, and its first contract was for tin. Mills have been able to hedge input costs for years, but theyand their customerscan now manage the volatility at the other end of the supply chain. With the LME that is billet, while exchanges such as CME are focusing on HRC.
Evans further differentiates the LME contract from that of the CME Groups hot-rolled coil contract, with the LME focusing more on long products and the CME focusing on flat-rolled contracts. The global industry is going to need all of these contracts, he said. The existing products are still finding their feet, and there is space for more. It will take time for the industry to embrace these new tools, but the last few years have demonstrated clearly to mills and to their shareholders the benefits of active risk management.
There is a small irony in the current focus on supplementing physical delivery with cash settlements: When the LME was developing the first steel contracts in 2008, the initial idea was for an index-based financial settlement. We had a change of heart from that, Evans said. The strength of our exchange is our physical delivery and storage model, and our members were familiar with that method of trading.
More to the point, there was some question four or five years ago if the steel indexes available at the time were suitable. The idea of selling on a formula linked to an index was in its infancy, Evans said. We did not think that the indices out there were robust enough for us to use. Now those indices have come a long way, and if we were to develop further contracts from our billets we would certainly consider indices.
Evans is circumspect about the next few steps as further additions to the steel market play out against the bigger picture of the LME developing its own internal clearing house. The exchange began work on that project late last year and has said the effort could take as long as two years.
In the even-bigger picture, the whole LME is in play. According to a statement the exchange issued in May, The board has received a number of detailed proposals from shortlisted parties in line with the process being conducted on its behalf by Moelis & Co. The board will now consider the proposals and provide shareholders with further information as appropriate. The discussions shareholders have held with the LME and its financial advisors during the process have drawn out issues of importance to users of the exchange. The board welcomes all input and will engage in further dialogue with the LMEs shareholders to reach the best possible outcome for the market.
In any case, there is an interest in new offerings but there is no great rush, Evans said. We are seeing the slow evolution of a large and relatively conservative industry. The breakthrough will come when management realizes that by using steel futures to lock in their costs and sales prices they can offer better customer service and better returns to shareholders. That gives them an edge over their competitors and provides steady income flow.
Historically, Evans said, steel was a protected industry in most countries because steel is a strategic resource and because mills and mines were major employers. Now the challenge to the companies in Europe and the Americas is that governments there have run out of money but competitors in China are still able to access state funds. To compete that means that non Chinese companies have to be smarter, do business differently, and manage better.
As the established exchanges develop new contracts, new exchanges also are coming into being. One is the Cleartrade Exchange, which handles over-the-counter swap contracts out of Singapore. The exchange, which was created in 2010, works only on a cash-settlement basis. The primary ferrous contract is a 62-percent fine iron ore swap that is settled against the Steel Indexs global index.
Late last year, Cleartrade reported that since it launched its China steel indices, uptake and regular usage by clients and the trading of lots through LCH.Clearnet have demonstrated that the market considers this a valuable service. The China domestic hot-rolled coil and hot-rolled ribbed bar markets are leading the way, while the iron ore volumes are growing exponentially.
China is still relentless in its consumption of steel and iron ore and is set to import more than two-thirds of global seaborne iron ore this year, Ray Ang, Cleartrades operations director, said. Currently, our China steel index is the only China-based steel index which is based on domestic spot steel transactions within China which allows overseas participants to trade and clear.
The next contract to be added will be a U.S. hot-rolled coil swap, which is pending regulatory approval and could be on the market in a few months, said Richard Baker, chief executive officer of exchange owner Cleartrade Exchange Pte Ltd., who added that the contracts are already being traded privately by brokers. To fill out the exchanges ferrous portfolio, he also is evaluating such swaps as north and south European hot-rolled coil as well as Turkish scrap. Any new contracts would adhere to the cash-settled swap format.
Business mostly is among brokers and suppliers, but Baker said that some mills are beginning to be active in iron ore. They are still not very active in steel contracts. That segment of the market remains an ongoing challenge to all exchanges in 2012. For inbound commodities to the mills, the banks and the brokers are using hedges extensively. For outbound commodities from the mills, we see mostly end-users, but that side is still very slow.
Baker acknowledged that while there is some hesitancy by big mills to move into the derivatives market, there also is mixed opinion in the trading community about the growth of many different instruments and exchanges. The big exchanges list multiple contracts, but some of them just never trade, he said. They take the approach that if you build it, they will come. We dont have that scale, so we build specifically to a market need.
That said, he also understands that, with at least 90 percent of the global iron ore market concentrated in Singapore, a new house has its work cut out for it to attract that open interest. There is certainly room for more, and we are seeing sustained growth.
Among users, its a buyers market during this growth phase of steel futures and options. The derivative markets were really developed to help manage price volatility, but what each market needs is industry participation, said Rick Dougherty, vice president of sales and marketing for Cargill Inc.s Cargill Ferrous International, a major global trader up and down the steel supply chain.
Ultimately, the exchanges need volume and liquidity to thrive, Dougherty said. We look at each one, and at the moment they all seem to be growing in dollar volume, in number of contracts and in number of participants. It just takes time for people to get comfortable with these tools and these markets. They are definitely helping the industry and will continue to do so.
For all the fecundity of steel futures, Robert McCutcheon, head of U.S. metals and industrial products at PricewaterhouseCoopers, said that steel and iron hedging today is where aluminum and copper were decades ago. He agreed that there is truth in the claim that there is high variability in the finished product, but he thinks the slow development of a forward market is more a matter of steel being viewed as a national resource as well as being a regional market.
There are pros and cons to each exchange, he said. To some degree, they take control out of the hands of the producers, and they are reluctant to let that go. The mills want to set the price, not necessarily do business based on an exchange- or index-based price.
McCutcheon said that the growing sophistication of commercially available risk-management software is driving interest in forward markets. There are highly developed commodity-trading and risk-management packages out there, capable of tracking and integrating many different trading instruments, he said. But those instruments are only as good as their liquidity.
Risk managers at mines and mills are looking at all the different ways of structuring their contracts, McCutcheon said. It is much easier to use derivatives because you can go back to the market every day and adjust your hedge position based on where your physical position is. But it is hard to go back to your suppliers and customers and try to renegotiate those contracts. That is the challenge: balancing your fixed vs. your variable exposures.
Ultimately, McCutcheon said, steel remains a highly fragmented market in terms of finished material as well as geographically and competitively. Look at the top five or 10 largest types of steel coming out of the mills, and look at their cumulative volume as a fraction of the whole industry. Now look at the top five or 10 types of ore or aluminum, he said. You see how fragmented steel is.
Over the next few years, new contracts and new exchanges will continue to be launched, which will be followed by a period of consolidation as the industry reaches consensus on the most economical and effective types of derivatives, McCutcheon said. Look back at aluminum. How long did it take us to get where were are?
We are seeing good, broad participation in the billet contract, Evans said. The merchants tend to be first in these situations, but the mills are participating. By participating in the market, we are requiring companies to think carefully about how they do business, and how they can do it better.