Back in the day, there was a car rental company that played up its status as the second-largest operator in the business with the mantra, Were No. 2. We try harder.
It is essentially the theme of commodity trading and risk management (CTRM) in the global metal markets. The smaller and more concentrated marketscopper, aluminum, specialty metals and alloyshave never had the scale to counterbalance potential swings in the market, so they were quicker to adopt software tools and management practices that helped mitigate volatility and other market risks.
In contrast, participants in iron and steelfrom mines and mills to fabricators and service centershave had advantages of scale that in many cases became natural hedges. That is especially true of integrated companies. Recently, however, with the rapid proliferation of short-term contracts and growing international competition, some steel operators have been looking into CTRMs possibilities for their sector as wellfacilitated by a burst of activity in commodity exchanges for physical metal futures contracts as well as cash-settled, index-based instruments.
We have seen an increase in exchange-traded contractsfutures, options, swaps and so forthfor iron and steel, said Robert McCutcheon, head of U.S. metals and industrial products for PricewaterhouseCoopers LLP. Aluminum, for example, has been better able to construct models for their sales practices, and to link them back to the market indices used for trading.
While steel has been a worldwide industry almost from its earliest days, it was not actually a global market as it is known today until privatization and consolidation began in the 1980s, he said. Until then, it was a patchwork of regional and national markets, somebut not allwith interactions. In contrast, aluminum was truly global early on, while steel was often regarded as a national resource.
There is a great deal of activity in the CTRM market today, McCutcheon said, and it is rising with the tides of in-house risk-management expertise at metal companies and the tools available on various exchanges. Trading has been focused on higher volumes and lower prices, which means that the margin is tight. The software today allows for daily management of a hedging portfolio, which is a long way from the spreadsheets of just a few years ago. However, that kind of access means the operatormill or traderneeds secure control, segregation of duties and good governance.
The industry is a mix of commercially available software, custom-made applications, home-grown solutions andstillsome souped-up spreadsheets, he said. There are still lots of home-grown systems, but more and more companies are quick-
ly thinking about commercial ones. Regardless of which direction management chooses to go, this is a very good time to address these issues and have these discussions within the company and with suppliers and customers.
Indeed, McCutcheon said that the bulk of CTRM adoption is driven by the C-suite. Typically, this kind of thing is top-down. CTRM and enterprise resource planning (ERP) are very much on the minds and agendas of CEOs, COOs and CFOs. These are operational, commercial, cost and risk-management issues, but the risk-management groups cant really solve all these issues on their own. Organizations need to generate as much open discussion as they can.
Many various exchanges started off with the same ideas in iron and steel, said Harry Knott, product manager for London-based software company Brady Plc. There are considerable volumes in the global market, and everyone wants a piece of that.
Knott said the current state of the steel market is like the very early days of aluminum. People are offering different products and solutions, but there is very limited liquidity and uptake. The cultural adoption is not high. Aluminum took years and years to get up and running to be usable in any real way as a hedging tool.
That difference exists today due to the long history of steel as a high-volume, low-margin, strategic commodity, Knott said. The reason CTRM adoption has been faster and more extensive in aluminum, copper and other metals is due to simple supply-and-demand curves.
Given the volumes of raw materials that steel mills had to buyand given the volumes that they have sold over the many decades before the earliest CTRM solutions became availablethey simply made do, and they now have practices in place. The soft reason why uptake has been slower in steel than in nonferrous metals is cultural, Knott said. It is a deeply conservative industry, inclined to stick with what is working even if it is working only fairly well.
Knott acknowledged that point is somewhat at odds with another common explanation: Steel is only a commodity as an aggregate industry. For any given relationship between mill and customer, there are so many grades that steel has more in common with performance products. Thus, it is too diffuse a market for the tight algorithms of CTRM to be of much help. But that explanation may be a bit too finespun. I am willing to accept that argument to a point. It is legitimately a more-complex material and market than is aluminum. But that can also be used just as an excuse. Historically, steel has been priced on long-term contracts based on some benchmark. So while there is an element of truth in the specialty premise, there is also an element of truth in the commodity premise.
Others find the differentiator not in the metal itself but in its end-use markets. Aluminum and copper have become essential components of the high-tech industry in Japan and South Korea, said Doug Gyani, director of sales for Asia and the Pacific at software company OpenLink. For casings and wiring, we have seen a higher concentration in the market, which has meant a more frequently traded market, and that has pushed liquidity. In contrast, iron and steel are still materials more for mass manufacturing. Although there is more paper trading recently than in years past, here in Singapore they trade a lot of iron-ore paper. The exchange is happy with any level of interest.
As other metal markets expand their use of CTRM and as vendors, consultants and service providers continue to hone their skills, Knott said, adoption in steel will accelerate, albeit slowly. The change in steel will be an evolutionary, discovery process.
Moving from philosophy to practice, Knott said that competition among exchanges and indices is adding to the complication. All the indices want to be the basis of any new steel futures contract or hedging tool, he said. No one wants to be left out at this formative stage of the business. If you look ahead, you see where copper is with its wire basis on the LME or Comex, and those markets are obvious and standardized.
Interest is developing on both sides of the industry, Gyani said. We have seen markets changing. There is certainly more interest in the physical space for steel, while the financial interest has focused more on precious and non-precious nonferrous metals. We are finding people taking multiple positions in multiple markets across the world.
Like any new tool, the more broadly CTRM is used the more integral it becomes. Taking multiple positions in physical and paper markets worldwide is not something that can be done on lined paper under a green eyeshadeor even, for that matter, on a spreadsheet, Gyani said. There are issues of inventory management, taxation and relative valuation. The financial side of CTRM in metals is quite similar to that of agricultural commodities or energy, but the materials-management side is very different.
The challenge for risk managers in the steel sector, then, is akin to that of the Federal Drug Administration: determine the safest, most effective solutions. Just as with clinical tests, making that determination is an iterative process, Knott said. On the supply side, upstream of the mill the basis seems to be working. That end of the business seems to be what is getting picked up.
Exchange-traded futures seem to be struggling for adoption, while cleared swaps are getting more traction, Knott said. That is because, as compared to futures contracts, swaps seem to be the more obvious hedge. So at this point in the development of the market, that route seems the more likely. And, honestly, I dont see a big difference in the validity of a swap or an exchange-traded future based on an index in utility as a hedging tool.
As Knott explains the situation, it seems as if mills are like sports fans trying to watch several games at the same time: The exchanges and indices are vying to bring new contracts to the market; physical exchanges are starting to offer cash-settlement instruments; and financial exchanges are starting to offer hard-metal contracts, all using different indices.
CTRM vendors and consultants are vying to stay current on the newest hedging tools while simultaneously tweaking their offerings to improve speed, accuracy and comprehensiveness. The term virtual steel mill is used with increasing frequency for the concept of tracking expenses in raw materials, production, sales and delivery all in the same matrix.
At heart, CTRM is an aggregating tool, Gyani said. For those people with their fingers in a lot of different pies, there is often a lack of clarity of their overall position. They have so many exposures. Some of those risks exist in certain commodities or certain markets, some are unique to metals, some are common across ag(riculture) and energy as well. Whether a specific user is in a specialty market, or is value-driven or supply chain-driven, not having a complete picture limits opportunities for growth.
The principle applies even in cases in which companies are more vertically integrated rather than horizontally dispersed among several sectors, Gyani said. The end game is the same. You need efficiency of the supply chain. CTRM is a decision-support tool. It never replaces a full ERP platform, but there is more and more overlap between CTRM solutions and ERP systems. That has happened, he said, due to the increasing development of vendors, but it also reflects the volatility that has come into the non-traded markets.
From a mills point of view, all these different prices for different grades are just added difficulties to the business, Knott said. In grain or oil, the spreads can be more easily tracked and the arbitrage opportunities can be more apparent. But that can also be done in steel. From a systems point of view, the fiddly bits can be done.
But there are a large number of fiddly bits. The lack of fungibility among products is a challenge, Knott said. Again, it compares to the energy sector: All over the country, producers of natural gas put their liftings into common-carrier pipelines. Drivers use many different brands of gasoline, all on top of each other. Substitutions for finished products are rarely seamless in steel.
Refiners know their cracking and blending costs, of course, but also their transportation costs, Knott said. Steel mills know how much they pay for ore and scrap and coal, and somewhere, someone knows how much they pay for transportation, but do all the people who need to know that actually know it?
Knott gives a lot of credit to the early adopters in any metals sector, but especially in steel. Right now, they are quite brave because they are facing a lack of liquidity in many of the markets. Conversely, the last ones to get on board will be facing market risks that their competitors are already likely to be managing better than they are, he said. Maybe they will get lucky, but the late adopters certainly run the risk of having their margins wiped out for a few months.
Mines are always long by definition, Knott said. Integrated copper producers, with both mining and smelting in the same house, have a built-in hedgeraw materials against finished product. But for non-integrated companies in any commodity, not just steel, they call themselves producers but they really dont produce; they are fabricators. They turn one thing into another. In steel, the term fabricator means a segment other than the mills, but the mills are actually that. And as fabricators, they face an inherent transactional risk.
The mills also have another element in common with fabricators, distributors and suppliers: Their business is in physical metal, and they need financial instruments as risk-management tools. In the market trading houses, they are essentially financial operators who need physical metal activity as a risk-management tool.
Traditionally, the derivatives analysts, the trading and finance houses, have been better at risk management than the physical commodity operators, Knott said. Each developed without the tools of the other: Trading houses and banks rarely had access to contract terms or pricing schedules, and mills and fabricators rarely had access to derivatives. Yet every business manager is groping for the same insight. Whether you have the thorny, fiddly contract issues or whether you have the power and flexibility and insight of a trading platform, you still need to know at bottom what is your current exposure on any given position and in aggregate, Knott said. Even the biggest guys need to know this. Maybe a steel manager knows his position for the next 10 days, or maybe at the end-of-the-month settlement. But does he have the ability to bring details of his companys disparate exposures together?
These days, every company has some sort of risk-management policy. The goal usually is to eliminateor at least minimizeprice risk on the commodities a company needs to operate. It is not trivial to translate all of those details and the risk-management policy into an overall system with the entire metal position, physical and financial, Knott said. If the senior executives dont know the true exposures, they dont know how the actions of their traders and sales staff and buyers and plant operators are affecting that position. They dont know if policy is being followed and executed.
The analogy Knott offers is having a map for a journey but not being able to see the road or signs due to fog, rain or darkness. CTRM software is not going to tell you whether or not to hedge. It can tell you that if you want to be in a certain position at a certain time, this is the way to get there, he said.
Gyani said that when he and his colleagues walk into the offices of a big metals trading house, a banks commodities floor or even some multinational mill operators headquarters, they often find former Enron Corp. and Bear Stearns Co. Inc. tradersthe ones who had nothing to do with the troubles of their previous companies but who cut their teeth in the first blooms of the trading heyday. Those guys are now bringing that level of skill and sophisticated trading ideas to the industry, he said. Now, to be fair, there are people who dont want these traders coming into a market that is functioning well, a non-traded market, and mess it up. But everyone acknowledges that some metal markets, especially steel, could use additional liquidity and transparency.
We read AMM and we see the volatility in China and other major markets, said Robert Hamilton, global sales director for metals at Aspect Enterprise Solutions Ltd., based in London. Now the LME will tell you that it all can be controlled, but we see customers using LME plus quite complex formulae in their pricing models. Copper could be in backwardation in one place and contango in another.
Theoretically, that reality would even open arbitrage opportunities, which could really draw speculators into the metals markets, but Hamilton said he has not seen a great deal of that. People are not moving metal around, but they are making more use of swaps. Steel guys in particular are resistant to hedging because they believe it will end up with the market driven by speculators, he said. However, some speculation is necessary to supply liquidity.
The latest segment of the market to see a surge in CTRM adoption is the scrap business, Hamilton said. We are doing quite a bit of business in Turkey. Globally, scrap is green, so there is a lot of support for that trade. We are seeing huge interest in us tweaking the standard edition of our software to provide price de-escalators for all non-refined inputsscrap, coal, ore and concentrate. Those are really discounters, he said. You buy the material based on a certain quality or grade, but if in monitoring your output you realize that there is a variance in the quality, you can plug that back into your operating model and cost functions.
Aspects business comes 95 percent from its standard, cloud-based solution and just 5 percent from enterprise deliveries in which there are low-level adjustments to a code for a specific client. In those cases, Hamilton said, Aspect tries to enhance the standard edition by whatever non-proprietary elements can be incorporated from the bespoke versions. In turn, every enhancement to CTRM gives mills more optionsand sometimes new challenges.
How do you assay scrap? Hamilton asked rhetorically. In practice, you have to monitor the quality of output, which is not exact, but there is an evolving view that scrap from North America is of a higher quality than scrap coming out of other regions. But whether you are talking about scrap or other inputs, CTRM is still in its very early days. It is an enabling tool with a long way to go, but at least we are all having this discussion.