The Chicago Mercantile Exchange trading floor.
Several weeks after the launch of a new ferrous scrap futures contract by CME Group Inc., the outlook for the new risk management tool is still mixed.
Everyone, from the developers at CME to traders, buyers and sellers, readily agree that these are still very early days. Supporters note that there has been a flurry of early trading--modest volumes, to be sure, but a positive note on which to start. There are no detractors, per se, but there are more than a few in the industry who doubt the utility of such a contract for both technical and strategic reasons.
Even the competitive picture is mixed. Cleartrade Exchange Pte Ltd., Singapore, just started trading a scrap contract that settles against the Turkish Scrap Index, and Indias National Commodity and Derivatives Exchange said it plans to launch a ferrous scrap futures contract by year-end, but a representative of the London Metal Exchange, which has no current ferrous scrap contract, declined to comment on whether it was contemplating developing something similar.
The new CME scrap contract is settled against AMMs Midwest Ferrous Scrap Index for No. 1 busheling. That is relevant because both the CME and the LME launched steel futures contracts competitively in 2008. At the time, global steelmakers expressed concern that such a contract would stoke speculation in a market that traditionally has been the domain of just buyers and sellers. The CME primarily handles contracts in agriculture and energy, precious metals and currencies, as well as equity indices and interest rates. In contrast, more than three quarters of the LMEs business is in industrial metals futures, including steel, aluminum, copper and nickel.
The world economy fell into a major recession at the end of 2008, led by the financial sector. Banks, brokerages and trading houses, the institutions that might have been willing to speculate in the steel market, were instead fighting for their lives. Still, the same specter of speculation shadows the new CME scrap contract.
The big exchange is sticking to its guns. Since the Sept. 10 launch, the reaction so far has been positive, CME director of metals research and product development Yong-jin Chang said. For any brand-new contract, there is a very steep learning curve and a long education process.
That said, Chang is cheered by some good news for the scrap contract. We saw some early adopters, as well as regular clients who are users of our hot-rolled coil contract, take some interest in the scrap contract. There was 420 gross tons of open interest in the first few weeks, which we are taking as a very positive sign. Those early adopters are taking one contract at a time, one position at a time, concentrating on the shorter months, November through January mostly, she said.
According to the exchange, daily volume traded in the CMEs domestic hot-rolled coil futures index peaked at 536 contracts in August. In contrast, there were 90,793 copper contracts traded on the CMEs Comex subsidiary in New York.
There are two primary drivers behind the new scrap contract, which is traded on CMEs Globex electronic platform. First is the sheer size of the market and the reality that it is just about the only major industrial commodity without some hedging tool. The second is that the CME has been promoting its integrated risk management suite, called the virtual steel mill, for some time. Chang said that a scrap contract is an essential component in the full steel life cycle.
In 2011, about 65 percent of the steel produced in the United States was based on scrap, according to the CME. About 73 million tons of scrap were produced last year, for a total domestic and export market of $35 billion.
Looking out across the broader base of the steel sector, on the yard side and on the producer side we are getting a lot of calls with inquiries. People are really trying to understand the new contract, and it seems clear to us that the industry is starting to see the value of this contract, Chang said. At the most basic level, then, the CME believes that a worldwide business of the size and scale of scrap steel needs a futures contract as a hedging tool for the same fundamental risk management reasons as other global commodities.
Based on those figures and that premise, everything the CME has said indicates high hopes for a large and robust trade in the new contract. But reading between the lines, there also seems to be the business proposition that even if the scrap contract by itself doesnt become a big standalone winner, it is still an element in the virtual steel mill and will be retained as a role player in that capacity. The virtual steel mill goes to the big picture in the industry, Chang said.
In either case, building liquidity takes time, she added. That liquidity is what people want to see in these contracts. And building that liquidity gets back to education and awareness. The education process is a very big portion of our development plan. We are holding hedging workshops and conferences around the country.
At the same time that the CME is working hard to enlighten the market and drum up interest in both the scrap contract and the wider virtual steel mill concept, the exchange is playing down any near-term expectations for the scrap offering. At this point, we would not want to speculate on future volumes for the scrap contract, Chang said. We are very encouraged by the fact that it was traded on its very first day and that volume is already building so soon after the launch.
Both developments are very rare in a new contract, she said. There is definitely capacity in the physical market against which this contract can grow. Just look at the growth in the (hot-rolled coil) contract. And look at the record volumes in iron ore contracts. We take all of that as very positive for the scrap contract. When the market becomes aware of these tools and understands how to use them, the adoption accelerates. The scrap contract is a nice addition to those.
Cleartrade chief executive officer Richard Baker said his exchange received regulatory approval for the Turkish scrap export contract in late August. We already trade north Europe (hot-rolled coil) and south Europe (hot-rolled coil), and we have looked at Midwest (hot-rolled coil), but we have not looked at North American scrap. The market is just too immature at this point. The players are not really ready for a scrap contract.
That said, Baker has every confidence in the long-term growth of the markets and their eventual need for more sophisticated risk management tools. We are seeing paper contracts in steel, he said. It took two-and-a-half years to get the iron ore contract to work, and we are only now just seeing volume increase. I tend to be practical about these new contracts. In the next 12 to 18 months, I expect to see broader contracts in steel as that market becomes more mature. There will be more acceptance of the paper contracts.
Baker offers a global perspective on the scrap market, beyond the shredders of Middle America. He sees the scrapping of ocean vessels as an important driver in the global scrap business. In the boom before the big recession, new shipyards were created across China, elsewhere in Asia and in many other regions. Since the recession, hundreds of ships have been idled. In the last few years, all those new shipyards have turned to disassembly, he said. The typical lifespan of an ocean vessel over the past several decades has been about 20 to 25 years. Just within the last 18 months, the average lifespan of the world fleet has gone down to 15 years because the owners of older or underused vessels are getting good prices for the scrap. This is a buoyant market.
Far from competition or complication for North American scrap markets, we see strong organic growth in scrap. But we dont yet see significant need for risk management in those markets. Certainly it would be nice to have, but the ecosystem is not ready yet, he said.
What gives Baker confidence in the ultimate growth of scrap contracts is straight economics and basic risk management, arising out of the needs of buyers and sellers rather than fueled by speculation. End-users and mills will wake up to the fact that they have a floating price behind their raw materials, and that has a profound effect on their profitability, he said.
Bakers model is the iron ore market. Until recently, iron ore was settled 100-percent bilaterally. Today, about 90 percent of the market is done in spot index contracts. Beyond that, the worldwide ore market was 43 million tons last year and there were about 165 million to 170 million tons of derivatives used. From ore to scrap is the full product cycle; scrap as a raw material brings the supply chain around 360 degrees, he said.
And that is where the market is headed, Baker believes. Today, however, scrap merchants are getting reasonable prices in bilateral trade so there is no need yet for more sophisticated risk management tools.
We have been watching steel and scrap and all the other futures for five years, Steel Manufacturers Association (SMA) president Thomas Danjczek said. The worth of any of those things is the real value added to mills or yards. So far, the exchanges and the traders have failed to sell the market as a whole on the value. That is why the volumes have not taken off.
Danjczek suggested several tactical reasons why industrial users, at least, havent rushed to embrace the new futures instruments. Lead time in our business is down to something like two weeks, he said, suggesting that the real-time physical market moves too fast for a paper market. Also, the size of scrap lots bought and sold doesnt fit well with standard volume contracts. Scrap goes in truckloads or railcars or shiploads. A shipment is usually the sum of lots of small orders. It is tough to handle that in a futures contract with all those different lots and sizes, he said.
Beyond the structural and logistical questions, there are some practical financial ones as well, Danjczek said. These days, with interest rates so low, you can just buy a pile of scrap and keep it for as long as you need. Who needs a futures contract to manage that?
In essence, scrap isnt a high-value or perishable commodity like gold or grain, he said. I dont know if we need to pay someone to manage our risk for us. I go back to my first question: what is the real value to the mill or the yard? What is the real cost reduction?
Then, of course, there is the shadow of speculation. Some SMA members simply see these derivatives as speculative, Danjczek said. Look at aluminum. The volume traded on the LME is seven times the volume of physical metal produced in a year. Look at copper, look at grain. They all have impacts in their markets that do not pertain to steel and scrap. What affects our business are location and logistics, freight costs and demand. You cant change any of those things with a futures contract.
For all his reservations, Danjczek is willing to concede that there may be a time and a place for a scrap futures contract. However, this is not it yet.