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Market players see risk reduction with scrap futures

Keywords: Tags  US ferrous scrap fdtures, CME Group Inc., No. 1 busheling, U.S. Midwest No. 1 busheling ferrous scrap futures, AMM Midwest Ferrous Scrap Index, Jonathan Putnam, Standard Steel Trading Co.,

It was less than five years ago, in 2008, that AMM’s consumer buying price for No. 1 busheling in the Chicago market plunged to $125 per ton in early November from $890 four months earlier. Short of another economic apocalypse, prices are unlikely to be this erratic, but one thing is certain: Volatility and scrap metal go hand in hand.

It’s no surprise, then, that even though the first U.S. ferrous scrap futures contract is still in its fledgling stage, observers suggest it’s just a matter of time before it’s widely accepted. Mills, buyers and metal recyclers are already setting up accounts as they embrace the risk-management tool.

Launched by Chicago-based CME Group Inc. in September, the U.S. Midwest No. 1 busheling ferrous scrap futures contract is settled based on AMM’s Midwest Ferrous Scrap Index for No. 1 busheling. Buyers can use the contract--equivalent to 20 tons of prime material--to fix their input costs. While it reduces their ability to take advantage of sweet spots when prices fall, it also eliminates their exposure to volatility.

“The whole concept of hedging is to mitigate or eliminate the primary risk of market price movement. If any buyer is incurring unknown costs to support a known sales price, he has accepted significant market risk,” said Jonathan Putnam, president and chief executive officer of Roswell, Ga.-based Standard Steel Trading Co. “A mill buyer of scrap doesn’t know what he is going to pay in the next month for scrap but has already fixed the price of (finished) steel for a quarter. If he purchased futures, he would have locked in his primary input cost and would know in advance the margin on his sales price out into the future, regardless of whether either scrap or finished prices go up or down.”

Hedging can help mills reduce their exposure to adverse and unpredictable price movements. One mill buyer said that he plans to use the tool on long-term contracts. “I hope it can help when I get a lengthy government contract; I could look out seven or eight months and lock in a scrap price. I don’t want to risk the profit of the contract, so I can quote the government a price and buy as many contracts as I need to cover it,” he said. “We do government business and already lock in on alloys but haven’t been able to lock in scrap.”

The mill buyer noted that some of his customers are intrigued by futures for similar reasons. “My customers are interested, too, and they are interested in the same thing. They get contracts and would love to be able to freeze their raw material price,” he said.

The futures market will make most sense in a normal environment where prices should be elevated somewhat months down the road.

The mill buyer has been monitoring the futures market and has set up an account but may not need to draw upon it this year due to a bearish, uncertain outlook. Prices have the potential to soften this year, so there wouldn’t be a need to take out futures contracts.

It is unclear where scrap prices are headed due to the scheduled June commissioning of Charlotte, N.C.-based Nucor Corp.’s 2.5-million-ton direct-reduced iron (DRI) facility in Louisiana. DRI is a substitute for prime scrap. “When Nucor turns on their DRI plant in June, the scrap flow is going to get better,” the mill buyer said. “There could suddenly be enough scrap for everyone, and scrap prices could fall.”

Recyclers also can hedge on futures. When scrap plummeted in 2008, recyclers couldn’t sell their scrap at any price because mills had no orders for finished steel. At times when material can’t be sold to mills, recyclers can sell futures forward to protect the value of their inventory.

If a circumstance--like the pending DRI capacity coming online from Nucor--makes a scrapyard executive bearish, he can act on his negative view and sell futures to protect the value of the inventory.

An executive at St. Louis-based recycler Kataman Metals LLC said that his company has embraced the notion. “We use futures to hedge our physical scrap trading business,” Brad Clark, director of steel trading, said. The hedging is part of business as usual and is not driven on events like pricing volatility, he said.

The futures can be used to help mitigate risks with its customers, Clark said. “If a supplier of scrap wanted to lock us up over the next 12 months, we would look at futures as one source to help build up our sales price to our customer.”

Adam Weitsman, president of Owego, N.Y.-based scrap processor Upstate Shredding LLC-Ben Weitsman & Son Inc., said that he is playing in the futures market to lock in margins.

Finished steel buyers can use futures to mitigate basis risk. That’s different from market risk, which encompasses the inherent ups and downs in prices; rather, basis risk occurs when mills raise prices on finished steel even though scrap prices have declined. “Basis risk can be eliminated by negotiating with a (mill) supplier to adjust the sales price based on movement of the scrap futures contract,” Putnam said. “A coil buyer will use steel futures, but a rebar buyer can use a scrap contract if he can negotiate to adjust his pricing based on the movement of that index.”

One challenge facing the tool is that many people are unfamiliar with the way the contract works. Numerous industry scrap players on the buy and sell side are still learning that the contract is purely financial and in no way physical. Speculators need to establish a brokerage account for the futures trading, and no scrap is actually traded.

“A lot of scrap companies have been hedging on copper for years, but I can see how this (concept) is new to pure-play ferrous guys,” said the owner of a Pennsylvania metal recycler. The futures contract could become an alternate to pricing on a “to-be-determined” (TBD) basis. Instead of TBD, material could be moved out and settled on the CME scrap price, he said.

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