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Traders lead early interest in ferrous scrap contract

Keywords: Tags  CME Group Inc., Young-Jin Chang, U.S. ferrous scrap futures contract, Cleartrade Exchange Pte Ltd., Cleartrade Exchange China Steel Index, Richard Baker, Shanghai Futures Exchange, Eka Software Solutions Pvt Ltd. Manav Garg

In the six months since CME Group Inc. launched a U.S. ferrous scrap futures contract, more than 20,000 tons have been traded in more than 1,000 contracts. Whether that is considered impressive or inconsequential depends on the comparison and the time frame.

Against other ferrous futures, it’s a tiny number. Hot-rolled coil, for example, saw 130,000 tons traded in February--but, in fairness, the hot-rolled contract is five years old and didn’t trade at all in its first six months; compared with that, the scrap contract is a hit out of the box.

The CME has traded a Turkish scrap contract for quite some time, and Cleartrade Exchange Pte Ltd. in Singapore also trades a Turkish scrap contract.

Given its role in what the CME calls the virtual steel mill, where hedgers and speculators can trade some or all of the commodities in the steel supply chain, the question of the place for a scrap futures contact seems to be when, not whether. That said, there remains an industry education challenge for the exchanges that trade futures, not just in scrap but all ferrous contracts, in convincing mines and mills of the utility of financial risk management.

“The scrap contract has grown in line with our expectations since the launch in September,” said CME director of metals research and product development Young-Jin Chang. “It is a very new contract, and still the gains so far make it a great success. We see scrap catching up quickly with (hot-rolled coil) and other ferrous contracts.”

Any broker registered to trade on Nymex or Comex can work with the new contract, she said, but noted that there are only about a dozen brokers currently specializing in the market. So far, the primary users of the CME scrap contracts have been traders, service centers and processors rather than mills, Chang said. “We are seeing new entrants using that contract, especially those participants that already trade other ferrous contracts. We see people trying a few contracts at a time, 100 tons here or there, to get the feel of it.”

The CME has put some market development effort behind the new contract, including a presentation at AMM’s 6th annual Steel Scrap Conference in Philadelphia last November. “That presentation was one of the best attended at the conference,” Chang said. “We are participating in as many speaking opportunities and workshops as we can. Our next step to continue the education process is to reach out to mills, processors and traders.”

That likely will remain a challenge for some time. Thomas Danjczek, president of the Steel Manufacturers Association, is careful to stress that as an organization his group doesn’t advocate one method of risk management over another. “We say let the market work. The market can decide on real solutions to real industry problems,” he said.

Anecdotally, however, Danjczek said “the challenge for many of our member companies is to understand the value proposition for some of these instruments. If the mill has to assume the risk in the end anyway, then why pay for someone else to do that? It has not been clear who takes the risk and who pays for it. Most of my members can do a one-year (bilateral) contract based on the same index as the exchange contract.”

Danjczek reiterated that he isn’t for or against any risk-management tool, but the association has been following the development of futures trading. “We are waiting to see what kind of traction it gets, how it affects supply and demand, what regulations are in place. If there is traction, it will probably start overseas. Here, today, the producer is still a partner with the supplier. They don’t necessarily want anything in between that,” he said.

In contrast, traders do seem to be taking up the new contracts.

“We buy steel and scrap,” Bradley Clark, director of steel trading at Kataman Metals LLC, St. Louis, said. “We hold inventory and we hedge that, so we use all the tools available to us. We use the HRC (hot-rolled coil) and the scrap contract to offer customers solutions they would not otherwise get, but on its own the scrap contract will take several years to take off. Look at iron ore: it took about 10 years, but it was a real success story.”

He offered the analogy of drybulk freight. “Freight was oversupplied and depressed for about 50 years,” Clark said. “Around 2005, when China started to build its infrastructure, freight went through the roof. But the shippers--grain, coal, iron ore--had experience in the futures market because of the underlying commodities so they were able to use hedging.”

In contrast, some mills and yards are more comfortable with their bilateral contractual business models and are less familiar with hedging on an exchange, but Clark believes that will change over time.

“People note that the HRC contact is doing well,” he said. “But it is not just after five years; there were two years of development before that. So figure seven years for the new scrap contract or others on different exchanges. It’s like a dance. The more people on the floor, the more want to come on the floor. But just having a few people out there dancing their heads off can sometimes be a hindrance.”

Cleartrade Exchange includes a Turkish scrap contract in its basket of ferrous metal contracts, clearing through LCH.Clearnet. The ferrous metal portfolio also includes northern and southern European steel, 62-percent iron ore fines and Chinese hot-rolled coil and rebar, settled against the Cleartrade Exchange China Steel Index (CCSI), priced in U.S. dollars and available to international customers who want price exposure to futures contracts traded in yuan on the Shanghai Futures Exchange. The CCSI is a daily price index developed in partnership with China United Steel/United Metal Network based in Beijing.

In March, the exchange completed a private placement to increase capital and diversify its investor base to include more users. “We have a potential new board of directors,” Cleartrade Exchange chief executive officer Richard Baker said. “More than 80 participants came in for the offering, which was very important for us to get new scale and new, wise heads.”

The timing was propitious, as traders struggle to manage new financial regulations, Baker said. “When (the) Dodd-Frank (Wall Street Reform and Consumer Protection Act) came into effect in October 2012, quite a lot of players got caught out. Some found themselves unable to trade. Now they know that it is all real and it is all here to stay.”

While Baker’s exchange handles many commodities, he has a soft spot for ferrous, having a background in steel sheet. “As we try to support and educate the industry, we see a lot of synergy between the risk-management tools and the supply chain systems they have been investing in. Some of the smaller guys are definitely moving quickly on all of this, and that may give them something of an advantage if the bigger operators are not yet in.”

A new entry in the U.S. commodity trading and risk-management business is India’s Eka Software Solutions Pvt Ltd. “We have several customers in Europe and one in the U.S. using our system through the life cycle of scrap to decide when to melt and when not to,” Eka Software founder and chief executive officer Manav Garg said. The Bangalore-based company has offices in Norwalk, Conn., London and Sydney.

The only way to hedge without a specific scrap contract is by the so-called dirty hedge, where a basket of correlated contracts are used as a proxy, Garg said. There have been long cycles of highs and lows in scrap and steel, but not so much volatility.

“Without volatility you get comfortable in your position,” he said. “Uptake is slow for all risk-management tools. People are not used to these things, and they need a lot of education. But what is driving all of it is volatility well beyond historic levels.”

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