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Progress in the use of steel derivitaves

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Speaking with Metal Market Magazine a year ago, Phillip Price, steel derivatives expert, and since then founder of Pool, said that he had seen a sea change in the steel sector’s attitude towards price risk management, hedging and derivatives, with a number of new participants making test trades, including one or two mills.

One year on, he said in January 2020 that the trend and momentum have continued: “There is an even wider range of
participants from across the supply chain integrating price risk management tools into their business.” Pool is now working with multiple steelmakers to help them implement a strategy. As a sector, steel mills are showing the biggest growth of new interest, Price noted.

That interest is coming from EAF-based mills in particular. Price added that they are using scrap derivatives at the feedstock end of their business, but are also generating more liquidity in the LME’s rebar contract.

Tim Stevenson, founding partner of commodity advisory firm Metal Edge Partners, said that the first step taken by his firm to help customers with price risk management is to do a full risk assessment of their business. “We need to adequately understand their risks and opportunities,what they want to achieve from price risk management, and then quantify it.”

For steel, Metal Edge mainly works with the North American flat-rolled sector, which often makes use of CME’s Midwest hot-rolled coil contract, but can work with any of the range of ferrous derivative contracts available.

Customers come from along the full steel supply chain, including service centers, distributors and OEMs. Acknowledging an ongoing reticence by some participants in the steel supply chain to embrace the use of ferrous derivatives as a tool for price risk management, Stevenson recalled the similar reluctance by major primary  aluminium companies years ago, who now view the use of LME aluminium prices as an integral part of their business.

He confirmed that some US steelmakers have embraced price risk management now and that volumes of trade in ferrous futures contracts have increased as a consequence. “It’s just a matter of time before it is understood and adopted,” said Stevenson, noting that innovative steelmaker Big River Steel has been one of the US steel producers to lead the way.

Some steelmakers focus on managing price risk in their raw material supply, but Stevenson said that adoption of the process on the revenue side of their business – that is the steel products sold – will come too. “Some of the banks will encourage them,” he noted, as reduced price risk also de-risks the lending profile.

Education still needed

US service center Priefert Steel has a successful history of providing fixed prices to some of its customers on long-term contracts by deploying price risk management, and it has helped those clients to understand its merits.

Last year’s market conditions were not so conducive to making such arrangements however, noted Chris Shipp, Priefert Steel’s vice president supply chain. He said that 2019 was a challenge for steel business: “When customers saw that steel price falls continued throughout last year, apart from a short blip up in August, they were not so concerned with locking prices in.” He noted that US steel prices fell almost continuously for 14 months.

“Providing education about price risk management to customers in a falling market is a challenge,” he explained, since clients hold off buying in the expectation of lower prices. By the end of last year, with steel imports held at bay by tariffs, US mills looked to raise prices. “Then they call,” Shipp said. “There is hope for the future, with an uptick from November onwards,” he added.

Since the demand for fixedprice contracts was impacted by US steel market conditions in 2019, Shipp’s sense is that the overall depth and breadth of knowledge about price risk management in the US steel sector is similar to the level at the beginning of last year.

The fact that long-term strategic price risk management is really about locking in margins, regardless of price direction, suggests that there is still a need for the kind of education that Priefert Steel can offer its clients. The company is an active user of US Midwest hot-rolled coil futures – something the company has continued to help some of its clients with, despite the market conditions over the past year.

Approaches taken

Price reminded that the concept of a “virtual steel mill” has been around for a long time. In that concept, the main steps in the supply chain – from raw material inputs, through semis to finished products – are represented by corresponding derivative products, which can be used for hedging.

“Unlike base metals, the steel sector is more complex in terms of how the supply chain works,” said Price. No single instrument is enough on its own to achieve effective price risk management, he added. “What’s needed is a virtual steel supply chain from mine to end-user in order to fully hedge.”

Relative value arbitrage between the prices along the supply chain then help to facilitate comprehensive price risk management. The LME’s scrap and rebar contracts provide one example, and CME’s US busheling scrap and hot-rolled coil contracts another, Price noted, adding that geographical spread trading, such as between hot-rolled coil prices in Europe, the US and Asia provide further opportunities. HRC and rebar contracts offered in Shanghai can be used for physical market hedging in the onshore markets in China too.

Industrial hedgers are interested too, Price noted, extending existing hedging in raw materials, including coking coal and iron ore as well as scrap, to products with similar price volatility downstream. “As a steelmaker, there is not much point in solely hedging raw materials unless you are fixing prices on products too.”

As Price noted last year, companies new to hedging also need advice about choice of trading venue, clearing, interaction with banks and the relative merits of trading electronically, by phone or over-the-counter.

Stevenson said that companies can bring in experienced risk traders, analysts and a risk manager, or sometimes the CFO can dedicate some of their time to managing price risk.

“Our value proposition is that we can replace some or all of the skill sets of these three at a more reasonable price,” Stevenson explained. Metal Edge can educate sales, finance and trading staff and facilitate OTC trading.

“We help them set up,” he explained, providing, for example, a position statement and a value-at-risk statement. “All of our customers had no trader when we first met them,” he recalled. Once they have made a start, clients are supported with on-going analysis of supply, demand and production data to give their own business the context of the big market picture. For customers wanting it, Metal Edge also provides trade execution.

Priefert Steel is both a service center and a steel fabricator/ manufacturer, “So we are our own customer,” Shipp noted. That means that on-going education of Priefert’s own staff on how price risk management fits into the company’s business strategy is valued.

“We did it more for ourselves than for others last year,” said Shipp. He explained that the company’s own hedging strategy enables it to fix its own product prices for a year or more. “Our ability to promote fixed prices for stock gives us a competitive advantage,” he pointed out.

Price said that he is seeing a shift towards industrial hedgers getting the right people in place to achieve price risk management: “There is more openness towards the use of derivatives.” He sees a trend for steel companies to train their own staff in risk management, rather than bring in people from other sectors. He also observed growing  interest from commodity trading companies that had previously focused on non-ferrous metals and energy in ferrous derivatives, although it is still a step away for some of these companies. With the imperative of tackling their physical price risks, steel companies are making more progress at present in Price’s view.

Gaps in derivative markets

Are more steel derivatives needed to enhance price risk management?

The evolving markets and structural changes in Asian steel industry have stimulated discussions about the growth in provision of the derivative tools needed to hedge steelmaking raw materials in particular (see boxes).

Price sees the growing market for containerized scrap shipments to south and southeast Asia as one ripe for a new derivative contract: “There is pent-up demand for risk mitigation and hedging there.

That’s a big one.” Such a contract will also allow “arbitrage between the deep sea and containerized scrap markets and establish a forward value for containerized scrap,” he explained.

Another potential area for value addition is the differential between hot-rolled coil and galvanized coil. “The best way to do that is through a tradable differential,” said Price.

Contracts based on such differentials could be offered through the banking community for commodities along the length of the main steel supply chain, including scrap, iron ore, coking coal, rebar and hot-rolled coil. He drew a parallel with futures contracts already offered for aluminium premiums, adding that ferrous instruments would not necessarily need to be cleared if they were offered OTC.

Stevenson said that a way to manage cold-rolled coil and/or galvanized and coated steel is needed, in addition to complement the hot-rolled coil contracts already available. He envisages something like the Midwest aluminium premium contracts already available, which allow regional price risk to be hedged on top of hedging the base price for the metal.

For steel, a similar premium contract for cold-rolled, galvanized or polymer-coated steel would not take away from the existing good liquidity in hot-rolled coil contracts. Stevenson also saw merit in a North American rebar contract. “It would never be as big as the hot-rolled coil contract, but there would be demand for that too,” he observed.

Shipp agreed that a new derivative contract based on the price differential between hot-rolled coil and cold-rolled, galvanized and polymer-coated flat steel products would be welcome. “The spread between HRC and CRC has got quite high. We buy a lot of cold-rolled and galvanized steel, but we can only hedge the hot-rolled coil. A new premium contract would gain traction,” he said.

Outlook for growth

Price expects that volumes of trade in the LME’s scrap and rebar markets will grow over the coming year as trade in the deep sea market for scrap climbs. He also predicts growth in interest from the construction industry in price risk management for rebar, but notes that an open interest limit on the LME’s rebar contract acts a cap on volumes in that market. “Once a solution is reached for that,” he sees volumes of trade growing, which should also feed through to volumes of trade in the LME’s scrap contract.

Price also forecasts growth in the US EAF sector, but sees the Section 232 tariffs limiting that to domestic operators. If those tariffs were revised, the US market would become the subject of wider international interest again, he noted. Price also believes that exchanges considering launching contracts for containerized scrap should have made progress on them by the end of this year.

Priefert Steel has gained customers in the automotive and aerospace sectors by being able to offer fixed prices, but the outstanding market for growth last year was providing tubular steel framework for supporting solar panels, particularly in Texas, Shipp noted.

He explained that long-term, 6-month, contracts with larger OEMs enabled Priefert to lock in its own profit and to gain market share, even in the relatively subdued market conditions of 2019. Solar energy was one of the largest growing markets for Priefert in 2019 and that sector continues to look strong for 2020. “We’ve started 2020 with a little more optimism than in 2019,” said Shipp, but we’re still a bit concerned about demand,” he added. The ISM manufacturing index has been declining for almost a year, which is one cause for concern when trying to forecast demand, he explained.

While there “may be a little bump in Q1,” Shipp is fairly optimistic for Q2-Q4, although he added: “We’re still just not ready to say things are a lot better.” The uncertainties of a US presidential election year are another factor making Priefert Steel very cautious about what it does.

Shipp recalled that many service centers bought stock at the low prices available at the end of last year, which has left their inventory levels high. He also noted that some US steel mills are reducing output to support steel prices and that imports to the US continue to be kept at bay.

He sees the scrap price as an indicator of things to come, noting that if ferrous scrap prices are flat in February that would signal a continuing challenging market for steel ahead in Q2-Q4. Stevenson said that price risk management is best done as a long-term strategy and that it is good to start it when volatility is low and markets are not faced by dramatic price changes – bearing in mind that it takes time to set things up.

“It’s not for everyone,” he said, “If you’re in a business where you can raise your prices [and so pass price risk on to your customers], but a lot of customers want fixed prices,” he concluded.

To view the entire issue, please click here.

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