Famed Wall Street investor Ray Dalio’s economic template consists of three main forces: productivity growth, the short-term debt cycle and the long-term debt cycle. These three forces can be applied to the service center industry in their own idiosyncratic way. Some short-term cycle dynamics include global pricing relationships, raw material prices, imports and lead times.
While much effort is focused on the effect these short-term issues have on price, there are significant long-term changes underway that bear watching. Developments in government policy on matters such as imports and carbon emissions have massive implications for our industry. However, these types of issues are subject to shifting political control and forecasting their outcome can be unreliable. On the other hand, massive steel price moves are very reliable. It is no wonder that interest in steel price risk management tools is picking up like never before.
Futures are a large part of our future. Adapt or die.
Futures contracts on corn, gold, oil and copper all saw their own introduction, general acceptance and rapid growth. Steel is no different. It isn’t about if, but when.
Steel is a cyclical business with steel price cycles some of the most extreme of any commodity. Service centers benefit in the up cycle with increased margins and volumes. However, in the down cycle, falling steel prices lead to a number of issues for service centers, with losses and write downs being the most problematic. HRC futures are a tool service centers can use to manage the down cycle. Why wouldn’t you want to learn how to use this tool?
Price risk tools are more relevant now than ever before as the general acceptance of steel price risk transfer strategies is creating a network effect. OEM interest in these tools is escalating as volatility, upside price risk and inflation expectations have increased. OEM customers are requesting fixed price quotes, creating a need to be solved by the supply chain. Recent additions in the ferrous futures products suite have increased liquidity in the space.
In 2012, Flack Steel decided to start a price risk management department. Flack Steel had one location, Cleveland, with fewer than 30 employees, 40 percent of its revenue concentrated with one customer and 95 percent of the product mix was hot-rolled. Since then, the company has merged with Globenet Metals, acquired CMP Metals and merged with Kenwood Painted Metals. Now, Flack Global Metals, a start-up in 2010, has over 80 employees with five locations nationwide, servicing customers in 20 industries with customer deliveries to 40 U.S. states, three Mexican states and four Canadian provinces.
This brings us to the crux of this article: evolution. FGM’s risk management department has evolved by embracing one of FGM’s core values, affinity for risk. We learn by doing. We accept that mistakes will be made knowing the lessons learned lead to growth and expertise. The totality of our experiences has translated into the evolution of FGM’s hedging strategies both for FGM’s and for our customers’ businesses. FGM’s level of sophistication is on par with many commodity hedge funds. If your company has yet to enter the fray, then your company is far behind the curve.
FGM’s risk management is much more complicated than simply buying and selling futures. The following is an example of these complexities and FGM’s progress. In late May 2017, prices of scrap, iron ore and Asian flat-rolled were under serious pressure. Midwest HRC prices were falling fast in response. The CME Midwest HRC futures curve was flat trading around $570/short ton. FGM needed to sell more futures to hedge our inventory price risk, but we were concerned that a restrictive policy resulting from the Section 232 investigation could be announced at any time and that would cause domestic flat-rolled prices and HRC futures to skyrocket.
At that time, we had accumulated a hedge position short 2,160 tons of July futures at an average price of $582/short ton. We needed to short an additional 3,000 tons of July futures. The current market price of $571/short ton was not a very attractive level to us and there was the Section 232 risk. What to do?
To manage these two opposing risks, we chose to execute a calendar spread (buy one month and sell a different month) instead of simply shorting the July futures. We sold 3,000 tons of July futures at $570 and bought 3,000 tons of Q4 futures at $571, i.e. 1,000 tons of October, 1,000 tons of November and 1,000 tons of December.
Within days, California Steel Industries announced a flat-rolled price increase, which was followed by the other domestic mills. Moreover, raw material and Asian prices began to rebound and rally throughout June. By early July, the HRC futures curve had moved sharply higher into the $625 -$635 range. After the first July CRU Midwest HRC print of $609, we sold the 3,000 Q4 tons at $635 and, instead of buying in the 5,160 July tons we were short at the prevailing market price of $625, we waited to see the next index print. The second index print was $613. The third and fourth prints also came in the low teens and we let the July futures settle at $611. We lost $185,640 on the July hedge, but we gained $193,500 on the Q4 position for a net gain of $7,860. This outcome was a direct result of our years of experience and the evolution of our inventory price risk management strategy.
When I started in 2012, I accompanied CEO Jeremy Flack to numerous steel conferences, where he spoke on the topic of risk management, promoting the benefits of using these strategies. He implored the steel industry and the service centers to educate themselves; to join the cause and adapt risk mitigation into their businesses. From conference to conference, we went championing this message. However, interest lacked and many of our service center competitors provided excuses. “It’s too risky.” “It’s just gambling.” “It’s too illiquid.”
Today, the ferrous derivatives suite includes Midwest HRC, iron ore, busheling scrap, Turkish scrap, Turkish rebar and U.S. shredded scrap. Liquidity in these products has been growing week after week and has reached a scale that more than suffices FGM’s needs. Over the last year, our customers have requested more meetings to discuss risk management and more quotes for our price risk solution products than ever before. With 11 months left in 2018, our physical tons tied to our risk solutions are already up 50 percent year over year. This space is advancing rapidly.
So again, I ask: why wouldn’t you want to learn how to use this tool?
David Feldstein is the director of risk management for Flack Global Metals, Chicago. The company, founded in 2010, has grown to become the 30th-largest service center in North America, with 2016 revenues of $320 million.