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Price Risk Management

Price Swings Spike Interest In Hedging

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MCN Editor Dan Markham Though still in its infancy, the use of financial tools to manage price risk continues to grow in the steel supply chain.

The North American steel production community has undergone a major overhaul in the past two years. 

At the start of 2020, there were six major flat-rolled steelmakers in the U.S. Today, there are four. Moreover, observers regularly remark on the mills' newfound discipline leading to expectations of greater pricing stability in the years ahead.

Not so fast, says Jeremy Flack. 

While acknowledging the change in the production picture, the founder of Scottsdale, Ariz.-based Flack Global Metals is not banking on an end to the whipsaw effect on pricing that has too-often characterized the domestic steel market. And for that, he blames not mill decision making, but the unique nature of the North American steel industry.

The United States is the only large format, flat-rolled steel industry in the world that has 70 percent EAF production on the mill side, a number that is expected to increase to 80 percent over the next five years. And those producers have a variable cost structure, unlike the fixed cost model inherent in the integrated mill calculus. 

"You have brand new mills that make fabulous products by great companies. But they don't help you manage your price risk because they have a variable cost model," Flack says. "The U.S. steel industry is the least polluting, it has the best products for the least amount of impact to the environment, but it's also super volatile to buy steel."

Flack has built his company on removing that volatility from the steel market through the use of hedging and other financial tools. It's a practice that took years to gain a foothold in the ferrous metals world, despite its longstanding application for the supply chains for aluminum and copper. 

For more than a decade, his company has been beating the drum for service centers and OEMs to remove price risk from their steel transactions. It's been an uphill climb, but the progress looks more promising from the present perspective than it did on the ascent. 

"Has it met my personal expectations? Of course not," he says. "But is it reasonable? Yes it is."

The steel market is well over a hundred years old. The exchanges, in contrast, have only been liquid enough for the past five or six years. Yet, he notes, the current progression in activity points to 63 million tons traded on the exchanges in 10 years. 

That growth hasn't followed a smooth, upward trajectory, but one that moves in fits and starts. 

"When prices rise and these guys book firm prices to their customers and then they're having to buy in the product at higher prices than they've been able to sell, it's always those times when people have suddenly gotten an interest in "How do we do this?'" says David Waite,  president of the New York-based Commodity Risk Management Associates. "The periods where prices are just going sideways tend to be periods when they don't have a problem. The last couple of years, people have started to realize the volatility presents a real financial problem so they're starting to get interested once again."

While some service centers and OEMs have begun using hedging as a mechanism to guard against price risk, its application is hardly universal. But if the trends hold, many, many more will be using these tools in the years to come.

Getting started
For companies that have not yet begun a program of managing price risk, the first step is an analysis of where they stand in terms of exposure, experts say. 

"First off, they need to take a look at what their position is, what are their current on-hand inventories and what are their priced sales looking like, how many tons or pounds in the future do they have sold at a set price," says Tim Stevenson, CEO and founder of Metal Edge Partners, a Plymouth, Minn.-based metals risk management, investment and advisory resource. "Those things are going to determine what they might need to do from a hedging perspective."

Andrew Lichter, vice president, corporate strategy and development for Mobius Risk Group, Houston, agrees. "For somebody going down a risk management journey, the first step is understanding what your risk is. It's going through all your contracts, understanding when does the exposure hit. When you ship and when you receive material are not necessarily when the risk hits."

How exactly you're buying and selling determines what your risk is and when it hits, he says, noting you might have a mill that prices to the prior quarter vs. the prior month. 

"Hedging is very efficient from a working capital perspective. You'll likely have to deposit some money on margin with those trades, but it's far less than the total purchase or sale," Stevenson says. 

Though many service centers pride themselves on their ability to add value through operations, that's not where the real fluctuation in margin exists. The difference in margin between the 50th percentile operation and the 75th percentile facility is going to swing no more than $15 per ton. 

In contrast, given the volatility of the market, the price can rise or fall more than $100 per day. "How you manage that market movement is very important," Lichter says. 

Even companies that don't employ the price mitigation tools must be aware of them. "Whether you care about risk management or not, you need to understand how financial products are priced," Lichter says. "There are embedded financial products in every contract. If you don't understand how they're priced, you'll overpay every single time.

He cites some mill pricing mechanisms, such as scrap-plus, which can be beneficial for the mill and less so for the distributor, given its increased volatility. "If you're going to put yourself in a risker position, you need to get paid for it," Lichter reasons. 

Traditionally, beginning the practice of hedging required one of a few steps. A service center can set up a clearing house by itself, which is a little tricky for a newcomer unfamiliar with the financial markets. 

An operator can also go through its bank, who may be able to handle the transactions themselves, but will likely be supportive of the effort if they can't. "In most cases, banks look favorably on a well-developed hedging program because it can serve to de-risk the business. In some cases, they may have the capability of trading steel and derivatives as well," Stevenson says. 

But Flack says the number of banks who fit that category are limited. "There are only two or three banks in the U.S. that make a market. You have to be lucky enough or strong enough to make deals with banks to deal with margining and credit lines," he says. 

Companies can also work through risk management firms, consultants who will navigate brokers and clearing banks for the client. 

Recently, Flack Global Metals launched a new method for metals supply chain participants to get involved through its Flack Metal Bank directed buy structured transactions. "With our products , you can buy the steel from whomever you want, but you can get your risk management handled by our capital markets desk," he says. 

Flack Metal Bank, which launched in late 2021, employs four former Chicago Board of Trade floor traders, two chartered financial analysts, its own research group and has two floor seats on the Chicago Mercantile Exchange. "It's one thing to buy futures; it's another thing to come to Flack Global Metals and outsource to our capital markets desk and have the best steel traders on the planet to help you get your deals done," says Flack. 

Mistakes to Avoid
Waite says not every company should be getting involved in hedging. It may not be worth the effort for smaller companies without the heavy volumes. He has a general rule that companies that move more than 10,000 tons of metal per year should be the ones hedging their risk. 

"You have to think like a commodities trader. It's purely units in and units out, when I'm pricing the units in and when they're starting to be a risk," Waite says. 

While hedging is primarily done to remove risk, it can also be a value-add for the experienced operator. Giving your customers your expertise on price management can add to your margins. 

However, it won't be done by outguessing the market on price. "People think the traders at banks and merchants are making all kinds of money betting on the price. That happens sometimes, but just as often they lose," Lichter says. "Goldman Sachs makes money every year because they process low, get paid to take a spread, and they get paid to lay that risk off. They structure products for their customers where they're able to lay that risk off in the market and make a profit on that."

Waite agrees. "When you get better at it than your customers, you can often do your hedging in a way that enables you to enhance your margin value you offer by storing it and warehousing it and supplying it. All of these industry hedgers have found ways to at least recover the costs of hedging as well as add a bit of vigorish to their margins."

Other miscues include the very perception of the transactions being made. "People look at the forward curve and they view it as a prediction. This is not the case. They're not saying the price will be lower in six months than they are today. What they're saying is, right now, you can transact at significantly lower for delivery in six months than you can transact or delivery tomorrow. It's a real price trading for forward delivery," Lichter said. 

But the primary error he sees happens on a structural level inside the companies.

"The biggest mistake is siloing the risk management function away from the physical. If you have a purchasing group, a sales group and a derivatives group and they're not talking, you're going to get into situations where one salesman is selling at a fixed price, which gets you short, and an import boat coming in that gets you long. The trader sees it a week late and two weeks late on the other, and he ends up hedging at $1,050 on the buy side and then selling at $950."

Ultimately, Stevenson says supply chain players need to have reasonable expectations for the process. 

"There are going to be times when you're making money and times when you're losing money on your hedge. It's important to have a long-term approach. The idea isn't necessarily to make money on every futures trade, it's to decrease the volatility of your company's earnings," Stevenson says.

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