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Risk Management

Hedging Your Bets

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While “value-add” has become a major part of the service center lexicon over the past few decades, the business still has buying, selling and stocking metal at its core. And the volatility of steel, aluminum and red metal prices makes those responsibilities fraught with potential danger. 

Distribution companies have long ridden the wave of rising prices to increased profitability. But when a sudden lull hits the market and prices tumble, that inventory purchased at higher costs suddenly becomes quite the anchor on profitability, and operators are challenged to hold on during the decline.

“Both steel and steel scrap buyers basically lived off their wits,” says David Waite, president of Commodity Risk Management Associates. “They tried to buy advantageously and sell advantageously. But with regular throughput you can’t just stop buying and selling.”

In recent years, the desire to hop off the roller coaster has become more prevalent in the steel industry, following in the footsteps of their aluminum and copper counterparts by looking at financial tools to mitigate their exposure to those volatile commodity prices. 

“The whole principle is: if you’re going to buy something and sell something that goes up and down, you have to protect yourself. You live off a relatively small margin and your exposure is huge,” says Waite, whose New York-based company helps businesses adopt price risk strategies. 

Waite has been in the business for decades, though the adoption of those strategies in the steel industry by mills and service centers is still in its relative infancy. Of course, slow ramp-ups are fairly common in the commodities exchanges. 

The first exchanges for oil were introduced in the early 1970s but mostly went ignored by the industry. That was until the OPEC oil embargo shook up the globe, with production cuts pushing the price to previously unseen heights. Suddenly, industry players looked back and saw there had been an option to protect themselves against volatility. 

Now, hedging in the petroleum world, as in many other commodity markets, is fairly routine. 
Aluminum and copper distributors are already quite familiar with this, their materials being traded on the various exchanges (LME, NYMEX, COMEX, etc.) for years. Steel players are not quite there yet, but the push is clearly on. 

Leading the way in the steel distribution space is Cleveland-based Flack Global Metals. The company and its top executive, Jeremy Flack, have been championing the use of financial instruments for the steel supply chain for years. Use of them, founder Flack contends, is how the company rose from a startup to one of the country’s Top 50 service center operations in less than a decade. 

“We wouldn’t be here. If we hadn’t used the hedge to protect our price risk over the last nine years, there’s no way we would have been able to compete against multi-generational companies, companies that have been around for 100 years. Our equity base at inception was very small compared to our competitors. This was the only way we had to defend ourselves in the marketplace,” says Flack, whose company had revenues of $320 million in 2017. 

The first set of futures contracts for steel or its raw materials emerged about a decade ago. Today, there are contracts for rebar and scrap on the LME, iron ore, hot-rolled and busheling on the CME, hot-rolled and shredded on the NYMEX and more to come. 

Many downstream purchases of steel were quick to explore the concept, but it’s taken much longer for mills and service centers to follow suit. Some supply chain participants believe the price of commodities is made more volatile by the exchanges. But Waite says academic studies disprove that assertion. “The interaction of the hedging and speculation creates a more rational market structure,” he says. 

The reluctance is slowly evaporating, Flack says. There is more interest now from producers and distributors, “the natural sellers of metal.” That interest has translated into greater liquidity in the marketplace, a must for an effective options market. 

And those markets are here to stay. “You may have an unsuccessful contract on NYMEX for hot-rolled, but it will be on the LME or CME. The individual contract might not do the trick, but the hedge itself will not go away,” Flack says. 

Flack says supply chain participants would criticize the tools as imperfect, which he thinks is a flawed way of looking at it. “What is perfect? You have no other ways of protecting yourself against risk. If you’re a mill selling into the hot-rolled coil market, you can look out at the forward curve and see if you’re willing to sell at those prices.   

“If you’re a buyer, you can lay your backlog risk into the market, and if you’re a seller, you can lay your sales risk into the market. These are tried and true disciplines,” he says. 

There’s typically more interest from Flack’s customer base, particularly the newer steel buyers who enter the market. Flack’s message to these companies is pretty simple. “We don’t lead our customers somewhere we haven’t been ourselves,” he says. “We’re not suggesting they employ these tools and we get some artificial benefit out of that or we’re putting them in a position we don’t understand. We use it to protect our own business. And we saved our customers a lot of pain in the run-up in price last year.”

Ultimately, the service center companies that commit to hedging will see less profit when the market is climbing, but much better results when it’s backing off. “We give up some profit when things are good to ensure we don’t have a downside,” Flack says. In addition to the stability it provides, such a move “puts us in position to do things when others are weak.”

Increased interest in financial tools typically follows a price collapse, when supply chain participants see their stocks being devalued with no easy way out of the predicament. Whether the slow slide of steel prices since the start of 2019 is enough to kickstart more participation remains to be seen. 

Getting started

For the service center that wants to move away from speculating and embrace the use of hedging, the process isn’t easy. It requires some changes throughout the organization. And it has to start with strong backing.

“You have to have a champion within the firm who can develop the process,” Waite says. 
Companies take a variety of paths to adoption. In some instances, firms will poach an employee from a competitor or another industry who has experience with the tools and let them run the operation. That method has definite drawbacks, chiefly how it doesn’t allow for the entire company to immerse themselves in the new ways of operating. 

“There are literally hundreds of people who have taken companies down without management realizing what they’re doing,” Waite cautions. 

Rather than rely on a single individual, Waite says the move requires a buy-in from many departments. “It’s a new way of running a business. You have to retrain your salespeople. You have to have a financial guy who understands the cash-flow implications. You have to have control and accounting systems. Traditional accounting is very vague capturing the real economic gains and losses in your business.”

Companies such as Commodity Risk Management Associates often work with industrial enterprises that are just getting started in the practice, helping them navigate the potential pitfalls. 

Flack acknowledges it is this transformation that keeps a lot of companies from taking the plunge. 

“Industry people don’t want to change. They don’t want to spend the time and effort to set up a bank clearing house, to learn what a bid and ask is. You have to know your game,” he says. 
Knowing this game is what’s differentiated Flack from the outset. And with the founder’s background in banking, rather than operating a slitting line, his company doesn’t stop at simply hedging the steel price. “We hedge against macroeconomic risk. We hedge against interest rate risk. You’d better have some expertise in house to do some of those things.”

The payoff, however, is worth it, both men say. Waite says he’s often asked what the point of expending the time and money if all you can expect in the end is “to break even.” But he disputes that conclusion.

“Once you have all the skills and controls, there are all kinds of ways you can improve your buying and selling,” Waite says. “You will enhance your bottom line.”

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