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Risk Management

On Your Terms

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MCN Editor Dan Markham Financial tools can help you take risk out of pricing while allowing you to buy and sell the way you prefer.

The service center operating in today’s business environment is faced with significant risks to profitability. There is the risk associated with higher interest rates. There is the risk that comes with inflation. Inventory risk, supply risks and more all challenge the modern operator. 

And all of these ultimately funnel into a single pot. 

“Just thinking from the standpoint of what we see in the market in our transactions, it’s all about inventory risk, which is substantially all price risk,” says Michael Jenny, managing director in the Investment Banking Group for Chicago-based Stout. 

Stout describes the service center as the “flex point” between the mills and the OEMs. “The mill just wants to run all out and has no interest in processing and the OE just wants a processed piece of metal to come in the door and has no interest in doing what the service center does. They have to have [the material] when the customer calls and they have to have a margin. That’s the risk they’re managing every day.”

Three years ago, that risk was minimal, as steel and other metal prices were on a seemingly endless upward trajectory. But every veteran metals executive should know there’s a downside to that pricing curve, even if some in the industry seem to occasionally forget it.

“When prices started to skyrocket in 2021, some people were running their businesses as though that would never change,” he observes. 

Today, we’re in a more traditional environment, with the price climbing and falling fairly regularly, often multiple times in a single calendar year. This is where risk management comes in. It’s also where Flack Global Metals found its niche and expanded on it. 

The Scottsdale, Ariz.-based company is a traditional service center that has built its name and reputation by being at the forefront of using financial tools to manage the inherent risks in commodity metals. The company launched as a buyer and seller of steel without a physical location.

Through the years, Flack has expanded its offerings considerably, constructing its first physical facility in Houston in 2022, followed by a move downstream with the acquisition of fabricating company Fabral and a follow-on investment in Windsor America, parent company of OEM Windsor Door, in 2023. Also  last year, Flack created a separate banking divisions to continue to push the industry forward.

Launched as Flack Metal Bank but rechristened Flack Capital Markets, the group helps Flack steel buyers and sellers manage steel price risk. Sean Kessler serves as the director of the group. 

Since its founding, the group has offered to work not just with those customers who purchase metal from Flack, but also other companies with no interest in procuring metal from the company but want to take advantage of its years developing its mastery of financial tools.

Similarly, the FCM Group has long produced internal research about the complexities of the steel markets. That research is now available, either on a complementary or premium subscription basis. 

There may be some hesitance to use FCM or other such outside enterprises to help guide the service center on this most fundamental of areas, though Kessler thinks it’s no different than many other functions distributors outsource to specialists. “It’s fairly common for companies to seek out expertise in various subjects. It could be legal, could be accounting. Hedging/risk management is no different than that.”

And, he adds, with Flack, those companies know they’re working with an organization that has first-hand experience dealing with the vagaries of buying, selling and holding steel. “We’ve solved it for ourselves or another customer.”

Jenny says there are two typical approaches to inventory. Some companies, such as master distributors, make an investment in inventory, offering value to the marketplace by making sure they have the metal when it’s needed. They get a good margin on the material which compensates them for the inventory holding cost. Others simply rely on turning inventory quickly so they are never on the wrong end of a price movement. 

“The successful service centers we see in the market are managing one of those two dynamics. Some are hedging; some are using market makers.”

But not all service centers are successful. The biggest mistake Jenny sees from service centers is getting caught with too much material on hand when the price moved downward.

“When service centers are not nimble enough to get out from under a price correction in the market is one of the biggest systemic mistakes I see. It can be fatal. If you have to sell high-priced material at a lower cost, you’re shipping dollar bills out with every coil that goes out the door.”

His company works with many of those who find themselves in that position. “That’s where our restructuring and special situation practices often times comes into play,” he says. “And our debt capital market comes into play, helping companies get recapitalized when they’re in distress.”

Of course, avoiding that distress is even better. 

“Service centers and end customers are always trying to time the market, which is impossible to do. Steel buyers get over inventoried as the market is going up, are in an oversupplied scenario as the market begins its decline and get stuck writing down inventory values because they can’t sell the material fast enough in a deteriorating price environment,” Kessler says.

And that, he says, is just one reason why steel buyers should be incorporating financial tools into their steel transactions. That approach has, he says, numerous advantages, not only removing the risk that comes with pricing swings, but also doing so on a steel buyer’s terms. 

One of the biggest advantages is it allows buyers to get the metal needed from the preferred source. The buyer doesn’t need to constantly be looking for the best deal. 

“The futures market allows you to secure a price independent of the physical supply. That way, you do not alter your supply chain or supply chain relationship,” he says.

Along those lines, buyers can find material on the conditions they’re looking for. Kessler points to a steel customer that has a floating supply agreement with a mill, but has a customer that’s looking for a fixed price. That too can be crafted.

“Using the futures market you can essentially have a fixed price buy and a fixed price sale. Their prerogative was to have a fixed price, and you accomplished that without altering your supply relationships. You still need the tons, but you don’t have to go back and renegotiate your pricing terms.”

The past 18 months have been noteworthy for the dramatic change in interest rates brought on by the Federal Reserve in an effort to curb inflation. After years of operating in a near no-interest rate environment, service centers have been forced to deal with this change to their basic economics.

And it carries a considerable greater risk than the business world pre-pandemic, which is reflected in how distributors are operating. 

“I’ve seen a lot of changes in the market because of higher interest rates. Even though an asset-based line or revolving credit line is relatively lower cost, the cost of money is increasing,” Jenny says. “That’s affecting people’s inventory positions. It’s affecting what type of inventory to carry, and it’s still evolving.”

Again, Kessler says, the forward curve can be your friend. For starters, the initial margin in the deal means only a fraction of the total contract value must be invested at the outset. Additionally, “the curve structure can offset the costs of carrying inventory, as those higher interest rates are often a driving component of where the futures months are valued.”

Fortunately, industry executives are getting better at protecting themselves and their enterprises, either through the inevitable accumulation of knowledge or a simple Darwinian Survival of the Fittest sorting out of the top companies from the extinction-bound.  

“The folks who do the best are the ones who are constantly measuring, constantly worrying about their cost position. Given the cycles we’ve had, I have to believe people are getting better at that,” Jenny says. 

If there’s one area where Kessler would like to see greater improvement is simply the mindset that some service center operators still apply to financial tools such as hedging. 

“They view the futures contract as a speculative tool when it reality it’s the opposite. A service center may not realize they’re taking a speculative view based on their unhedged physical position,” he says. “By pairing the physical position with hedging, they’re actually de-risking the business.”

Photo credit: anyaberkut