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Steel Hedging: Crossing the Chasm

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Steel. It’s been around since the 17th century via the blast furnace route, though it’s been produced for far longer than that. It’s been around so long, in fact, that it has seen not one, but several “industry lifecycles,” rising again and again with successive periods of industrial growth. The old adage that “if it’s not made of steel, it’s made with it” continues to be true—even as the world moves in increasingly electronic and virtual ways. So the huge upwards leap in Asian industrial development has given a new lease on life to an old industry. Again.

This time, things are somewhat different. In previous episodes of industrial growth, “hot-spots” of economic activity were highly localized. Think Western Europe from the late 1700s and the U.S. from the 1900s. These growth spurts were regional “booms,” sucking in raw materials as societies developed. What is different today is that, unlike before, a huge boom is taking place while other economies, in other regions, remain at high levels of development. If in the past we saw one engine of growth or sometimes two, today we see two heavily developed continents, with four more developing rapidly.

It’s difficult to overstate the tension that causes. Thinking back to the ’80s, America was not just worried about Japan surpassing them, but also, in a practical sense, there was concern about resource availability. Further back in time, Germany sought autarky for raw materials, and Imperial Britain expanded across the world in order to secure inputs. Commodity availability is not a new concern.

What is new is that the new kid on the block, China, is eating the lunch of a host of developed countries: the U.S., Germany, Japan, France, the UK, Italy, Canada, South Korea, the Netherlands and others.

Remarkably (taking into account the broad sweep of human history), global economic integration has contained that tension at a commercial level. The consensus political view that global trade is not a “zero sum game” translates into a recognition that China is not in fact eating anyone’s lunch (if your mealtimes consist of iron ore and coking coal). Rather, it is simply making that particular lunch more costly.

What that means is that individual corporations and their customers are dealing with these supply-chain tensions, not governments. Thank goodness! Within the steel sector, iron ore markets are emblematic of these commercial tensions. In early 2010, the world’s three largest iron ore miners—Vale, Rio Tinto and BHP Billiton—switched to index-based quarterly pricing, rather than benchmark pricing set in closed-door negotiations between a handful of miners and steelmakers. Overnight a 40-year tradition for determining prices was thrown out of the window and a brave new world of market-based price discovery was introduced. Coking coal is seeing a similar move.

With the uniquely global business environment we now find ourselves in, these shorter length commodity pricing changes are driving changes through the entire industry. Steel is a regional industry, and different regions have differing business norms.

As a very rough rule-of-thumb, Asia (with the exception of Japan) tends to be more spot price oriented. The U.S. is flexible, with a variety of spot, indexed and contract pricing mechanisms. Europe and Japan have tended historically towards more relationship-orientated long-term price contracts. These background characteristics have natural “fits” within the new environment.

The greatest dissonance has occurred where the disconnect between the contract terms of the finished product are most dissimilar to the raw material pricing duration. With Asia accounting for 65 percent of global crude steel output, and the next largest regional bloc accounting for just over 11 percent, the global steel industry is very much dragged in Asia’s wake. This is uncomfortable for those regions that don’t have such a natural fit between raw material buying periods and finished product selling periods.

Due to the shorter raw material pricing timeframes, corporations want to be able to manage the new price risk inherent in free-floating iron ore (and increasingly coking coal) prices. They have the opportunity to manage this by using the derivatives market—a story that is well entrenched by now.

This story has a long way to run, however. Most commodity markets trade at a multiple of the physical markets. Aluminum, for example, trades 30 times the volume of the physical market annually. While that may seem counterintuitive, aluminum is “handled” by many actors many times before making it to an end-consumer, so it is quite natural for the derivative market volume to exceed the physical volume.

The seaborne iron ore market is a 1 billion metric ton a year market. First-half 2012 saw 45.5 million tons being cleared basis TSI. Extrapolated forward, 91 million tons will be cleared this year, which would represent only 9 percent of the physical market. That is not saying it won’t continue to grow, but rather pointing out that there is a huge amount of growth still to come.

That growth will come as companies from around the sector look to manage the raw material price risk. What it also does is shine a spotlight on three key items. First, its rapid growth shows how great the demand is for price risk management. Second, companies are embracing this tool at differing speeds as they seek to understand how best to leverage it. Third, it has highlighted an industry desire for more price risk management tools—inputs and outputs.

Miners, traders and mills want to be able to hedge iron ore, but there is risk in other raw materials, too: scrap and metallurgical coal. There also is risk in semi-finished markets, notably steel billet, as well as on regional “finished” steel products. The price risk has been compounded by the rising base prices of steel.

Whereas in 2001 someone would take on risk of billet at $300 per ton U.S. for a $10 margin, they may do the same today for the same margin, but the billet costs $600. The capital intensity to achieve a margin has increased significantly. The same issue is mirrored in scrap, coking coal and finished steel prices.

So how have the needs of the physical industry been met? So far, on a piecemeal basis (excluding China, where only Sino-domiciled firms can trade on exchange), with clearing venues adding ferrous contracts slowly to concentrate liquidity. SGX, NOS, ICEX, ICE and SMX have contracts for iron ore. The LME has a contract for billet.

However, two venues have listed multiple ferrous contracts, providing “margining” benefits to users trading, say, scrap and steel (netting out overall positions for margin requirements). The CME in Chicago has launched hot-rolled coil, iron ore, coking coal and scrap. In Europe, LCH.Clearnet provides clearing services for iron ore, scrap and HRC.

Both routes are yielding results and the outcome is a remarkable change in the availability of practical ways in which companies operating in the ferrous industry can mitigate their price risk. The early resistance to taking a position on “futures” has ebbed as research has shown these are simply tools, and the industry is far better informed than it has ever been. Cleared volumes are growing, though trading data is understated as the majority of transactions, with the exception of iron ore, are uncleared (i.e. counterparties trust in the strength of each other’s balance sheets).
And yet, we are really only at the very beginning of the market participation curve.

Existing visionaries with multi-domestic manufacturing footprints are only now locking in HRC prices in both the U.S. and Europe. As a domestic U.S. scrap contract becomes available, the same path can be expected for cross-pollination between U.S. and Turkish scrap derivatives markets.

With ferrous prices volatile and the macroeconomic outlook still uncertain, more and more companies are exploring how to practically use these tools to add to, or to create, competitive advantage. As these pragmatists enter the swaps, options and futures markets, ferrous hedging will have truly crossed the chasm.

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