Service center executives at Cargill, using lessons learned by other subsidiaries of the corporate giant, take advantage of the latest financial tools to manage steel price risk.
Investors have long encouraged the use of financial tools to mitigate price risk. At steel conferences across the country, advocates such as World Steel Dynamics have championed the idea of futures trading in steel to lessen the impact of the metal’s price volatility. Steelmakers have been reluctant to support the concept, however, fearing that futures trading could shift pricing power from the mills and place it in the hands of financial players with no stake in the game.
Before the run-up in 2004, volatility wasn’t much of a concern in the steel industry, as the price of hot-rolled coil and other products typically traded in a narrow, slow-moving band. Earlier attempts to create a futures market for steel gained little traction. But raw material volatility, the recession and steel crash of 2008-09 prompted buyers and sellers of steel up and down the supply chain to reconsider whether derivatives might just be the tool needed to prevent future pricing catastrophes.
Executives at Cargill, which owns North America’s 25th-largest service center operation, encourage fellow distributors to join them now in the futures markets. They’ve been there for a while. Cargill occupies a unique place in the steel supply chain, and not just among its peers in the Top 50. Most service centers are standalone distributors or part of a service center chain. Cargill’s service center business is just a small piece of a huge corporate conglomerate that has major holdings in agriculture, energy, finance, chemicals and transportation. Such a broad portfolio gives the company a special perspective on the value financial tools can deliver to manufacturing and distribution operations.
“When you think about derivatives and financial instruments, the very first contract was developed about 100 years ago, when farmers needed a way to price their product so they would know what to plant in the spring,” says Tim Stevenson, a director for Cargill’s Risk Management business, Hopkins, Minn. “To help them manage price risk, and to help them decide if they should plant corn or soybeans or wheat, they were able to do a forward contract and lock in a margin. When you think of Cargill and its energy, ocean freight and ag businesses, it’s a very comfortable world for us to play in.”
Slowly but surely others are gaining a comfort level with steel futures. Contracts for hot-rolled steel are now offered on the CME NYMEX exchange. CRU was chosen to set the settlement price because mills were already using CRU data to price their products. Still, domestic producers have pushed back against it. End-users have been the most vigorous early adopters, Stevenson says. Service centers have followed more slowly.
But not Cargill. It’s all in. “We could see the importance of having the physical along with the financial tools to manage the business,” says Rick Dougherty, business development lead for Cargill’s U.S. metals supply chain. “Having the nexus of those two is what Cargill is able to leverage.”
Unlike other business practices where exclusivity provides a competitive edge, Cargill and others using derivatives welcome more players into the fold. The more liquidity in the market, the more options for buying and selling, and the better price visibility becomes.
That’s why Cargill Risk Management and Stevenson have hit the road, speaking at trade shows and metals conferences, extolling the benefits of NYMEX and derivatives to others in the industry. “We believe it’s good for the industry. We believe that the more people participate, the more liquidity there will be and the better people will be able to manage their price risk. It’s still quite volatile, which you can see by looking at the last three years of the CRU,” Stevenson says.
There are several ways supply chain members can benefit from using the financial tools, the executives explain. The first is to hedge an import purchase. As an example, Stevenson says, if a company is going to buy imports at $400 per ton, but the forward curve is higher, the company can buy the physical tons today, sell the “paper” (a contract to deliver a certain amount of steel at a certain date in the future) at $500 per ton and lock in the $100 per ton margin regardless of what actually happens in the market. If the steel price rises, the company benefits from the appreciation of its inventory. If the steel price falls, the company is insulated from a loss by the futures contract.
Another way is to offer end-users fixed price contracts, which mills shy away from due to uncontrollable swings in raw materials prices. In such cases, a company like Cargill can buy up the paper in the market, securing the offtake of the physical product. “Ultimately, the customer wants the steel. You have to have the paper contract and the physical steel to deliver,” Dougherty says.
Additionally, derivatives help in inventory control. For service centers, managing inventory risk typically comes down to a matter of turning inventory as rapidly as possible. But in a falling market, service centers are all trying to unload product at the same time, putting further downward pressure on pricing. “Using financial tools lets you reduce your inventory position, which allows you to reduce your exposure quicker or get longer quicker,” Dougherty says. Taking a longer position allows a party to contract
for delivery further into the future in anticipation of improving prices.
Such techniques are a boost to working capital, Stevenson says. A service center could offer a customer a fixed price on 12,000 tons of steel to be delivered each month of the year. Rather than buying 12,000 tons up front and placing it in inventory, the service center could contract with a mill to deliver 1,000 tons a month. Then it could buy a hedge to protect itself from fluctuations in the steel price. “In buying the hedge, you don’t have to lay that money out immediately because you settle up as a contract matures.
It’s much more efficient.”
For service centers interested in employing derivatives, Stevenson does not recommend doing so half-heartedly. “The biggest mistake is when companies try to give the responsibility to somebody in the business but who already has a job. This is not something to do a couple of hours a week. You’ve got to dedicate the resources to use it properly.”
Futures trading is not for everyone, he adds. “If you’re truly a spot player and you’re happy managing your inventories that way, that’s OK.”
Using these financial tools does not remove all the risk in buying and selling steel. Service centers still face counterparty risks, the risk of late payments from customers or failure to claim material, transportation costs, weather-related issues, and rust or damage, among others that can make hedging less effective.
“People say trading derivatives is risky. I say owning 100,000 tons of unhedged steel in a volatile market is risky,” Dougherty says. [Cargill Risk Management utilizes financial tools to manage risk for its service center division and others in the metals supply chain. It can be reached at www.cargillriskmanagement.com.