May/June 2009
Despite opposition from steelmakers, several commodity exchanges recently launched steel futures contracts to provide price transparency and reduce risk in the steel market. Are such contracts here to stay? And, if so, how can ferrous scrap recyclers benefit from them?
By Ann C. Logue
For more than a century, the world's commodity exchanges have traded metals of all kinds, with one exception: steel. That omission is startling considering that steel is the world's second-largest commodity, in dollar terms, after oil. The debate on the pros and cons of a steel futures contract raged for decades, with many steel producers asserting that steel is not suited to being an exchange-traded product. Steel is bulky and perishable, they argued, so there's no easy way to store it in exchange warehouses without it degrading. Steel also comes in a wide array of sizes and specifications, making it too complex to create an accurate hedge product on an exchange, the producers said. Others complained that such contracts would add no value to the industry. Then there was the unspoken fear that steel futures would somehow take away steelmakers' pricing power in the market.
Those and other reasons did not deter a few commodity exchanges from launching steel futures contracts in the past few years. In steel, they saw a volatile market that would make such contracts attractive to those who desire greater price transparency and a way to manage their price risk as well as to those who look to profit from the market's price fluctuations.
The Dubai Gold and Commodity Exchange introduced the first steel futures contract—for rebar—in October 2007. The idea gained further international exposure in February 2008, when the London Metal Exchange began offering two futures contracts for billet. "For the first time in the history of the steel billet industry, the physical market has access to a transparent, exchange-traded spot price," says Liz Milan, the LME's commercial director. Eight months later, in October 2008, the New York Mercantile Exchange—now part of Chicago-based CME Group—unveiled a contract for U.S. Midwest hot-rolled coil.
Together, these contracts ushered—some would say dragged—the global steel industry into the future—and into futures. What are these new contracts all about? How has the market responded so far? And what, if anything, do they mean for ferrous scrap processors? Though many questions persist about these contracts, some answers are starting to emerge.
Two Very Different Contracts
Futures contracts are standardized agreements to buy or sell a specific amount of a commodity, currency, or financial instrument at a set price on a specific future expiration date. The contract buyer agrees to buy the item from the contract seller unless either side sells its part of the contract to someone else. Most contracts are settled daily, which means that the exchange adjusts the amount of money in the traders' accounts to reflect their profit or loss each day. Also, most contracts are purchased or sold before their expiration date. If the buyer or seller holds a contract to its expiration, some types of futures contracts call for physical delivery of the underlying commodity, while others let the parties settle up financially.
The LME and Nymex contracts differ in several ways. The LME offers two contracts on billet, one for delivery in the Mediterranean and one for the Far East. Both billet contracts allow physical settlement. The Nymex contract is not based on the physical metal itself; instead, the buyer agrees to pay the seller an index price based on the prices of hot-rolled coil in the U.S. Midwest. If the parties keep their positions open until the contract's expiration, the settlement is in cash.
The LME billet contracts relate more to the scrap markets because billet is largely a scrap-based product. Hot-rolled coil, in contrast, incorporates relatively little scrap. Billet not only reflects the scrap markets, Milan says, it also reflects demand for steel in the developing world because rebar, the primary end product of billet, goes into building and infrastructure construction. It's no surprise, then, that the LME based its steel contract pricing on delivery to warehouses in Turkey, United Arab Emirates, South Korea, and Malaysia—all locations near major billet consumers. That reduces the effect of transportation costs on the futures prices, among other advantages, Milan says.
Because the LME's steel contracts allow physical delivery, the exchange had to set tight specifications on the chemistry, shape, and length of the billets its contracts cover. Though physical settlement is a common contract feature on futures exchanges, actual physical delivery is rare. Most market participants don't trade futures with the goal of owning the underlying commodity; they simply seek to hedge their price risk.
Differences between the LME and Nymex steel contracts are in part a function of the products they represent. Manufacturers use hot-rolled coil to make flat steel products, thus its futures contracts reflect derived demand for consumer goods such as appliances and automobiles, says Paul Shellman, a consultant to the CME Group. In contrast to semifinished steel products such as billets, hot-rolled coil is not stored indefinitely, so it was impractical to create a futures contract based on physical inventories and delivery. That is one reason why the CME Group based its Nymex HRC contract—like many other of its contracts—solely on financial settlement. Plus, he adds, the steel industry has "robust and accurate price assessments," providing the necessary price foundation for the HRC contract.
Futures contracts that allow financial settlement and physical delivery, like the LME billet futures, and contracts that allow financial settlement exclusively, like the Nymex hot-rolled coil contract, have different strengths and weaknesses. In the former case, mills could deflate the price of the particular steel product by producing excess inventory and selling it into the exchange warehouse, says Jonathan Putman, chairman and CEO of Birmingham Futures (Birmingham, Ala.), a commodities brokerage firm specializing in steel. Likewise, speculators could potentially manipulate the market by buying up inventory in the spot market.
On the other hand, physical delivery keeps the prices of the futures contracts relevant because the industry has to accept the price that is discovered through active trading. The LME's Milan points out that if steel producers do not agree with the futures contract price, they can buy or sell their products at delivery in the market at a profit. As long as that possibility exists, prices should stay in alignment.
Settlement based on index pricing has its own problems, analysts note. A key challenge is determining which index to use as the price foundation. Some products have well-known indexes, such as the Chicago Mercantile Exchange's contracts based on the Standard & Poor's 500 Index. Other products are more complicated and might require the creation of an index simply to support a futures contract or an exchange-traded fund. Unless the index uses an objective calculation that the industry accepts, the futures price is at risk of being distorted. Nymex derives its hot-rolled coil contract price from an index CRU Indices developed using data on physical transactions between steel buyers and sellers throughout the industry supply chain. CRU reports its price weekly, and the Nymex settlement price is the average of the four or five reported prices for each month.
| Sidebar: Steel Futures Facts Here are the basic details on the LME and Nymex steel futures contracts, with a note on related contracts at other exchanges around the world. London Metal Exchange
Contracts: Far East and Mediterranean steel billets.
Introduction: Debuted February 2008 in a "soft launch" offered initially on the LME's electronic platform and on the telephone market. Officially launched in April 2008 with the introduction of ring trading and the establishment of daily official prices. Spot/cash trading commenced in July 2008.
Contract Size: 65 mt.
Settlement Type: Cash or delivery.
Delivery Locations: Inchon, South Korea, and Johor, Malaysia, for the Far East contract; Tekirdag, Kocaeli, and Iskendurun, Turkey, and Dubai, United Arab Emirates, for the Mediterranean contract. New York Mercantile Exchange
Contract: U.S. Midwest domestic hot-rolled coil steel.
Introduction: Introduced in October 2008.
Contract Size: 20 short tons.
Settlement Type: Cash.
Pricing: The contract price is based on an index CRU Indices developed using data on the volume of prompt physical transactions between buyers and sellers throughout the industry supply chain. Price reporting is weekly, with each settlement price representing the average transaction price of the four or five reported prices for each month. Four other commodity exchanges either have or plan to launch futures contracts for steel products—the Dubai Gold and Commodity Exchange, which launched a rebar contract in October 2007 (making it the first futures exchange to offer a contract for steel); the Multi Commodity Exchange of India (Mumbai), which has contracts for long and flat steel products; the National Commodity & Derivatives Exchange, (Mumbai), which offers a contract for mild steel ingots; and the Shanghai Futures Exchange, which plans to introduce contracts for steel wire rod and rebar. |
The Volatility Argument
Before the LME and Nymex introduced their steel contracts, many steel industry executives opposed the very idea of steel futures. In addition to the physical storage limitations of some steel products and the size/specification concerns, steelmakers feared that such contracts would open up their market to speculators, exacerbating price volatility and potentially disconnecting prices from market fundamentals. Some executives said a steel futures contract made no sense in the absence of similar contracts for steelmaking raw materials like ferrous scrap, coking coal, iron ore, and lime. "We will not use them," stated Dan DiMicco, chairman, CEO, and president of Nucor Corp. (Charlotte, N.C.), in a 2006 interview on TheStreet.com. "The industry has come out against them on a global basis. For us it's just an attempt by bankers to make money. We have real concerns over the unethical trading in other metals futures markets. I do not believe it will fly [for steel]."
When the contracts became a reality, however, some steel companies showed signs of changing with the times. ArcelorMittal (Luxembourg)—the world's largest steelmaker—applied to join the LME in January 2008, a month before the exchange launched its billet contracts. Some U.S. steelmakers reportedly have shown a willingness to work with their customers by pricing their products off the prior month's Nymex HRC contract. The LME also notes that as of March 17, its steel billet contracts had traded 1.3 million mt—or 20,000 65-mt lots—of product valued at $679 million, proof that at least some players in the steel supply chain find such contracts useful. It appears that steel futures are gaining some momentum, a fact that may lead other steelmakers to reconsider their opposition and set aside their fears, especially regarding the potential for more volatility in the market.
"A futures price is just today's forecast of tomorrow's price," Shellman notes. If those prices are volatile, it's because the price of the underlying commodity is volatile, too. "In general, there's been little academic or statistical proof about futures causing volatility in underlying markets," he says. "What futures markets do is allow you to manage your volatility. They don't eliminate volatility, but they allow you to manage it."
In fact, the steel industry's price volatility is precisely what made it attractive to the futures industry. "You wouldn't launch a futures contract in a market without volatility, but the contract doesn't contribute to the volatility," Milan asserts. "The volatility is there already. We're just reflecting it. If it's a really hot day, you don't blame the thermometer."
If prices tend to fluctuate, then futures contracts will attract companies that want to hedge and reduce their price risk. Futures contracts also make it relatively easy for investors to get exposure to the price of the underlying asset without having to own it. Hence, a hedge fund that wants to invest in changes in commodity prices, industrial production, or steel-intensive infrastructure buildup in developing countries might find buying steel futures contracts a better investment than trading stocks of steel producers.
Regardless of rhetoric, Milan says futures contracts become popular with speculators after the underlying industry accepts them. That's the only way there will be enough volume—or liquidity—to ensure that they can move in and out of the market, which is what investors need to be able to do. "You wouldn't get into a market that didn't have liquidity," she says. Nor are speculators necessarily a bad thing. "Speculators ... tend to get a bad rap from the media," asserts Martin Evans, steel analyst for the LME. "Without them, the physical industry would have to assume all the risk itself. Speculators don't always make money or windfall profits. Often they lose money in one part of a portfolio and make revenue in another."
| Sidebar: Figuring the Scrap Angle What, if any, opportunities do the new steel futures contracts offer scrap sellers? First, recyclers could use the contracts as price references to determine the value of their ferrous scrap, much in the same way they use nonferrous exchange prices to value their nonferrous scrap. That practice may gain more momentum soon, when two industry price sources—Platts and SteelOrbis—start using the LME Mediterranean billet contract as the central reference point for their scrap and rebar market assessments. According to the LME, both organizations will publish rebar prices as a premium over the LME billet price and scrap prices as a discount to the LME price. Scrap companies also could use the new steel contracts to hedge their ferrous scrap prices. Working with their mill consumers, for example, they could sell their scrap for a price based on a set discount to the futures contract price for the underlying steel product. Then they could hedge their price risk by buying the corresponding steel futures contracts. Also, metal traders, who have long used forward contracts to lock in prices, may find that steel futures contracts offer some advantages for managing cash flow, says the LME's Liz Milan. That's because people buying and selling contracts put up a small amount of money, known as margin, to ensure that they can come up with the total amount needed when the contract expires. Then, each day, their gain or loss is posted to the margin account, preventing big cash outflows. |
A Futures Future for Steel?
Though steel futures contracts likely are here to stay, they are still newcomers compared with other metals contracts and still need to establish full market support. "Launching new contracts is always an uncertain business, particularly [launching] one this big," Anthony Hilton, financial editor of the Evening Standard (London), said about the new billet contracts in the LME's Ringsider magazine. "Indeed, the new steel contract is the biggest for years, and it can take a long while for such innovations to gain market acceptance." On the plus side, steel industry players already have experience using futures to hedge their purchases of other products, such as nonferrous metals and natural gas.
Going forward, the exchanges undoubtedly will nurture their fledgling steel contracts and adjust them as necessary to meet market needs. They potentially could change the underlying physical or index measures, settlement methods, or minimum trading sizes. One way to increase interest in the existing contracts is for the exchanges to approve more products from more producers to build cooperation and make the contracts more representative of the market. There's also always the possibility of new steel-related contracts altogether. "We are constantly reviewing our existing contracts and also considering new offerings," Milan says.
Of course, there is the chance—however unlikely—that the steel contracts could fail to muster enough market support to stay alive. After all, commodity exchanges are businesses that seek, first, to offer what the market wants and, second, to make a profit in the process. If the market for a futures contract falls short of the exchanges' expectations, they will alter or drop the contract. "We put a lot of work into our contracts, both before and after launch," Milan says. "We understand that it sometimes takes many years for liquidity to grow, and we are prepared to give the contract sufficient time." That said, she adds that the LME would delist the contract if it ultimately proved unsuccessful, as it did with silver years ago.
In the meantime, both the LME and Nymex are educating steel market participants—through conferences, one-on-one meetings, publications, and online education courses—about how the contracts work and how to use them to manage price risk. The volatility in the steel market won't go away, but companies have new tools—for now, at least—to manage that risk and, perhaps, even make a profit from it. •
Ann C. Logue is a writer based in Chicago.
Despite opposition from steelmakers, several commodity exchanges recently launched steel futures contracts to provide price transparency and reduce risk in the steel market. Are such contracts here to stay? And, if so, how can ferrous scrap recyclers benefit from them?