Hedging Your Bets

Nothing better illustrates the need for a futures market than the extraordinary volatility seen in commodity prices during the economic crisis. The Rogers International Commodity Index, a broad index of commodity prices, suffered a 60 percent drop between summer 2008 and February 2009. But in more recent months, prices have recovered, with the Financial Times reporting earlier this year that “commodity prices hit their highest level for the year” in the first week of August 2009.

This market volatility has been a major issue for those in the steel billet and scrap market, as prices have seesawed and confusion about basic supply and demand fundamentals have ensued. Consumers, producers and traders of steel need to be able to manage the risk caused by volatile price movements to “recession proof” their businesses. 

 Of course, it was not always like this for steel producers. For decades, the price of steel was relatively stable. It was such a crucial commodity that, in most countries, the industry was overtly or implicitly nationalized and companies received help from the state if times were bad.

But the situation has altered dramatically in recent years. Companies have become global, rather than national; the state has become less involved; and, at the same time, China has burst onto the world stage, changing the dynamics in steel forever.

In just a few short years, China sent annual global steel production capacity from 1 billion metric tons to close to 1.4 billion metric tons. From being a small player in the industry, it has moved to the center stage, becoming the world’s largest consumer of steel as well as its largest producer, revolutionizing volumes, demand and, of course, prices.
Soaring demand also came from other emerging markets, while a considerable surge in construction projects across the Middle East boosted the appetite for steel still further.

WHY FUTURES?
Futures markets are well-established in many industrial commodities, including copper, aluminum, nickel and tin. And for the participants in these markets, futures bring a number of compelling advantages, such as:

• Providing protection against price movements;

• Protecting physical stock against a fall in price;

• Accessing a transparent reference price for use in negotiations;

• Hedging physical purchases in times of production difficulty;

• Allowing producers to access better financing; and

• Providing firms with the ability to manage counter party risk.

Futures trading harkens back to 18th century London and Paris coffee houses but  the origin of today’s futures markets stems from the American grain market in the late 1840s, where farmers needed to secure prices for future harvests, so they would be insulated from volatile price movements. Consumers and producers benefited from grouping together to trade standardized products, and the farming community was and is still today, able to protect itself against adverse changes in the market.

FUTURES LAUNCH
Equivalent (and often adverse) changes have recently affected the steel market, resulting in price spikes, supply disruptions and increased financial and commercial volatility. This volatility has led consumers and producers of steel to look for new ways to mitigate price risks.

To address this market need, the London Metal Exchange (LME) launched steel billet futures (www.lme.com/steel) in February 2008 with the intention of providing a secure, transparent and reliable platform for price discovery.

REFERENCE PRICE
In the base metals industry, where futures are well-established, the LME (London Metal Exchange) monthly average cash settlement price is the accepted price of the major base metals. This means that producers and consumers do not need to waste time negotiating prices. Their discussions revolve solely around agreeing on a discount or a premium to the LME price on a given date, be it next month, three months or even years in the future.
For industries that have been using futures markets for years, this type of negotiation is second nature. For the steel industry, it means that, for the first time ever, market participants can take control of their own risk management.
They do not need to worry about prices being renegotiated time and again between initial discussions and the actual physical delivery. Their vital profit margins can be fixed in advance using the futures market. And the trades are predictable and secure, as the LME never walks away from a contract.
Removing price negotiation from the equation enables consumers and producers to treat each other less like adversaries and more like partners.
FOR EXAMPLE
Looking at the LME steel billet contract going back to June 2008, when the price of steel billet was $1,260 per metric ton, any physical deals done for September delivery would have probably involved several renegotiations if the parties concerned had not used the LME. The price fell to $500 per metric during that three-month period, so the consumer would have benefited, but the producer would have been left bereft. He would have had no control over cash flow, profit margins or budget forecasts.
If the same physical transaction had taken place using the LME, the agreed price would have been the then unknown cash settlement price for September plus a negotiated and pre-agreed premium. Both parties could then separately decide if they wanted to hedge their exposure to price movement by buying or selling futures at $1,260 per metric ton against the average cash settlement price for September.
Even though the price of steel billet fell during the period, if either party had chosen to hedge, it would have known exactly what it was doing. It would have been able to plan. It would have been able to forecast. It would have been in control.

FORM OF FINANCING
Using an exchange such as the LME for industry reference prices has wider implications too. The terms on which banks are prepared to do business may improve for users of the LME, as the price is transparent and widely acknowledged by the market. Some lenders also are prepared to construct trade finance loans where interest and repayment are indexed to the prevailing price of LME billet. Project finance deals requiring capital market transactions also can be arranged, linking bonds or notes to billet prices. For example, the interest payable on a loan for a new production facility could be lower when billet prices fall and higher when they increase, reflecting the producer’s assumed ability to repay. Such deals are a feature of the nonferrous industry and there is no reason why they also cannot benefit steelmakers and consumers. They can make project management more efficient and more effective for all stakeholders.
Many companies are developing new and innovative ideas to improve available financing from their lenders. For example, in Europe, ferrous scrap companies have recognized that having access to a tolling agreement with an LME-registered billet producer can enable a scrap company to dramatically increase its financing levels. This is because scrap can be converted to LME deliverable billet, a commodity that banks typically are happy to finance at more than 90 percent of its value.

IN THE WAREHOUSES
In the U.S. and Canadian aluminum market, producers have been able to stave off serious financial problems by being able to produce at a much higher capacity than physical demand would normally be able to absorb. The excess aluminum has been sold to the LME and is being held and financed by banks in LME warehouses. The warehouses currently hold more than 10 percent of the annual global aluminium production and act as a release valve to the market. Warehouses allow producers to sell excess product in periods of oversupply and are a source of material when metal is in short supply.
For the steel industry, significant benefits can be gained from moving in this direction, not just in terms of the warehousing, which acts as a buffer during periods of wavering demand, but also because of the opportunity to manage market risk.

STEEL BILLET TODAY
Key developments since steel billet contracts were launched on the LME in April 2008 include:
• Total trading of 2 million metric tons of steel billet;
• Total financial turnover in steel billet exceeding $1 billion; 
• The European ferrous scrap industry is increasingly pricing scrap at a discount to the LME price for physical supply contracts;
• Some construction firms are using the LME steel price as the reference point for rebar as well as hedging rebar price exposure;
• 100,000 metric tons of steel billet have been delivered in to LME approved warehouses since launch, with more than 60,000 metric tons of steel billet delivered, equating to 60 percent turnover in stock; and
• The addition of a new warehouse in Rotterdam to satisfy market demand.

WHERE NEXT? 
A sea change has affected the steel industry in recent years, and accepting that the industry dynamic has moved to one of increased volatility and challenging financing conditions is key to the steel and scrap industries surviving, growing and thriving.

An established futures market is a necessary and valuable way of addressing this structural change to the steel industry.  

The author is business manager, steel, for the London Metal Exchange and can be contacted at lotta.
ulfsdotter@lme.com.