The Value of Hedging

During the second half 2008, the price for ferrous busheling scrap fell from approximately $900 per gross ton to the low $100s in a matter of four months. The drop occurred because of a number of factors, mostly the European Union fiscal crisis, volatile demand in Asia and the downward spiraling of the U.S. economy.

As the recession wreaked havoc on the scrap price, prices for other commodities, such as oil, were sinking too. The price for West Texas intermediate (WTI) crude hit $147 per barrel in July 2008. It dropped to less than $40 per barrel by December.

But, unlike in the oil industry, many scrap producers could only stand by and watch as the drop in prices damaged their margins and their balance sheets. Though the drop in the WTI price certainly took a toll on the oil industry, producers and others in the supply chain could limit their losses by hedging their exposure to fluctuating prices. They had the opportunity to do this through futures contracts on the New York Mercantile Exchange (NYMEX), which allow market participants to lock in a price for oil. At the time, no such contract existed for scrap.

That changed Sept. 10, 2012, when CME Group, headquartered in Chicago, added the first ferrous scrap futures contract available to the North American steel industry to its product suite on the NYMEX exchange. This U.S. Midwest Scrap futures contract, based on American Metals Market’s (AMM’s) Midwest scrap index, has the potential to be for steel input prices what WTI futures contracts have been for oil—a global benchmark and liquid product that can help the industry manage volatility.

In late 2008 and early 2009, trading volume for WTI futures contracts rose substantially as companies looked to hedge the risk that comes with rising and falling prices. That kind of opportunity can be found in the ferrous scrap industry today, where volatility is showing no signs of going away.

As technology develops, many industrial manufacturers are looking to recycle and use more scrap as raw material. Scrap is a more cost-efficient, sustainable and socially responsible material to use. The U.S. is the world’s biggest ferrous scrap exporter, accounting for more than 20 percent of the global scrap export market. Scrap also is one of the first pricing indicators for the U.S. steel industry, as more than 60 percent of the steel produced in the U.S. is based on scrap.

A Changing Environment
Changes in regulation, the fiscal cliff and continued fluctuations in demand from emerging economies such as China have defined the market landscape for many industries lately, and scrap is no exception. In addition, the world is more connected today than it ever has been. News of increasing demand or diminishing supply takes no time to reach the other side of the world, and the market reacts instantly to that kind of news.

Until recently, the steel industry’s approach to managing price risk mirrored that of a world where increased demand in Asia did not mean much for U.S. producers or manufacturers. Steel mills, manufacturers, such as appliance companies, and scrap processors were aligned closely in terms of geography and agreeing on a price for input steel.

However, emerging economies in Asia and the Middle East will continue to build their infrastructure and are heavily dependent on imports from developed economies for their scrap supply. In fact, when the price is right, it is no longer unusual to ship a container of scrap from Chicago to Kaohsiung, Taiwan.

A steel futures contract has been available at CME Group since 2008. Our Midwest Hot Rolled Coil (HRC) contract has seen rising volumes as volatility has increased and the industry has more readily embraced futures markets. However, price correlations between scrap and steel are no longer high enough to hedge scrap using the HRC contract, making a compelling case for having a standalone scrap futures contract.

As communication and globalization have changed, so have the needs of those in the steel supply chain. New infrastructure in the U.S. and other parts of the world means more demand. And more demand means more supply shocks. That is what the new ferrous scrap contract is designed to help producers and suppliers control. It can provide producers, manufacturers or scrap processors with a way to offer customers lower priced or steady, fixed price scrap.

Demolition contractors, for example, often bid on projects like a building teardown, where the sale of the recovered ferrous scrap may not be realized for six months or more. Without a viable futures contract, these contractors are left simply hoping that the price for scrap doesn’t decline during that span.

Steel mills can use futures to differentiate their businesses by giving customers a fixed price months in advance because they are able to hedge their scrap input costs, resulting in a more predictable balance sheet.

Likewise, service centers, automakers or appliance companies that generate scrap for sale can move on from an index-based floating price system that sells leftover scrap to the highest bidder. They can now better predict income for their scrap and build it into their budgets for the next year.

A smoothed-out balance sheet and more predictable margin are not the only advantages to a futures market for scrap. Companies that use these markets—whether for grains, energy or metals—are positioned to be more attractive to banks and other lenders because of that predictability. Moreover, prices become more transparent to the industry. Companies are then in the position to haggle less and to focus on making their firms more competitive. This is further accomplished by allowing steel producers to more readily compare input costs relative to substitutes such as iron ore.

Adopting a New System
The key for all of these participants in the supply chain is adoption. Moving to a completely new risk-management system can be a challenge. There’s the education factor for those who might not be familiar with futures (How does this work for my company?) and there’s convincing management that in today’s market, a futures contract makes the most sense (How do I educate others?).

In addition, this is a new contract designed to meet hedging needs, not speculative interests. Market liquidity will need to be built by those in the supply chain, which can be a slow process, though CME Group’s scrap futures contract is seeing increased open interest.

Here again, we can look to oil as an example. Derivatives markets generally require a market event to overcome barriers to success—a compelling event that requires new ways of managing risk. CME Group’s crude oil futures were introduced in 1983, but some producers were hesitant to trade in futures markets until the Gulf War in 1990, which brought on extreme volatility. First, one producer began trading, then several. Speculators followed to provide market liquidity, and today the WTI contract is the world’s most traded oil futures contract.

In the steel market, the Shanghai Futures Exchange has already proven a similar trend possible. Its rebar futures are currently the most liquid steel contract in the world, allowing the industry to hedge effectively. Investors also are using the contract as a benchmark for Chinese economic and infrastructural development.

The current environment of economic uncertainty could be the event for the U.S. steel industry that makes it a liquid market for managing ferrous scrap price risk. The same uncertainty has fueled the finished steel futures market in recent years, and we have seen commercial companies become more accustomed to our HRC contract. Companies are building risk management teams geared toward using HRC and similar products, and we are seeing steadier volumes. In 2012, close to 1 million tons of HRC were traded. The contract also has more than 10,000 in open interest (the total number of options and/or futures contracts that are not closed or delivered on a particular day) consistently throughout 2012, which is an indicator of future growth.

A Virtual Steel Mill
Despite the response from the market to that contract, HRC alone will not help all participants in the steel supply chain manage price risk. A scrap processing company might not have much need to lock in a price for hot rolled coil, since it is selling the scrap that produces it. Steel mills, however, might have a heightened interest in managing long- and short-term risk through such a contract.

The current volatility is not reserved for one or two participants in the supply chain. Miners, steel mills, merchant traders, finished steel consumers, brokers and financiers all need a solution. That is why CME Group has established a suite of products called the Virtual Steel Mill, of which ferrous scrap is one of the latest additions. If those coming to the market to hedge scrap find there’s a need to hedge hot rolled coil (like an appliance manufacturer might), they can do so on a single exchange.

The scrap industry is facing new risks in a new economic environment. The industry is beginning to understand the need for a new way to guard against wild fluctuations in price and demand.

A year ago when I talked to steel mills or manufacturers, the question was, “Why do I need a futures contract?” Today that question has changed to “How do I use a futures contract?” That is a positive change in mindset of an industry that is sure to face continued market volatility. The industry now has the opportunity to use futures markets to help them get through it.

The author is director, metals research and product development, for Chicago-based CME Group. She is responsible for researching the structure and performance of metals markets and for evaluating policy positioning related to market regulation. She also designs and develops new metals futures and options contracts and writes trading rules.