Price Risk Management
Metal Market Magazine | February 2019
Finding value in steel derivatives The range of ferrous derivatives enabling price risk management that is available to businesses operating in the steel supply chain – from steelmaking raw materials to finished steel products –grows ever larger. Richard Barrett asks experts in managing price risk about the value that they are bringing to ferrous markets.
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When commodity exchanges first started to see merit in offering derivatives as a means for steel price risk management in a similar way to the futures and options contracts they had already provided for other commodities for decades – such as base metals or agricultural products – the idea was enthusiastically embraced by some players in the steel supply chain, but strongly resisted by others in the physical market. Many steel mills in particular, used to their existing pricing mechanisms and the power in the market that they provide, were particularly hostile to the concept. Since then – over ten years after the LME made a move into ferrous metals with the introduction of two regional contracts for steel billet in 2008 – a range of new price risk management tools have been launched on exchanges and over the counter for the ferrous sector, from steelmaking raw materials, such as iron ore and scrap, through to hot-rolled coil (HRC). Cash-settled contracts have been added to the range of derivative products available. The Nasdaq Futures Exchange’s (NFX) launch of a HRC futures contract on December 14 last year is a recent example. The futures contract is based on the arithmetic average of the daily price assessment published for the given month, pinned to Fastmarkets AMM’s daily US Midwest hot-rolled coil index. Another example is the high-grade iron ore derivatives settled against the daily Fastmarkets MB 65% iron content Iron Ore Index launched by The Singapore Exchange (SGX) on December 3 last year. “Interest in risk management tools from the ferrous industry has gained momentum over the last year,” said Grace Lavigne, Fastmarkets price development manager for North America. “Market participants are recognizing that hedging can provide a competitive edge by enabling them to receive or offer fixed prices in volatile pricing environments.”
Skepticism about the benefits of using derivatives in a centuries-old steel industry still prevails in the minds of some mill managers. But many mills have now at least experimented with using them as a means of managing price risk, while other players in the steel supply chain and the interconnected markets along it now see them as an indispensable tool in managing their business and an appropriate level of price risk day-to-day. “Over the past 12-24 months, we have seen a sea change in the steel sector’s attitude towards price risk management, hedging and derivatives,” said Phillip Price, CEO of Ferrometrics LLC.” “There has been a number of new participants making test trades,” he noted. “Many are already hedging a significant part of their book.” Ferrometrics provides support to companies wanting to take advantage of price risk management in the steel supply chain, from raw materials to finished steel products. Price noted that scrap traders are particularly interested in the use of derivatives to manage their price risk. “Some smaller size scrap operators are hedging 100% of their business now,” he noted. While steel mills as a group have shown the most reluctance to embrace futures markets – not least through fears of diminishing or losing their historical producer pricing power – some mills have certainly been testing the waters recently. Price knows of several that have tried them out in the past 12-14 months: “These mills have completed test trades and are looking at the next step for their long-term strategy.” More steel mills have become actively engaged in the markets and he stressed that now he never meets anyone who is against the concept of hedging, while many are actively interested in the derivative price products that exchanges can offer. He says that there is now far more acceptance of price risk management in the steel sector and more interest in knowing how to incorporate price risk management in the day-today business plan.
Another price risk management source agreed. He was skeptical about any thought that mills are still reticent about, or ignorant of, hedging. They deserve more credit for their knowledge of price risk management than some in the market would give them, he stressed: “Certainly we are aware that the majority of them have experimented and tested hedging,” he observed. While some mills’ regular direct use of price risk management may not be commonplace, they will sometimes hedge through, and at the behest of, their banks. “Some mills believe that they just won’t get the liquidity they need,” he added, but said that in reality there is actually more significant liquidity than they might expect when it is requested. “Large steel mills and scrap operators are a lot better off in having futures to navigate risk than without them,” he concluded. And the more large companies use the range of contracts available, the more liquidity will grow.
Some companies have extended their own successful use of steel price risk management as a means to offer their customers a fixed price service for the steel that they supply to them. For example, reviewing business over the past year, David Feldstein, chief market risk officer for Cleveland-based service center Flack Global Metals, estimated that the company saved the customers using its fixed-price service an average of over $150 per ton. “We had a lot of very happy customers who trusted and took our advice,” he said. The company uses steel, scrap and aluminium futures in order to provide its fixed-price service. The company continues to see growing interest in price risk management and he is seeing lots of customers returning to price out new deals once they have experienced the benefits of hedging. “We tell our customers that to get good at price risk management they have to try it. There is a learning curve to climb and they can learn by doing.”
He added that it is not that difficult or different from buying steel on traditional terms for spot delivery, but enables steel delivery months down the line at a price fixed today, but with the flexibility to adjust the type of steel delivered at a later date. Flack Global Metals serves original equipment manufacturers (OEMs) and other companies in the metal building, transportation, infrastructure, distribution, energy and construction industries. It manages its customers’ price risk on their behalf as a value-added service. The company supplies HRC, cold-rolled coil (CRC), galvanized and painted steel. It has already done some recent fixed-price deals on its higher-value-added coated products. Growth in the company’s fixed-price business grew five-fold over the past year, Feldstein noted. Priefert Steel has also leveraged value from price risk management. Chris Shipp, vice president of sales for Priefert Steel, based in Mount Pleasant, Texas, said that hedging has certainly helped the company to find new markets. During a mid-January phone call, he said that he was “knee-deep in arranging extended-period contracts.” The company traditionally manufactures farm, ranch and rodeo equipment, but told Fastmarkets AMM last year that its ability to provide fixed prices through hedging had enabled it to add automotive and aeronautical customers to its range. “As we get into large OEMs, it opens up new markets and opportunities to compete in small-to-medium size companies,” he said, welcoming the opportunity to gain market share. The hot-rolled coil futures market has allowed Priefert to fix its prices beyond the typical 30-60 days.
Attitudes to adoption
In assessing market attitude towards price risk management in the steel sector, Feldstein likes to draw a comparison with the technology adoption cycle. Early adopters will queue outside Apple stores before they open to purchase the latest iPhone at launch. The early majority will buy in the following months, while the laggards wait much longer. On an adoption curve that typically has a steeper upward gradient the further that time elapses from launch, the number of users of price-risk-management tools to enable longer-term fixed-price deals appears to be significantly into the earlymajority phase. “So buyers need to start doing it now to stay ahead of the competition,” he stressed. Feldstein has been with Flack Global Metals for over six years and joined the company to start the risk management division to manage the company’s inventory price risk management when buying stock and assist in the sales and operations of fixed-price deals when selling steel on to its customers. He stressed that the company is a real service center selling real physical steel – not a financial institution. “We sell physical steel with alternative pricing mechanisms,” he emphasized. From the company’s internal point of view, its departments for
sales, risk management, purchasing, operations and finance have to work together as a team to deliver good customer service, Feldstein explained. His own responsibilities have grown to include training, explaining and guiding the firm’s customers on price risk management in addition to staff in house. Partly to reflect the growing importance of the process for the business, his job title changed from director of risk management to chief market risk officer in August last year.
Explaining the role
A key part of Feldstein’s role is to help customers with backed-up price risks. “Our goal is to help our customers grow their own business through better price risk management practices,” Feldstein explained. A classic example is a construction products company wanting to sign a contract to deliver its products for one of its customers’ building projects 6-9 months in the future. If it hedges the price of steel needed to make its construction products for that project, it can confidently quote a price to the project developer and lock in its own margins, rather than trying to pass that price risk on to them through prevailing steel prices at the time of delivery. For building firms looking for certainty to meet their own budgets, that can provide a welcome degree of comfort to them, while giving the construction products supplier a competitive advantage over others. “It means they do not need to use such a large ‘fudge factor’,” Feldstein noted, as a supplier might otherwise use to create a large enough cushion to protect their margin against unfavorable price movements. Ferrometrics acts as an advisory company on how to integrate market risk management into a company’s business, and to what degree. “We take a light-touch, less-interventionist approach – our customers work on their own balance sheets,” Price explained. Providing more of a management consultancy role, Ferrometrics helps clients’ own staff to run their
own book and accounts and manage their own price risk. “We are starting to consider becoming a commodity trade advisor, but we are primarily about ‘hand-holding’ at present,” he added. “The principles are not complicated,” Price asserted, but the successful implementation of a price-risk-management strategy on a day-to-day basis requires experience and expertise. Companies also need advice about choice of trading venue, clearing, interaction with banks and the relative merits of trading electronically, by phone or over-the-counter. While Priefert Steel itself is relatively new to the hedging opportunities that enable extended-period contracts, it has built up sufficient experience and expertise to guide its own customers on the benefits. “The biggest challenge is education,” said Shipp. He said that Priefert’s customers in the southern US are often unfamiliar with the concepts of price risk management, so part of his time is spent explaining how it works to chief financial officers and business owners. “We look closely at futures and how that can impact their business.” Training sessions and continuing dialogue helps Priefert’s customers to understand how price risk management works.
Managing price risk in iron ore
The Singapore Exchange (SGX) launched high-grade iron ore derivatives settled against the daily Fastmarkets MB 65% iron content Iron Ore Index on December 3 last year. The introduction of the SGX MB Iron Ore cfr China (65% iron fines) over-the-counter swap contracts for clearing and the futures equivalent for trading and clearing has got off to an encouraging start. The final settlement price for the contracts is the arithmetic average of Fastmarkets’ MB 65% iron content Iron Ore Index in the expiring contract month, rounded to two decimal places. SGX accounts for the bulk of the ex-China iron ore paper market. The need for the high-grade derivative stems from the Chinese government’s increased efforts to protect the environment and steel mills’ robust margins that have underlined strong demand in the physical market for high-grade ore in China. These factors resulted in volatile and wide spreads between the different grades of iron ore, which in turn made it difficult for market participants with exposure to the high-grade segment to manage their risks effectively. As an international price reporting agency (PRA), Fastmarkets MB has developed a comprehensive suite of iron ore price indices. In the early days of iron ore’s derivatives market development, SGX was one of the first exchanges to offer a futures contract. SGX also launched a low-grade iron ore contract settled against Metal Bulletin’s 58% Fe Premium Index in 2015 to complement its established mid-grade offering. Spot market indices that reflect the ‘price of the day’ have opened up the opportunity for price risk management through exchangebased, and sometimes over-the-counter, contracts and swaps. Fastmarkets MB lists daily, weekly and monthly indices because of the varied liquidity displayed by different parts of the market. Sinter fines and lump make up the bulk of the seaborne iron ore market, and are the products most frequently traded on spot basis, so daily pricing is used for the key 62% Fe, 58% Fe and 65% Fe fines, and lump premium references. By contrast, the beneficiated ore segment, comprising pellet and concentrate, is smaller in terms of both volume and liquidity, and weekly indices are therefore more appropriate.
Value-in-use indices are calculated by analyzing price and specification data of spot market transactions over the course of a month, so they are published on a monthly basis. Fastmarkets MB’s iron ore indices are all tonnage-weighted average calculations of observed and reported market activity within a specified data collection window (e.g. 24 hours, 1 week). Being a variable commodity, prices are normalized back to index base specifications by using coefficients derived from statistical analysis of prior index data. Fastmarkets MB incorporates a unique sub-index approach in its iron ore indices, which mathematically ensures a balanced impact from all parts of the market (producers, consumers and traders) on its prices. Different percentages of iron content reflect both the natural variation in iron ore grades found in mine deposits and the degree of processing (if any) employed to upgrade the ore for a certain use case. In general, higher purity ores help increase hot metal yield in the blast furnace, and also lower the cost by reducing the amount of coke required. For these reasons, the rule of thumb is ‘higher Fe grade, higher price’. Most steel mills use a blend of different grade ores, and a mix of sinter, lump and fines, but the quality requirements depend on the circumstances and availability. For example, ore used in the direct reduction process to make direct-reduced iron or hot-briquetted iron destined for melting in an electric-arc furnace needs to be of much higher grade than that fed into a blast furnace. Prices vary accordingly.
Since the LME’s original model of ferrous futures contracts based on a physical delivery mechanism was introduced years ago, its own and others’ index-based cash-settled contracts have been launched, enabling greater flexibility, Ferrometrics’ Price noted. “The availability of iron ore and hot-rolled coil derivatives also means that you can now hedge conversion margins,” he added. For example, the LME’s scrap contract has seen growth in liquidity, Price noted. While the LME’s rebar contracts in their original form did not flourish, he believes that since rationalisation their prospects have improved and that they will see a gradual increase in liquidity and more open interest.
With a range of ferrous derivatives covering steelmaking raw materials, rebar and hot-rolled coil now available, Price believes that there will be an increase in trade in the electric-arc furnace margin. He also noted the LME’s January 17 announcement that it is progressing plans for additional ferrous products to add to its existing scrap and rebar contracts. The exchange will introduce two new regional HRC futures contracts for North America and China. It is also working to deliver a Northern Europe HRC contract. “Exchanges are increasingly tying their strategies to cash-settled futures contracts and diversifying their offerings to provide more options for users,” said Grace Lavigne, Fastmarkets price development manager for North America. “Fastmarkets is a premier price reporting agency that offers compliant, representative indices to underpin these cash-settled contracts.” Price sees a lot more trade through instruments settled by daily indices than the weekly index settlement model already available and he pointed out that the LME’s new China contract will be the first to provide the opportunity for direct exposure to – or to mitigate the risk in – China’s export price for offshore market participants. Asked to identify whether there are any additional derivative contracts he would like to see available as a tool for managing price risk in the US, Feldstein said that, from a commercial standpoint, it would be useful to have a futures product that would enable hedging of the differentials between galvanized and HRC, and between CRC and HRC. “From a commercial point of view, that would be useful to manage deals,” he added. He also said that it would be interesting to have a futures product based off a Houston price to represent import prices, which could add liquidity to the market. Very high levels (30-35%) of price volatility have encouraged scrap traders to make more use of hedging. “Reading the market is not easy and both the earnings and equity of some businesses have been affected,” Price noted. In turn, that affects a business’ purchasing power in the physical markets because the advance rate offered by banks is then impacted, and restrictions may be placed on the type and level of deals it can enter into. “The use of derivatives can mitigate a company’s exposure to risk when they want to,” said Price. Banks are often then willing to increase advance rates and offer more favorable terms. If businesses then have new options to finance opportunities that others cannot, they achieve a competitive advantage. Protecting margins Feldstein noted that price risk management tools can be used to offset or add speculative risk according to the exact business situation of the customer. “We are trying to build a long-term relationship to provide the most efficient pricing mechanism,” he summarized. It is about knowing and quantifying the business position of a client managing its own order book and then making a decision about whether the level of price risk inherent in its orders is acceptable. “We try to match clients’ own order book – fixed price with fixed price, and floating with floating. It’s about analyzing the customer’s price risk that is inherent in their business,” he explained. To work efficiently that requires continuing and regular dialogue as well as an understanding of the opportunities provided by the direction of the forward curve – whether in backwardation or contango. Flack Global Metals can help the client to decide when to take risk off the table as well as when to put it on. “Our discussions now have moved more towards profit margins than price direction,” said Feldstein. The aim of course is to protect margins whatever the price direction – increasing margins for products if prices rise, but protecting them if prices fall. Successful price risk management creates a “win-win” situation, said Feldstein. It pays to look at deals earlier to take advantage of the futures forward price curve rather than potentially becoming a disadvantageous-price taker later on.
Priefert Steel’s Shipp said that falling steel prices in the third and fourth quarters of 2018 slowed the flow of customers wanting to lock in longer-term prices, but he says that business is starting to pick up now, with US domestic mills looking to increase prices. He believes the market is now close to the bottom. “It hasn’t helped that the scrap price has been dropping, but domestic mills are now trying to hold the line,” he said. Shipp adds that it was telling that although Priefert Steel received double the number of sales orders in 2018 than the quantity in 2017, the average order size was way down. “Now we are seeing business picking up,” he said. “Customers are looking at buying again.” US steel demand had really slowed during the second half of 2018. “It has been hard to plan business with all the volatility that we’ve seen,” said Shipp. Section 232 tariffs have been one source of the volatility. He believes that demand will be up a little at the beginning of 2019, but also that people will run with a lean inventory. He also thinks there will be less volatility this year, but that otherwise the outlook is very hard to predict. “People are afraid to say this will be a great year,” he added. Uncertainty has discouraged expansion plans, which are likely to be very limited while there is too much risk and political uncertainty. Anecdotally, Shipp said that for the first time during his eight years at Priefert Steel, one presentation slide for his business outlook for company staff at the start of the New Year comprised a single large question mark. “It’s tough to be positive for 2019,” he concluded. “US steel prices were influenced by a number of unpredictable factors in 2018,” said Lavigne. “Increased domestic capacity, the negotiations for a replacement of the North American Free Trade Agreement, end-market demand, domestic scrap prices and the Trump administration will continue to impact the sector in 2019.” At the beginning of 2019, Feldstein noted the bad fundamentals for steel prices, with the economic prospects for China, Asia and European markets on the slide, as well as political uncertainties in the US and the UK. “It’s a bad start to the year,” said Feldstein, noting that Flack Global Metals’ own customers are holding back from purchasing when faced with such uncertainties. Even so, he reiterates that the company’s and its clients’ past experience of successfully seizing opportunities by deploying price risk management underscores its value.