Future Shock

Features - Metals

Ferrous derivatives are here to stay.

November 5, 2013

Alvin Toffler gave us the term “information overload,” and back in 1970 he wrote a book with this title, defining the term as a perception of “too much change in too short a period of time.”

The steel industry has been through enormous changes in the last 20 years; it has literally been turned upside down. Total crude steel output more than doubled between 1992 and 2012. In the same period, that production swung from 36 percent Asian based to 64 percent. The growing use of electric arc furnace (EAF) technology (which uses ferrous and other metallic scrap) was reversed as new capacity using blast furnace (basic oxygen furnace, or BOF) technology (which primarily uses iron ore and coking coal) largely was installed. Ever-decreasing finished steel prices shook off their torpor and began to fluctuate wildly.

As if these changes were not enough, the IT revolution and three major recessions (the Asian financial crisis, tech-bubble burst and 9/11 and the global financial crisis) also bubbled around in the background. No one can say the steel industry has not successfully navigated challenges.

That said, the western steel industry has largely avoided meaningfully tackling a potential sea-change: The introduction of financial tools designed to manage price risk and uncertainty. Given the enormous uncertainties in the macro and micro environments and the positive implications of the new tools, this is hugely surprising.

Could it simply be that there has been too much change in too short of a time to consider yet more change? The level of “futures” knowledge at conferences has mushroomed over the last few years, so perhaps with various successive crises breaking upon the industry, the default position has simply become “continue to monitor” or “wait and see.”

Adoption rates have varied significantly between contracts: Many now think that we are at a stage where the contracts that have shown staying power to date will simply see additional companies registering to trade and existing users expanding the volumes they trade. Others expect liquidity from more liquid ferrous contracts to “spill-over” into hitherto less liquid ones. Either way, it does not seem as though ferrous derivatives are going to go away.

Why? Because they are useful to businesses. To be clear, steel industry companies using these contracts are not using them to speculate; among other things, they use them to:

1. Manage price risk for forward commitments (i.e., a buyer may lock in prices of steel for a number of months ahead);

2. Manage the price risk of inventory, as stock of anything rapidly shifts from an asset to a liability in the event of adverse price movements;

3. Book “paper profit” immediately (An example would be a buyer having a physical position of scrap purchased at $400 per long ton and seeing a forward contract being available at $450 for next month. Rather than waiting to see if that is achievable in 30 days, the buyer can lock in that $50 per long ton profit immediately using swaps.); and

4. Derisk their overall business from unknown unknowns (e.g., Turkish mills that are registered to trade scrap swaps have a way to lock in prices when “big events,” such as a huge East Coast storm, happen.

Contract Recap
All of the ferrous industry contracts that are around are relatively young, so it is worth recapping them all. Before examining the contracts, it is worthwhile noting a few things. First, there are two main ways of constructing a contract:

1. Physical delivery – Forward contracts can be settled either by cash or by physical delivery, either from the stocks of the exchange or by delivering physical material to the exchange.

2. Cash settlement – Contracts are solely settled by money. The underlying commodity never trades hands. Companies are looking to remove price risk from the commodity in question rather than source or deliver the commodity. Companies are locking in a price, and cash is paid out to “deliver” that price.

Second, exchanges have been offering price-risk-management tools across the ferrous value chain, namely in steelmaking raw materials, semifinished goods and finished goods themselves. This means quite a variety of contracts are out there.

Third, as there have been a number of launches, sometimes covering the same commodity, it is inevitable that there have been losers as well as winners.

Only “extant” contracts, i.e., those that have or are seeing trading against them, will be discussed. Those at the dormant stage of new product development will be left aside.

Hot-Rolled Coil. The CME group launched its cash-settled U.S. Midwest hot-rolled coil contract as the global financial crisis broke—just as financial liquidity dried up and firms began looking not to the future but to basic survival. Unsurprisingly, in the fourth quarter of 2008, it saw an unimpressive grand total of 23 lots traded.

From this inauspicious start, it has, however, grown at a fairly steady rate year on year. From 460 short tons being traded in year one, it saw 877,340 short tons being traded during 2012. Nevertheless, the physical market is roughly 40 million short tons, so this represents around 2 percent of total output being hedged.

LCH.Clearnet (the London Clearing House) launched a cash-settled European hot-rolled coil contract in the less terrifying (though deeply depressed environment) of 2011. Again, it had a quiet first year, seeing 200 lots traded. By 2012, that had increased to 3,900 lots. In context, this is less than 0.2 percent of physical volumes.

The London Metal Exchange (LME) launched two physically deliverable steel billet contracts (Mediterranean and Far East) in February 2008, having an advantage of launching into a prefinancial crisis era, when steel billet prices were soaring. By August of the following year, more than $1 billion worth of billet had been traded. The Far Eastern contract, which saw volumes shrink by 84 percent between 2008 and 2009, had underlying issues. Nevertheless, the Mediterranean contract grew 132 percent over the same period. However, again, the contract had structural issues, as warehousing was not available into Turkey, a key billet producer in that region. By July 2010, the two contracts were merged into one “global” reference point as open interest shrank on the Far East contract.

However, physical delivery issues were largely cited as the cause of problems for the LME contract throughout 2012, culminating in some high-profile companies such as Deutsche Bank publicly “abandoning” the contract. Volumes have retreated markedly since.

Black Sea Billet. The CME Group launched a cash-settled (Black Sea focused) billet contract in 2011. As the LME contract stumbled, there was a flurry of interest and trading in this contract. In 2012, 1,065 lots were traded, though levels in the first three quarters of 2013 were subdued.

Coking Coal. Perhaps the most enigmatic of all launches, the cash-settled CME Group’s coking coal contract, has not taken off in a significant way. Trades continue to be registered, yet volumes remain some way below the debut year.

Iron Ore. Iron ore is the stand-out success in the world of freely tradable derivatives. Each month sees around $2.5 billion worth of financial contracts traded. At least seven exchanges and clearing houses around the world offer clearing services for iron ore.

The underlying market for iron ore fines is enormous, single-handedly moving global bulk freight rate prices by virtue of its size. Nevertheless, derivatives volumes are growing so fast they are already an appreciable proportion of that physical market (over a quarter of it by the end of the third quarter).

However, while iron ore derivatives are well on track to hit “1x physical” in 2014, most futures markets trade a multiple of times the physical market. This is because, in the example of aluminum markets, the bauxite producer hedges risk via aluminum contracts, the alumina producer hedges risk against the same, as does the aluminum producer. Stockists and end buyers do as well. The same aluminum contract changes hands as each leg of the supply chain off-loads price risk. As a result, more than 20 times the physical market of aluminum tons are traded financially.

While iron ore derivatives are showing quick growth, nevertheless, at only one-third to half of the physical market this year, a lot of growth clearly is left.

Scrap. Finally, to scrap! If iron ore’s “home” is naturally in Asia, North America is the home of ferrous scrap: The U.S. is by far the world’s single largest origin of imported scrap alongside its significant domestic market consumption.

For EAF mills, scrap forms a higher proportion of input costs than iron ore does for BOF mills. Therefore, on the basis of the U.S. being the world’s largest single group of collectors, consumers and exporters, scrap derivative contracts should be expected to see quick adoption by a large proportion of the market.

Adoption has not been spectacularly quick, however. Since 2011, the U.S. Midwest busheling contract and the Turkish 80:20 import scrap market have seen a total of 167,120 tons traded between them. In context, that is only slightly more than four Handymax vessels worth of export material, or around a monthly buy for a mill’s strategic head of purchasing.

The busheling contract is focused on prime scrap, whereas the Turkish import market is focused on obsolete material. Between them, they address the needs of Midwestern industrial scrap buyers and sellers as well as East Coast obsolete collectors, processors, exporters and mill buyers.

Industry Leaders & Crowd Composition

Readers of Recycling Today magazine are unlikely to have as much of a visceral interest in coking coal swaps as they might in the scrap contracts. The big question is: Why did the iron ore contract take off so spectacularly and why have the scrap contracts not followed suit?

With iron ore, a large number of banks were involved in the early days, trading on their own books or on behalf of clients. Physical traders looking to convert floating prices into fixed prices (i.e., to “book” profits) found that brokers easily matched their trades with companies that wanted to convert fixed prices to floating. Why did companies want to do that? They saw upside in prices—particularly those that had annual supply contracts at far lower levels than the spot market. Ultimately, a variety of firms—sellers, traders and buyers, the whole supply chain—registered to trade.

As, some physical industry leaders really embraced iron ore derivatives as being fundamentally useful for hedging risk.

Looking at the companies registered to trade the 80:20 contract, they are almost exclusively traders. This is hampering the ability to book trades, as each party largely wants to make the same trade. A similar situation seems to exist in busheling. Furthermore, no physical scrap market leader (seller or buyer) is currently standing up and actively looking to implement hedging into its business.

On the positive side, any mill, processor or exporter registering to trade ferrous scrap swaps is likely to find a “wall of liquidity” waiting. This would be hugely beneficial for those looking to hedge, allowing trades to be booked quickly.

On the negative side, brokers say they are not overwhelmed by clients opening accounts to trade ferrous scrap. This is surprising, given that setting up a trading account costs nothing. A prerequisite of trading is access to clearing. Without that, opportunities that arise to lock-in advantageous prices (if gate prices rise or buy prices begin to weaken) can never be taken.

As it stands, when East Coast scrap prices rise or fall, exporting firms simply look on. Midwestern prime scrap buyers ponder where prices will be next month rather than locking them in. A default position of “waiting for liquidity to grow” is as fatalistic as selling on a “to be determined basis.”

If companies have a real interest in the ability to hedge risk, they need to register to trade and begin trading small volumes. This encourages others to do the same and smoothens the learning curve as companies book trades on small volumes.

Sleeping Giant
One thing that has not been discussed here is the East/West split and huge liquidity within China.

In stark contrast to the West, ferrous derivatives volumes in China have been staggering. While many point out a natural cultural interest in risk taking in China, which has been amplified by the openness of contracts to “retail” investors (i.e., individuals as well as corporate entities), the fact is that the huge liquidity of contracts makes them immediately useable by corporate entities.

An example of this liquidity can be seen in coking coal. In its first six months of operation, the Dalian exchange’s contract has reported 49.3 million lots traded. That represents 3 billion metric tons of metallurgical coal, or 12 times the entire physical seaborne market. While only 6 percent of that total was traded by corporate entities, average daily trading of 404,000 lots is attractive to industrial companies looking to book trades. Existing rebar and hot-rolled coil contracts are abundantly liquid.

This has medium-term implications. These contracts are currently accessible only to companies that have a footprint in China; but, which large-scale firms do not have a footprint in China presently? If market participants use these contracts, simply in light of their liquidity, this could retard the development of derivatives markets in the West.

Secondly, Chinese liquidity centers will not remain “walled off” forever. A European firm can easily set up to clear American contracts, and a U.S. firm can set up to trade on the Singapore exchange, so it is entirely reasonable to expect Chinese clearing houses to open up in time.

China is moving toward full renminbi convertibility as well as toward making its exchanges internationally accessible. If non-Chinese exchanges have not developed, it is possible that China will have ended up controlling the centers of ferrous trading after all.

Ferrous derivatives are not going away; price certainty is simply too useful. The only questions are: When will it develop and where?


Tim Hard is director of steel and scrap at The Steel Index, www.thesteelindex.com. He is based in Singapore.