Volatility spurs renewed interest in ferrous hedging

The month of April saw a noticeable increase in the use of the CME Group’s U.S. Midwest Busheling Ferrous Scrap contract, according to information posted daily by CME. By the close of business April 29, some 1,050 block trades had been made attached to the contract for the June through September 2020 timeframe.

Fastmarkets AMM says the scrap futures trade at the end of that day had “surged to 1,272 lots (25,440 gross tons)” of hedged material.

“In my opinion, the industry is increasingly embracing hedging,” states Mike Frawley, CEO of New Jersey-based World Steel Exchange Marketing. “The seismic change that has taken place in our world during this incredibly short time span is hard to come to grips with,” he adds.

Veteran ferrous scrap trader and current industry consultant Nathan Fruchter, principal of Lawrence, New York-based Idoru Trading, has been a proponent of hedging in the ferrous market. He says there is still plenty of room for the practice to grow.

For most of the past two years, Fruchter says, the contracts have been “mostly traded by the market makers and financial institutions. Very few recyclers really use them to hedge their ferrous stocks. It’s the same scenario with the electric arc furnace (EAF) steel mills.”

Like Frawley, Fruchter sees COVID-19-related fluctuations in price, supply and demand as driving potential change. “One would think that with the sudden and against all odds price hike we have seen in the last three weeks, that people would learn a lesson in the purpose of these futures contracts,” he remarks.

Frawley, whose company is helping promote the CME-traded contracts, sees reasons for the change being permanent. “Market disruptions impacting prices can be mitigated by hedging,” he states. “For me, a fundamental for sustained success [in the scrap and steel sectors] is having in place staff dedicated to hedging with disciplined business practices.”

Scrap companies have the in-house knowledge to use hedging properly, Frawley adds. “Since almost all of the top 20 steel scrap processors are also nonferrous scrap processors, they all know how to hedge, and most hedge a portion of their nonferrous intake,” he remarks.

“Physical dealers in copper and aluminum frequently hedge by laying off their price risk on either the CME or the London Metal Exchange (LME),” he adds.

Frawley continues, “Many of the EAFs, and for that matter service centers, have risk management departments, and they too understand and frequently utilize futures and OTC [over the counter] markets to hedge.” 

Fruchter expresses more skepticism and sees some potential barriers. “Unlike the nonferrous futures contracts, where you can actually take physical delivery of these goods from accredited warehouses, this option does not exist for the ferrous scrap future contracts,” he comments.

The veteran trader says he is in favor of the notion of hedging ferrous material. “Any tonnage hedged means taking some element of the risk out of that tonnage,” he states. Fruchter says he remains concerned, though, that “the liquidity is not there because not enough contracts are being traded,” adding, “I also would venture to say that the small sized 10-tons lots of these [contracts] makes this a difficult task.”

Despite any upgrades needed to how the contracts are formatted, risk mitigation could boost their use, says Frawley. “Throughout any given year there will be challenges to the business, from storms, logistical bottlenecks, flooding, equipment failures, low prices drying up intake and now the pandemic.  Futures markets provide quick liquidity with ready buyers and sellers. Ferrous futures hedging and open interest is steadily growing. Futures, combined with block trades and look-a-like OTC ferrous markets, are sufficiently liquid for those who are seeking to hedge large volumes,” he states.

Adds Frawley, “Ferrous scrap sellers should be comfortable hedging 25 percent to 50 percent of their inventory, assuming they are carrying one. The ferrous industry is in business to process and make steel, not speculate by not hedging risk.”

Without warehoused inventory in the mix, Fruchter remains skeptical about ferrous hedging’s ceiling. “I don’t really see a direct connection between short supply of scrap and filling orders or hedged lots,” he remarks. “For every futures contract one wants to buy, there needs to be a seller of the same tonnage somewhere. For now, it remains a tool for speculators who follow the ferrous scrap and rebar markets and buy and sell these contracts hoping to make money on these transactions. It bears no resemblance to their physical transactions. And the traders who do hedge their physical transactions with a futures contract are very few and far between.”

Frawley does not refer to such limitations, saying, “In my opinion, the industry is increasingly embracing hedging. I have no doubt there will be a significant uptick in hedging volumes over the next few years. Companies cannot continue to take these hits and survive. Careers and jobs (to say the least) are at stake. There is no reason to operate a business with your fingers crossed and wide-open exposure.”