For most of its history, the steel industry set prices privately and for the long term. But with major shifts in global infrastructure projects in emerging economies, the industry is increasingly turning to futures markets.
The evolution of steel futures as a financial risk management tool is somewhat akin to an aspiring actor who dutifully rehearses his lines, only to be relegated to the role of understudy. Patiently, he bides his time until his big break comes.
Like that actor, steel futures have been around for a while. On a limited basis, the concept was tried in China in the 1990s, although the contracts eventually closed because of a lack of business. According to Platts, a McGraw-Hill subsidiary and provider of metals and energy information, current interest in steel futures dates largely to 2008 when the London Metal Exchange launched contracts in April of that year and the New York Mercantile Exchange, a CME Group subsidiary, began trading hot rolled coil futures six months later.
Timing is everything, and steel futures have taken off since, serving as a valuable counterweight to rising volatility as the Chinese economy entered a period of rapid expansion, and now, a slower rate of growth.
The Next Wave of Innovation
Whirlpool Corp. provides an example of how end users are increasing their reliance on futures. The company buys steel futures over the counter through financial institutions, and purchased its first steel contract in July 2009 because it wanted to ride what it envisioned as the next wave of innovation. “We were involved in certain industry associations and we were aware the market was starting to take off for futures,” says David Brooks, director of global commodity risk management for the Benton Harbor, Michigan-based company. Whirlpool is no stranger to futures, having traded in them on the base metals side for years, starting in 2005. “We get involved in programs to reduce volatility and increase price value,” Brooks adds.
When China began demanding more raw materials for infrastructure, the supply base could not react fast enough, and the price of commodities increased rapidly, which was a major shift for the steel industry, according to Jeremy Flack, founder and president of Flack Steel, a Cleveland-based provider of custom steel products.
“If you look at pricing with hot rolled coil or band from 1980 through 2003, the price never went much higher than $400 a ton and never went lower than $225 a ton … you had a $150 spread there,” says Flack. “So it was a pretty quiet thing. The dollar was pretty strong in the 1990s. That put downward pressure on the commodities market.”
A steel service industry company formed in 2010, Flack Steel began trading in steel futures in the summer of 2011 and has been very successful with it, says Flack, an ardent supporter of his industry’s plunge into the trading practice. “The futures have helped hedge our inventory many times,” he says, adding that the practice has steadied earnings for the company.
For Worthington Industries of Columbus, Ohio, the impact of steel futures contracts was “very minimal” through 2010 and parts of 2011, recalls Marc Gase, its director of price risk management. “About three percent of our purchases were based off hedge in 2011, but as you go forward we’ll be pushing 10 percent of our purchases in Q3 2012.”
More Reliable Pricing
Cargill took the steel futures plunge in 2009 with an eye to managing “the risk we were exposed to in the hot rolled coil market,” says Brian Hatlevig, commercial director of the company’s metals group. So far, the experience has been positive. “It has allowed us to create solutions for our customers by being able to provide fixed-price solutions for them,” he says.
“It was a big need our customers were calling for ever since 2004 when the whole China boom happened, and commodities started to go crazy and we started to see a lot more volatility.”
Worthington, says Gase, got into steel futures for two reasons: the need to offer customers a fixed price, and the need to reliably base price off of an index.
“As the steel industry became more volatile with raw materials, scrap and iron ore, the mills just wouldn’t offer a fixed price because they didn’t want to take a big hit like they did in the past,” says Gase. “But customers still needed a fixed price. If you look at other commodities such as aluminum, it isn’t based off negotiations. It’s based off the LME index, and we believe that steel will get to that point at some time.”
Futures contracts have improved the bond between Cargill and its customers, says Hatlevig, “because we can provide a sight line not only into pricing, but also assurance of supply.”
A New Generation
Youngjin Chang, a director of research and product development at CME Group, says the steel industry, mostly driven by the service center group, is becoming more comfortable with the concept of futures. “This is a new market, so there is a big learning curve with the industry,” she says. “It is taking time for the steel industry to understand the value in this, and to manage their price risk, companies have to see the value in this.”
Companies are starting to see that value; a fact that can be attributed to a generation shift taking place in the steel industry. There’s a new breed of executives that is more willing to embrace new tools available in commodity markets.
Flack is an example. “There’s a large untapped market in trading not just to hedge our own book, but to supply product to our customers and help our customers hedge their books,” he says. “We’re looking to expand. Our next step is to have our paper book be as large as our physical book.”