Markets are slowly getting used to the idea that China, once the juggernaut of the world economy, is set for a period of slower growth. Despite this, industrial commodities are one area where China will continue to play an important, if not dominant role.
In the past decade, China transformed the traditional pricing of iron ore as its prodigious metals appetite helped double global demand for seaborne iron ore. The resulting spike in price volatility led to a shift in pricing from annual contracts set between mining and steel companies, to the shorter-term agreements which are now commonplace today. With this fluctuation in the delivered price and the emergence of a larger spot market for iron ore came a demand for futures contracts to manage risk.
While challenges remain to make the trading of ferrous metals futures mainstream, China’s influence will continue to be key. Not only does it retain a huge appetite for ferrous metals and iron ore, its efforts to liberalize its largely closed capital markets could also be significant.
Additionally, according to research by Gavekal, during the first decade of this century, China’s per capita steel consumption grew at a compound annual growth rate of 14.8 percent – more than quadrupling. As the chart below shows, China is using more steel per head than any of its predecessors were at similar levels of income, and growth in that consumption has been faster. Public comments by executives of major mining companies indicate they are anticipating a slowdown in the growth of China’s demand, but still believe they need additional capacity to meet the absolute increase in demand.
To get a sense of what lies ahead, we spoke to Martin Evans, Director of Metals Products at CME Group.
China’s economy appears to be going through a slowdown. How do you expect this will play out on the demand for steel going forward?
China’s massive infrastructure spending has been a major source of demand for everything from copper to iron ore in recent years. There is still substantial demand for new roads and railways as the government is committed to a continued program of urbanization. That said China’s demand growth for steel appears to be cooling from previous double digit levels suggesting downward price pressure for iron ore and ensuing volatility. There is also the supply dynamic – this year we have seen both BHP Billiton and Rio Tinto increase their iron ore production substantially.
China’s economy will continue to grow, but the quantum of growth will likely slow as it undergoes efforts to rebalance its economy to put growth on a more sustainable footing. China will remain the largest source of global metals demand for the foreseeable future.
We are used to trading futures on a host of soft commodities, oil, and other metals. Why have iron ore and other ferrous metals been more difficult to trade?
The particular challenge with iron is it is not a homogenous product and you have volatility across each individual product in the steel chain. The obstacles range from the sheer variety of different products in the iron supply chain to the impracticalities in physical delivery of one of the biggest dry bulk commodities that is traded and shipped.
There is an inherent volatility as there is a time lag in supply and demand. You have to transport iron ore to the mill – queue up, then they get made into molten steel or billets. This means you do not have reliable correlations across different commodities in the metals chain.
In addition, iron ore pricing was determined on an annual fixed price basis resulting in limited price volatility and little need for financial contracts. The emergence of Chinese demand coupled with spot supply of iron ore, from India and elsewhere, led to the demise of the benchmark mechanism necessitating derivatives to mitigate price risk.
Can you tell us how CME Group’s ‘Virtual Steel Mill’ helps to solve some of these issues?
Our virtual steel mill introduces a suite of ferrous related contracts, which help cater for the complexities of the steel cycle. We believe this will allow companies to use hedging to remove the business risk associated with increased price volatility at the stage where it directly impacts them.
This year we have seen strong growth in our benchmark U.S. hot-rolled coil steel contract with turnover approaching 700,000 short tons. The addition of options on this contract has been well received with 168,400 short tons cleared in 2013.
Another move forward, was the May listing of iron ore on our Globex electronic trading platform. Over half a million tons of business has already transacted on Globex complementing the almost four million tons of cleared iron ore business. With strong support from dedicated market makers and the August 26 launch of iron ore quarters and calendar strip contracts, we anticipate a very strong fourth quarter for this contract.
With such a variety of contracts – how do you pick one which is most suitable for your hedging needs?
How you hedge depends where you are in the industry. A car manufacturer might hedge steel at the output level with plate steel. Alternatively, it could hedge the raw material iron ore. These tools are still very new and at this stage a lot of analysis is still going on in the industry to assess correlations.
There is also the issue of steel mills and other end users having sufficient expertise to trade these new contacts.
Part of this is down to education. It is also down to steel mills making use of in-house expertise. Many steel companies have experience hedging nickel, zinc, aluminium and foreign exchange through their finance departments and can make use of this experience to manage risk in other steel inputs and outputs. For some it will be the upfront cost in terms of margin.
There’s also been a feeling among steel companies that “we’ve been around for a hundred years and not had this and we are still here.”
How do you see financially settled futures work alongside physically settled futures in the steel industry?
Given the physical limitations, there are clear benefits in financial futures. There have been concerns that because you do not get the price conversion you get in the physical market, you will see speculators moving the market.
But we have shown we are getting conversion to spot pricing as evidenced in the growth in participation from commercial and physical steel trading firms.
How is progress so far on adoption of the Virtual Steel Mill? What do we need to see for wider usage and what might be the tipping point?
Another big advance is moving to onscreen pricing. This means prices are delivered electronically, which gives much greater price transparency.
We have also seen a pick-up in interest since steel futures were listed on Globex last month, which represents the latest ferrous push.
The benefit of on-screen trading is market participants know they can trade at that price. This should give people a huge amount of comfort they can execute. Before this, brokers were required to phone around and did not know they would get orders filled.
How do you see Chinese participation in the steel market moving forward, particularly as we see more policy initiatives towards deregulation?
China has been taking steps to ease some of the restrictions on its capital markets, and we expect this to continue. In the past 12-15 months Chinese Futures Commission Merchants (FCM) have begun using metals as well as agricultural futures from their offices in Hong Kong. Due to restrictions, this is currently the only way for FCMs to access metals products. There have also been some encouraging steps towards greater liberalization with the announcement of a free trade zone in Shanghai, which promises to remove curbs on trading commodities and currencies.
We have still to see how the appetite of Chinese state-owned commodity and industrial companies develops for metals commodities. Currently there are restrictions on what SOE’s can do, but the Chinese government appears to be moving faster in the direction of deregulation. The moves China is making could have a lasting impact on the development of metals futures. In the medium to long-term, China could be one of our most important markets.