Steel futures | Industry | S&P Global Commodity Insights

The S&P Global Commodity Insights Steel Futures Guide has been created to help steel industry executives improve their understanding of the futures concept, and keep up to date with the latest developments in launching a price risk management tool. S&P Global Commodity Insights is in close contact with all concerned parties and is the leader for steel futures news.

Futures trading has been around for a long time and is used by many different industries, including most non-ferrous metals. For steel, however, currently only regional futures contracts are available on 3 different exchanges, but further contracts are planned for launch over the next 12 months.

What is currently happening in steel futures?
What are futures contracts?
What is hedging?
Are risk management tools new?
Steel risk management tools - are they new?
What are the risks and benefits?

What is currently happening in steel futures?
The London Metal Exchange launched steel futures contracts in April 2008, trading billet in the Far East and the Mediterranean region. These were merged into a single global billet futures contract in July 2010. In November 2015 the LME additionally launched futures trading in steel scrap and rebar. The contracts are cash settled against reference prices provided by The Steel Index and S&P Global Commodity Insights. Visit www.lme.com for more information.

The New York Mercantile Exchange (NYMEX) division of CME Group began trading hot rolled coil futures in October 2008. The contract is settled financially against a published price for the US Midwestern market. Visit www.nymex.com for more information.

The Shanghai Futures Exchange began trading futures contracts in Chinese rebar and wire rod in April 2009. More information at www.shfe.com.cn

As a consequence of its unique price collection and calculation processes, The Steel Index provides independent, accurate and fully verifiable weekly steel reference prices that can be used as the settlement prices for financially-settled steel futures contracts or other Over-The-Counter (OTC) forward price risk management products.

The Steel Index is a company owned by S&P Global Commodity Insights, and S&P Global Commodity Insights Subscribers receive a 10% discount on subscriptions to the weekly price service. Sign up for a free trial now!

What are Futures Contracts?

Futures contracts are financial risk management tools that enable companies to hedge their price risk exposure by agreeing to buy or sell a particular volume of product for delivery on a fixed future date at a price agreed today.

Markets have different forms of risk, and while some participants wish to avoid risk, others deliberately want to a acquire it. The risks depend in part on the market for example; interest rates rising and falling, currency rates changing, fluctuations in equity prices, raw material prices changing, energy costs fluctuating, etc. Futures contracts are exchange-traded risk products that hedge the risk levels. Other risk management tools, such as forward contracts or swaps may, and have historically been offered by individual companies.

What is hedging?

A futures contract provides an understanding of price risk and a mechanism to reduce it. Many steel mills already hedge currencies and energy sources, whilst others just hedge some or all of their raw materials purchases, such as zinc, tin or nickel. The possibility of hedging would be open to all in the industry - mills, traders, stockists and end-users.

One definition of hedging is “The offsetting of perceived risk in one market by the deliberate assumption of an equal and opposite risk in another market"

Are risk management tools new?

Such instruments have been used for thousands of years. In ancient Greece farmers sold a percentage of their olives at a predetermined up-front price, months before the harvest. Thus sharing the price risk with the buyers. In ancient Rome there was a forward market in grain. Futures contracts are issued on many products and commodity materials such as oil and gold, on currencies, indexes or equities and bonds. In the last decade in the USA alone, the futures market grew from 300 to 600 million contracts (a contract can be in multiple units for example; 25 tonnes, 5,000 litres etc).

Steel risk management tools - are they new?

No, but a very limited range of steel futures contracts have been available to date, both in terms of regional scope and the products covered, and trading volumes have been low.

In the 1990s, a number of contracts were launched in China. In fact, three different exchanges were set up to trade steel price risk. But by 1994 all of them were closed due to lack of business, which was possibly because they were lightly regulated and were seen more as exchanges for speculation and betting as opposed to risk management. Currently the Shanghai Futures Exchange is awaiting approval to launch a new steel futures contract by the end of 2006.

In India, the NCDEX exchange offers futures contracts in steel and billets - but trading is understood to be very limited.

What are the risks and benefits?

Benefits

Risks

Price risk management
Price risk exposure can be managed and controlled.

Reference Price
Transparent prices will facilitate external and internal negotiations with other market influencers, such as unions and governments. Futures contracts increase price transparency. As they are traded on an open exchange and acknowledged as the most transparent price, there is no one market maker (in theory) who can influence the price.

Experience in other markets (e.g. oil and aluminium) shows that there is a high correlation between spot prices of different related products. In the case of steel products this could mean that a futures contract for one product, e.g. HRC could be used as a reference quotation price for other products such as cold rolled coil or slabs with a premium or discount. For similar reasons, the management of raw materials relationships could also be made easier – e.g. iron ore contracts could be linked to the price for HRC on an exchange; hence protecting margins.

Forecast tool
Decision making on capital investment can be more objective. Knowing the future revenue streams – say for a period ultimately up to five years ahead means that producers should be able to better plan capacity. Such planning and more certain cash flows should also reduce the cost of borrowing or capital.

Lower cost of capital for producers
Banks charge higher interest rates for businesses which they view as being more risky. If a producer can show that his future cash flow risks are less with a hedge of futures contracts, a bank is likely to lend cheaper money, or in some cases even to lend money when previously it would not. In addition, smaller companies who currently cannot borrow, could be able to by use of steel futures. A risk management tool such as futures contracts would, therefore, be healthy for the industry by potentially increasing the capital available and also reducing the cost of capital and thus improving profitability.

Consolidation
In certain industries the introduction of a futures contract has increased the opportunity for sector/specialist consolidation. This is because the open exchange price and related transfer pricing (e.g. a premium between CRC and HRC) make vertically integrated businesses less risky. Additionally the open exchange price allows the whole industry to share the risk. Thus if steel futures are a success we could see some companies becoming specialist slab or billet producers, as others strengthen their downstream operations. It will therefore be easier for companies to specialise in what they are good at.

Lack of liquidity
If companies do not use futures contracts, i.e. there is a lack of liquidity or traction in the market the concept will simply fail. However, the underlying asset value of the global steel industry is large – estimated by some people as being $440bn, compared with about $130bn for the base and precious metals industry. Plus the annual turnover of the steel industry is massive; between $200bn and $300bn. Thus it is likely that liquidity will develop, but not certain.

Speculation
There is a fear that too few steel companies would use a futures’ market. In this case, could some traders corner the market? – in theory, yes. But if the contract is appropriately structured, and the exchange is well regulated this is unlikely.

The divergence of the physical and futures price
This is possible if there is speculation or too little liquidity. Cornering the market could lift the futures price, and leave the spot market behind.