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September 7, 2006

Steel in Your Futures

It's time to lay our cards on the table about steel futures. They could benefit everyone in the steel value chain, from producers to end users. Steel futures contracts can reduce risk, enhance profitability and stabilize the markets.

Industry naysayers—and there are many of them, including more than a few CEOs—are worried.

They worry about the pernicious effect of speculators, not recognizing that speculators are the risk-assuming grease that keeps the squeaky wheel of trade moving smoothly. They worry that prices can be rigged, or at least manipulated, by the forces of greed. They say there’s no way to establish trade based on a contract for any sort of steel, since every coil has its own metallurgical signature and no two coils are exactly alike.

Valid concerns to the uninitiated perhaps, but not the whole story.

Even if mills or service centers never hedge a ton, the arrival of steel futures would create public reference prices that would change the way steel is quoted. Further, once a viable market is up and running, hedging price risk through futures contracts offers the opportunity for mills, service centers and end users to shape another element of their own fate.

In a classic hedge, a buyer or seller of commodities cushions himself against adverse price swings and locks in a price. For example, a steel mill worried about falling prices in September would sell a futures contract for June delivery. Even if the producer’s fears are realized and he sells his hot-rolled steel at a lower price in the physical market, he’ll make a profit by closing out his futures contract. Conversely, a user worried about rising prices could profit by buying futures, with a profit offsetting higher prices he must pay in the cash market. In either case, the risk is assumed by speculators who bet on the direction of prices, sometimes over the long term, other times hour-to-hour or minute-to-minute.

That’s the upside. There also is a downside. Steel companies will have to learn how to use the market to do so effectively. There is expense involved, albeit comparatively minor, for staff or supervision of authorized traders, and to pay transaction costs. Because futures contracts are highly leveraged—comparatively small amounts of money control very large amounts of contracted steel—unsupervised speculative trading on company accounts can lead to financial disaster, as a number of organizations, including trading companies, have learned.

None of those issues have slowed the determination of those who see a great future in steel futures. At least two major exchanges—the London Metal Exchange (LME) and the New York Mercantile Exchange (NYMEX)—have steel futures contracts under development.

Clearly, no potential futures market can work without the participation of producers, distributors and end users. So, as of today, the skeptics hold great sway. That was the case in the aluminum industry three decades ago, when futures trading was under discussion. It took at least seven years for the LME’s futures contract to become widely accepted following its launch 28 years ago. Today, every segment of the aluminum industry participates on the exchange (See “Aluminum Leads the Way” ).

FORWARD INTO THE CURVE
One key to how a futures market could change the industry rests in the creation of a forward price curve—a list of prices as of today for the delivery of steel at different dates in the future. Currently, the industry lacks a single widely used set of prices. A functioning futures market automatically would create these prices, which would be transparent, instantly available and universally accepted.

On the basis of the price curve, the price of steel today—any grade, sold for delivery anywhere—can be calculated and used as the basis for negotiations. A mill that wants more for its products than the London or New York reference price will have to find buyers willing to pay more on the basis of product quality, its unusual metallurgy, favorable terms, lower delivery costs or some other factor acceptable to both sides. Similarly, a mill that needs to liquidate extra product can credibly lower prices knowing that all potential buyers will immediately understand the value offered.

“Price transparency will come with a forward curve,” says Jonathan Putman, who is working to launch the Birmingham Futures Exchange (BFEX), an exchange-type market designed to hedge steel. “Whenever I introduce people to do a [private, over-the-counter] deal, the question is always, ‘What is the price?’ Right now, the price is set by whomever I can find who will do it with you. It’s very difficult to get people to come to an external price because there’s no external information.”

Much like what has happened in aluminum and other metals with a working futures market, once these forward prices are created, the steel industry will see them as a reference. The forward price curve will reflect future prices, anchored by a current cash price. This creates a whole new set of dynamics for service centers, which often see their competitive edge as their ability to buy metal at an especially low price and the benefits that accrue from their relationships with mills and end users.

“Even though [distributors] may not be users of the futures market, they will be forced into buying their steel on the basis of this contract,” says James Southwood, president of Commodity Metals Management Co., a Wexford, Pennsylvania management firm that specializes in metals price risk management. “So what they are going to lose is some flexibility in negotiating fixed-price agreements with their suppliers. What they are going to gain is the visibility of pricing, meaning there’ll be published and traded and observable prices, which will allow them to hedge product price risks without the producer.”

As a result, service centers will have less opportunity to differentiate themselves on price and will have to gain an edge on quality, service or better supply chain management.

A CONTRACT WITH THE FUTURE
Once reference prices are established, a range of financial instruments designed to hedge price risk exposure in steel can come into use. While there’s little doubt that any financial derivatives—transactions based on the underlying value of a commodity—can get complex pretty quickly, in the case of steel, like other metals, two key mechanisms are likely to dominate: forwards and futures.

Forward contracts, by their very nature, are straightforward, over-the-counter transactions where two parties agree to the delivery of a set amount of goods at a set price at a future date. For example, a service center agrees today to buy steel at a set price a year in advance without knowing for sure what the price will be later, and completes the transaction at the agreed-upon price when the date arrives. While forward contracts currently are available as private, over-the-counter transactions, they aren’t widely used beyond three-month time periods. The arrival of a futures market will allow everyone to work off the same playbook of published prices and extend the industry’s time horizon.

Futures contracts, in comparison, are standardized, fungible—that is, every steel futures contract is exactly like every other steel futures contract traded on a given exchange—and traded in a regulated environment. The point is to take a financial position at a given price in the future, offsetting the risk of fluctuating prices in the cash, or physical, market.

“Futures contracts won’t change the actual mechanics of getting steel from point A to point B while someone like a service center provides a value-added product,” says John Short, founding partner of Steel Derivatives, a Dubai-based consultancy. “All futures and derivatives will offer are tools to manage your price risk. That’s it.”

With those tools, a host of benefits may flow. The ability to hedge steel price risk can lessen the fear of debilitating losses should steel prices move the wrong way—a constant concern throughout the supply chain. Diminished price risk also may mean more uniform cash flows and better inventory management, leading to competitive advantages for those who manage their risk well.

Scott Stewart, director of global risk management for Aleris International, a Beachwood, Ohio-based aluminum recycler and producer of semi-fabricated aluminum rolled products, says using LME aluminum futures is at the heart of his company’s business model.

“Because Aleris is trying to make profits based on its ability to effectively and efficiently buy raw materials and its ability to sell quality value-added products, the benefit of the futures market is absolutely essential,” he says. Aleris last month agreed to be acquired by private equity group Texas Pacific Group Ventures.

In a typical situation, Aleris might quote a customer who wants to buy 1,000 metric tons of a product in June 2007 at a price of $2,520 per metric ton, based on the LME forward curve. “What’s the risk?” Scott says. “The risk is that prices will go higher in the future, before we have to physically buy the raw materials.”

As a hedge, Aleris might buy 1,000 metric tons of aluminum futures for June 2007 delivery at $2,520 a metric ton. As April or May 2007 arrives, and Aleris starts buying the raw materials it needs, it might find the price has risen by 20% to $3,024 per ton. If that happens, Stewart can start unwinding, or selling, the futures contract and profit on the gain, which offsets the higher price paid in the cash market. The effective price paid for a metric ton of aluminum remains $2,520.

“In this way,” he says, “we end up having the physical materials to produce our sales. And, we’ve used the financial futures contract to offset the pricing risk of market movements that will occur between now and June 2007.”

 

THE SKEPTICS
Of course, not everyone is convinced.

“If one wanted to be cynical, one could say that people are trying to get between us and our provider, and create a business as a third party between the two contractual partners,” says Edward M. (Bud) Siegel Jr., president and CEO of Russel Metals, the Ontario, Canada-based metals processor and distributor. “And what are they providing to us? When we [at Russel] buy our steel, we have a contractual arrangement between us and the physical supplier. I’m not worried about our supplier raising the price on us.”

What Siegel and others worry about is the arrival of speculators and what that could mean to the industry.

“A futures market probably will introduce speculators into the steel markets that aren’t there today,” says Gary Heasley, vice president and CFO of Steel Dynamics, a minimill in Fort Wayne, Indiana. “Whether that increases volatility or decreases volatility remains to be seen.”

While it is true that the arrival of a futures market would bring outside players into the industry, there’s a big difference between hedging and pure speculation.

“In many cases, even the publicly owned companies are reluctant to participate,” says Putman, who, prior to working to launch BFEX, spent 18 years as CFO of Hanna Steel, a Birmingham, Alabama, service center. “They’re very afraid, and part of it is rightly so. They read the horror stories about people who have lost their shirt in the commodities exchanges.”

Those who have taken a pounding on speculative contracts often missed learning the market fundamentals or bet the bank on an extreme position. This happens at companies that lack adequate internal controls to prevent such a step. Individual speculators come looking solely for a profit, while companies that make, fabricate, distribute or use the actual steel hedge to protect their profitability.

Mike Walsh, managing consultant with Hatch Beddows, a London-based engineering and strategy consultancy that specializes in steel, says metals companies would use futures independent of their day-to-day cash transactions, which are based largely on ongoing personal relationships. “Whether you expose yourself or don’t expose yourself to hedging is your choice,” he says. “It’s got nothing to do with your customer, who will still buy from you because he gets good steel at the right time, at the right place, at the right quality.”

BENEFITS FOR THE CUSTOMER
Ultimately, the value of a functional futures market rests in a steel supplier’s customer base. Tony Taccone, a founding partner with First River Consulting, a Pittsburgh-based steel consultancy, points out that enhanced stability in prices for service centers with customers whose requirements are consistent over long periods of time is likely to offer clear benefits.

“These customers are original equipment manufacturers of all kinds of things who would very much like to know what their steel cost is going to be for the year,” he says. With the arrival of futures contracts and the ability to see that price going forward, steel producers and distributors should be able to offer better service to their customers through enhanced price stability. For producers and distributors who can rise to the challenge, price stability could prove a strong competitive advantage, along with a powerful allure for their customers.

“It is certainly something we would consider participating in,” says Mary Valenta, executive vice president and CFO of O’Neal Steel Inc. in Birmingham, Alabama. “It would help us with our price quoting to customers and improve our relationship with mills because we would not have to go back and forth about volatility and pricing and unexpected increases or decreases. I think the stability in pricing would be good for the market overall, from the mills to the service centers to the customer.”

From his position as vice president of London-based Koch Metals Trading, which offers over-the-counter hedging tools in steel and other metals, Jeffrey Kabel sees the opportunity that futures could offer for a wide range of industry segments.

“What we’ve seen is if service centers are allowed to lock in the price financially, they’re more comfortable going out and taking bigger positions physically because they think they have a point of view that is correct and they are going to lock it in,” he says.

While few in the industry seem to be actively hedging or taking forward positions today, the pressure for the introduction of a successful futures market is building (See “Stepping Up to the Plate”).

Smaller exchanges in Nagoya, Japan; Shanghai, China; and Mumbai, India, are up and running or in the planning stages. Meanwhile, as industry consolidation continues, the pressure to gain competitive advantage will increase.

“At the end of the day, you’re going to have fewer mills, fewer distribution centers, and they’re going to have to compete,” Kabel says. “One way that they’re going to compete is on guaranteeing a price for a certain amount of time. More than spot for a month or a quarter—more like six months, nine months, a year. And that’s what this allows them to do. There’s a price out there; they can lock it in and manage their physical purchases accordingly.”

But whether steel futures come tomorrow or more than a few years down the road, don’t look for the steel industry to change overnight.

“Nobody’s going today, ‘Oh, the steel industry changes on this day,’” Walsh says. “That’s not going to be the case. It’s going to be very slow, very subtle, and first and foremost, you can opt in or opt out.”

ALUMINUM LEADS THE WAY

Mike Petersen’s career in aluminum began around the same time the London Metal Exchange (LME) introduced an aluminum futures contract in the late 1970s. Looking back on it now, the president of Petersen Aluminum Corp. remembers how many in the industry worried that the arrival of a futures market would hurt their businesses.

“I recall a lot of the mill people wringing their hands at the prospect of exchange-based pricing,” he says. “But since then, my feeling is that the existence of exchange pricing may have had a positive effect on the profitability of the industry as a whole.”

The numbers back Petersen’s view. During the first six months of 2006, futures contracts representing an average of 77 million tons of aluminum were traded monthly on the LME, a 32% jump in volume over the year before. That makes the metal the most heavily traded contract on the exchange, which also handles nonferrous metals such as copper, nickel, lead and zinc, as well as plastics.

But such acceptance didn’t happen overnight. In fact, it took quite a few years after the LME introduced aluminum futures in 1978 for the market to reach the kind of critical mass it currently enjoys.

“For about seven or eight years, it bumped along the bottom of our volume curve,” says Neil Banks, director of exchange development for the LME. “Producers were very much against it and would not participate in the process at all. But by the mid-1980s, as emerging aluminum-producing countries such as Russia increased output significantly, price recognition and hedging on the exchange meant those who were able to offer the LME price as a benchmark were gaining a significant advantage. And so we saw a sudden upturn in aluminum volume on the LME.”

Today, every industry segment in aluminum—including mills, service centers and end users—participates on the exchange. Recently, Alain Belda, CEO of Alcoa Inc., said that the aluminum giant uses the LME to price “virtually all” of its commodity grade products and “actively” uses hedging tools to manage metal price risk across its business lines.

A representative for Pittsburgh-based Alcoa declined interview requests. However, speaking in April to the 2006 Dow Jones Metals Finance conference in New York, Belda cited a number of benefits for both his company and the industry as a whole, including increased liquidity, price transparency and enhanced inventory management. Aluminum futures have “enabled Alcoa to disaggregate the commodity from the fabricating lines of its business,” he said, thereby allowing it to properly measure profit for each sector of the company’s business.

For his part, Petersen sees the value of using futures contracts to hedge price risk, but admits that his company simply doesn’t take advantage of as much as it could. Hedges could help protect the value of inventory in the case of a sudden price drop, he points out.

Petersen, whose Elk Grove Village, Illinois, service center buys as much steel as aluminum, predicts the benefits of aluminum futures could be transferred to steel once a viable steel contract is up and running. “The one thing I like about futures—and the reason why I think it would be good for steel—is it gives you a forward look where prices are heading,” he says. “It would give us a good marketing crystal ball as to where prices might be.”

 

STEPPING UP TO THE PLATE

Despite a perception that steel futures are far off in the future, a number of exchanges, traders and third-party information providers already are in the game. And right behind them, others are set to jump in should the London Metal Exchange (LME)—currently the odds-on favorite to launch a global contract—succeed in creating a viable worldwide market.

Right now, for example, steel futures contracts are being traded in Japan and India. In March 2004, the Mumbai, India-based Multi Commodity Exchange (MCX) launched a domestic contract for hot-rolled coil, followed more than a year later with the October 2005 creation of a domestic ferrous scrap contract on the Central Japan Commodity Exchange (C-COM) in Nagoya. While these exchanges cater primarily to their domestic markets, no less than six additional exchanges currently either are planning or considering the launch of a more global contract: the LME, the New York Mercantile Exchange (NYMEX), the Chicago Board of Trade (CBOT), the Dubai Multi Commodities Center (DMCC), and China-based Dalian Commodity Exchange (DCE) and Shanghai Futures Exchange (SHFE). While the LME is considered the most likely exchange to step up next, several of the others—most notably the NYMEX and CBOT—may possess the reputation and financial backing to go it alone.

“We do believe that a contract will be launched somewhere in the next 12 months,” says Robert Levin, senior vice president of research for NYMEX. “We’re going to continue to evaluate the commercial landscape in deciding if and when we launch steel futures. I have a lot of confidence that once we make that decision, we have the capability to introduce very quickly—even within 30 days, and certainly within 60 to 90 days.

Beyond the global exchanges, there is a small but significant market in over-the-counter hedging products. For the past few years, London-based Koch Metals Trading has offered swaps on hot- and cold-rolled products, in which two steel purchasers can swap contracts for future delivery of the same material at different prices.

Others, such as Dubai-based Steel Derivatives and a number of smaller steel consultancies, have created viable businesses in offering steel price swaps. For his part, Jonathan Putman, the former CFO of Hanna Steel Co., has worked to create the Birmingham Futures Exchange (BFEX) as a venue to hedge steel. In Putman’s plan, mills with excess steel coil would submit paper vouchers to the exchange—specifying the particulars of a given lot of steel coil—to be traded like futures contracts.

But it is the LME that looks ready to lead the charge for the creation of a universally accepted, worldwide futures contract. Currently, the exchange trades six different base metals futures contracts in addition to its recently launched plastics contract, which makes it, along with the NYMEX, one of the few key players with the institutional weight to make a global contract a reality.

Neil Banks, LME director of exchange development, says the exchange is developing the means to offer derivative products for steel. In May, the exchange selected commodity news and information provider Platts, a division of McGraw-Hill Cos., to compile steel reference prices, a move seen as a key step down the path toward the creation of a steel contract. Citing the problems associated with variances in steel quality, storage and cost of carry, the exchange is focusing on an index-based contract, one that replaces physical delivery with financially settled contracts based on cash prices compiled by Platts.

“While nothing has been set in stone, it is Platts’ aspiration—and I believe they’ll meet that aspiration—to be publishing cash prices for a variety of steel products this year,” Banks says. “And it is our aspiration to be able to offer derivatives on those cash prices sometime next year.”

In the end, it’s not hard to see why so many players are looking to step up to the plate when it comes to steel futures. “Steel has the largest volume of purchases in the world, second only to oil,” says BFEX’s Putman. “If the LME, for example, gets a steel futures contract, the volume of those contracts will dwarf the total of all the other metals they have, combined.”