Metals exchanges want buyers to use futures to hedge

By Tom Stundza –
LME and Nymex may push steel into world-trading spotlight
Since steel is sold directly by the mills to large customers or through such middlemen as metal service centers, steel buyers have few mechanisms to manage risk during periods of price volatility. The price of hot-rolled sheet in coil—the most common steel product—rose by 116% and then fell by 47% in the past 20 months. So, the London Metals Exchange (LME) and the New York Mercantile Exchange (Nymex) are revisiting the possibility of global trading in steel futures.

“The steel industry has been in need of reliable risk-management tools for a number of years now,” says Simon Heale, LME chief executive. However, dates haven’t been determined when steel futures trading might be launched. And that doesn’t surprise Jon Putnam, who points out the idea of widespread futures trading of sheet-steel product has been broached annually since 2003, with little success.
Putnam is a former CFO and CPO who has been developing the Birmingham Futures Exchange (BFEX) in Alabama to handle swap and voucher trading in steel. He says the London and New York nonferrous metals exchanges have been unable to choose marketplace pricing indices for steel, or to develop sufficient interest from producers, distributors or end-use companies. “Allow me to invoke Putnam’s Principle,” he says, “which is: ‘Over time, people tend to do what they perceive to be in their best interest.’ And then there’s the first corollary, which is: ‘Any system that expects them to do otherwise is bound to fail.'”
Futures contracts have been used in the nonferrous and precious metals markets for more than a century. Because these futures are traded on exchanges that are anonymous public auctions with prices on public display, the markets perform the important function of price discovery. There is no such exchange-based pricing transparency for steel.
Hedging is widespread in nonferrous
The purpose of a hedge is to avoid the risk of potentially volatile prices. A hedge allows participants in nonferrous and precious metals market to lock-in prices and margins in advance of purchase and, thus, reduce the potential for unanticipated losses.
The LME is the world’s premier nonferrous metals market. Last year, it traded 72 million total lots with a value in excess of $3 trillion. Meanwhile, the nonferrous and precious metals trading on the Commodity Exchange (Comex) Division of Nymex reached a record 29 million contracts in 2004.
“Hedges are very popular with producers, processors, distributors, traders, merchants, investment-fund managers and speculators,” says Jeff Kabel, vice president of London-based Koch Metals Trading. Steel producers and consumers are facing increasing challenges in managing profit margins and cash flows; however, investors and lenders are demanding greater stability. However, year after year, surveys find few original equipment manufacturing (OEM) companies admitting to hedging metals prices. “That’s probably because few purchasing or financial groups want to publicize how they are managing market price risks,” Kabel says in an interview.
Or, he adds, they buy steel—and there are few options to hedge prices on steel purchases. And there’s little to suggest the steel marketplace will jump into the futures trading pond anytime soon. “A few large-volume users do want trading in steel futures, that’s for sure,” says Kabel, “but it’s still an uphill battle to get a majority of the steel buyers interested in a futures exchange.” Koch Metals’ steel trading unit offers financial products to hedge the risks associated with steel pricing in over-the-counter trading of steel futures.
Putnam, the BFEX chief executive, agrees that “there is no clear picture of effective risk management by steel buyers. While the nonferrous metals buyers are comfortable with commodity exchange-based trading, steel buyers still are not comfortable with the idea of a global or regional futures exchange.” BFEX was designed to provide a price-hedging venue for a limited number of dues-paying members.
Other market analysts interviewed agree with Kabel’s view that the steel price spike of 2004 has created an environment in 2005 where small-inventory positions are fashionable. “So, steel buyers, by and large, are opposed in principle to taking large futures positions on physical metal,” he says. “These days, the OEM buyers aren’t thinking beyond three months of supply while proponents of a London or New York steel futures exchange want trading out six months to 18 months at least,” says Kabel.
“Many buyers still would rather lay risk off onto the mills, or service centers,” says Putnam, “and many don’t want to invest the time to develop credit lines and learn how to do swap agreements or other trading actions.”
Albert J. Getz, senior director of metals research at the Nymex, says that physical delivery contracts would require precisely defined quality specifications, weight specifications and pricing indexes for traded commodities. “From what we’ve heard,” he says, “the contracts that take place in the steel cash market are somewhat ambiguous in nature.”
And that’s partly why steel industry executives oppose the concept of futures trading in their sector of the metals market. There are almost unlimited combinations of chemistry, physical and structural properties, surface requirements, and dimensional specifications of both gauge and width, that make the task of having suitable steel in an appropriate warehouse almost impossible, they say. They also believe that the cost of both transportation and storage of thousands of tons of steel, relative to the very low margins available on the material, would overwhelm the value of the transaction. (see, Sept. 2, 2004; Steel futures market: It’s not in the cards—yet)
Volatility of steel prices in the past two years is working against purchasing executives being proponents of a formal risk-management project that involves hedging of steel. The U.S. spot market for steel has been setting the price for the U.S. and Europe. “Merchants and traders on both sides of the pond are watching the pricing trends set in the U.S.,” says Kabel.
Also, risk management decisions are not made in a vacuum; Koch Metals’ steel trading group works with purchasing directors, financial officers and sometimes even sales executives in developing over-the-counter risk-management services for hot-rolled and cold-rolled sheet in coils.

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