Iron Ore Hedging Moving Down the Supply Chain to Steel Consumers

We may be excused for thinking the move by miners and the Asian steel majors from annual iron ore contracts to quarterly and finally to spot (or largely to spot we have various permutations all being used at present but that’s the direction) will be the end of the iron ore pricing story, but in fact it’s just the beginning. The acceptance by CISA and the steel mills of spot pricing is moving in tandem with those same mills imposing spot pricing on their customers, essentially allowing them to pass through cost increases to their clients. For the first time in 40 years, Posco broke its annual price tariff and started adjusting prices quarterly in response to iron ore costs. We wrote last week about JFE’s evident surprise that their clients had so readily accepted a move to spot pricing, and they are not alone. While Chinese steel mills have always sold a large proportion of their material on essentially a spot basis, mills in other parts of SE Asia and in Europe have tended to adjust prices much more gradually – annual fixed prices being the norm and even longer for major consumers like automotive and consumer goods manufacturers. The semi annual adjustments that European majors like ThyssenKrupp, ArcelorMittal and Voest Alpine have imposed this year are the first step in a trend of more and more short term pricing that will manifest itself over the coming months.

You would expect howls of protest from major steel consumers and warnings that the price of a car or a washing machine are going to have to fluctuate with the iron ore market, but in fact apart from some bleating from manufacturers associations there has been a surprisingly muted response. Talking to market insiders it becomes apparent that major steel consumers are already hard at work developing hedging strategies to offset their supply price risk. Steel consumers face several closely related risks. The first is a simple agreement to index price rises and falls. If a supplier moves from annual to spot pricing, an index or benchmark is needed for agreement on prices changes, both as the price rises and to ensure fair reductions are made as index prices fall. The second risk is for the steel consumer to hedge that risk forward, ensuring a net cost balance going forward. If an automotive supplier enters into an agreement to sell steel panels to an OEM at a set price he needs to ensure his cost are controlled over the life of that pricing agreement. Over the counter iron ore swaps cleared via LCH Clearnet and SGX AsiaClear provide financial settlement of forward dated derivatives allowing consumers to essentially cover the price of steel inputs forward and more importantly by buying to an agreed index hold their suppliers accountable to price falls as well as price rises. The crucial issue here is to have the supply chain accountable to the same metric, by aligning price movements between the miner, steel mill and consumer to the same index, to hedge and reduce cost volatility.

Not surprisingly the leading players in this field like Credit Suisse are already working with major consumers such as automotive, construction and consumer durables to develop such techniques in Europe. The US is lagging behind the curve partly it seems because the integrated steel producers are more vertically integrated than Asia or European mills and therefore feel themselves less pressured to move to spot pricing, partly because scrap based EAF steel producers play such a dominant role in the US market and of course they are driven by a different set of pricing dynamics. Sooner or later however, the US will likely trend toward shorter term pricing even for major end users and ultimately hedging will become a necessity for downstream steel consumers. The interest in the Nymex MW HR coil contract when it was launched was an indication that consumers are keen for mechanisms to achieve price stability. Maybe for larger players taking one step back up the supply chain to iron ore is the way to go.

–Stuart Burns

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