A Successful Year For the LME Steel Billet Contract

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Arguably the LME steel billet contract came of age last year.

As the following graph from data released by the London Metal Exchange shows, volumes picked up dramatically throughout 2010 and apart from a hiccup in October, show a strong upward trend.

Source: LME data

What is behind the surge in enthusiasm for the steel billet contract? It’s difficult to be precise, but a number of factors have contributed to its new-found popularity. One significant step forward was that the LME merged its Mediterranean and Far East steel billet contracts into a single, global steel billet contract in July 2010, although volumes were already on an upward trend; this will have helped increase liquidity in the contract.

Another is a realization and gradual acceptance by both the industry and financial markets that the LME steel billet price is a fair and consistent reflection of the scrap-to-billet-to-rebar market and provides an effective hedge for producers and consumers in those industry segments. For scrap dealers, it represents an index and hedging opportunity for future sales as scrap is being accumulated. For steel billet producers, it is a hedge both on scrap costs and steel billet sales and for rebar producers and consumers it is a hedge on input costs, and hence, rebar sales prices going forward. As this graph from the LME shows, the US scrap price, the LME Steel Billet price and the Turkish Rebar price have fallen into a remarkably high degree of correlation this year —

Source: LME

— sufficiently high for banks to require clients to cover trading positions with hedges via the contract.

But why would the LME choose these three metrics to illustrate the contract’s success? Simply because this is what the LME steel billet contract is currently being driven by. Scrap arises in the US East and Gulf Coasts, is shipped to Turkey where it is used to produce steel billet (Turkey is not the only destination for US scrap exports, of course, but being one of the largest prices in other markets are in part driven by Turkish demand) and in turn, the Turkish mills export both steel billet and the downstream product of billet rebars in considerable quantities back to the US, the Middle East and Europe. In addition, the sizable Turkish steel industry came about because of a large domestic demand driven by long-term infrastructure and construction demands in the country Turkey is a sizable rebar consumer in its own right. Nevertheless, Turkey is a major regional player, according to the Steel Index: Turkish billet exports surged over 50 percent in 2010.

Is it a total correlation? No, other factors do come into play, although much of the Turkish industry is an import scrap- or billet-and-export billet-and-rebar dollar-denominated sum, so fluctuations in the Turkish Lira also come into the equation. In addition, if, as now, scrap prices become excessively high as a recent Reuters article explains, scrap prices are higher this month than in January 2008, but steel demand is nowhere near as high then rebar mills will switch to buying steel billets rather than scrap, supporting the CIS Steel billet price at the expense of scrap prices. However, the arbitrage opportunity is limited and if scrap prices weaken as a result then buyers promptly switch back, so rather than a major distortion it can be seen as a balancing mechanism keeping the three products in a steady inter-relationship. CIS Steel billet prices tend to follow rather than lead the Turkish scrap/steel billet/rebar market over the medium term.

Looking forward, in June 2010 the LME gave approval for New Orleans as a point of good delivery for its steel billet contract followed by Chicago and Detroit in August 2010; more recently the first US producer Sterling Steel Company based in Sterling, Illinois, applied in October for registration of their brand with the exchange, FuturesMag reported last year. While US volumes are not a factor in the 2010 rise in lots traded, it is a clear indication of the growing acceptance of the contract and its internationalization as a hedging instrument.

Could steel billets rival copper or aluminum, the LME’s behemoth lead contracts? Not in the short term, but it’s taken those metals decades to reach their global acceptance. The billet contract does appear, though, to have found its first major niche and has become a valuable hedging tool for players in that market. Time will tell the extent to which it breaks outside those confines and finds wider acceptance.

–Stuart Burns

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Comments (5)

  1. Jarek says:

    Hi Stuart,

    Great article! I would just like to point out however that Steel Business Briefing, our majority shareholder, reported the 50% billet increase, and we pick and choose some of their headlines when producing our scrap index.

    Furthermore I would also like to add that in addition to the hedging opportunities available by using the billet contract, there is now a ferrous scrap contract available on the LME, should producers wish to directly hedge their input costs.

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