We are pleased to introduce a two-part series from guest contributor Spencer O. Johnson, who has worked at INTL-FCStone as the primary risk management associate for steel since December 2009.
Until 2008, steel and its raw material counterparts like iron ore, were the largest commodity market in the world that had yet to be tapped by exchanges and transformed by an active futures market. Indeed, most estimates suggest iron ore alone has a physical market second in size only to crude oil. And yet even global industry leaders like Lakshmi Mittal and Dan DiMicco of Nucor have echoed concerns about futures, though Mittal has been more hesitant about condemning them outright. Even so, the world’s largest and the US’ largest steel producers, respectively, have both stood in opposition, at various times, to the establishment of a futures market for steel. But thankfully for the industry, that was not the end of the story, as steel futures, despite a slow start, posted record full year volume levels in 2010 for both LME steel billet and NYMEX hot-rolled coil products, and are very likely poised to become a major force in the steel industry in the years ahead. So what happened? The answer is found in a careful assessment of the concerns raised by these producers and the realities of commodity hedging.
The best way of understanding the validity of these concerns starts at the outset with the fact that steel companies like Nucor have already relied on commodity futures to hedge their own risk exposure in commodities outside of steel for years. For example, Nucor’s most recent 10-k states that: “Nucor uses cash flow hedges to partially manage its exposure to price risk of natural gas that is used during the manufacturing process. The 10-k also shows that Nucor uses hedging to deal with its copper and aluminum exposure. This might seem confusing, as it would suggest that DiMicco’s company is acting in direct opposition to his concerns about volatility, legality and ethics in today’s futures markets. Actually, it is not confusing at all like steel prices, natural gas and other metal prices can be highly volatile. It is therefore advantageous, and probably even necessary for the likes of any steel producer to hedge its price risk in those volatile commodities to avoid exposing themselves to dramatic swings in the purchasing price of energy or metals.
Functionally speaking, this is in no way different than what steel futures offer to those in the steel industry whether it be a service center that is looking to hedge the value of its base inventory against devaluation or an OEM looking to fix its costs for purchasing steel, hedging is a crucial component of any business with significant exposure to price volatility in a given commodity. In fact, if there is one important distinction between natural gas futures and steel futures, it is that natural gas futures prices are currently driven far more by speculators than are steel futures; an analysis of fund positions in the two commodities confirms that there is a massive pool of managed money invested in the natural gas futures market, as evidenced in the graph below:
Of course, this is not a serious problem in fact, quite the opposite. Those speculators provide the necessary liquidity for end-users of natural gas to manage their price risk. In fact, unlike oil, most market participants agree that the forward curve in natural gas is a fair one and despite speculative interest, the future price is a reasonable result of market forces that produces a fair approximation of what natural gas prices might be over the course of the next few years, based on the information that is available now. Currently, speculative interest in steel futures has been non-existent as the contract is not active enough to attract that kind of interest, but as futures volumes increase, speculation will be a useful and necessary component.
Steelmakers’ hesitations over futures are not surprising; a free market that determines the price of steel will take some of the pricing power away from the producer, but in doing so it also provides a valuable tool to virtually every segment of the industry, including the producer. This advantage stems from the ability to use futures to lock-in forward pricing. Whether it be a service center looking to establish a firm margin on inventory or an OEM looking to insure against a dramatic spike in prices, futures represent a key tool in the steel risk management toolbox, and one that will play an increasingly relevant role in the business of buying and selling steel.
–Spencer O. Johnson