One subject we are frequently asked about from the floor at conferences or by clients in face-to-face meetings is a two-parter: how can they manage steel price risk, and do rumors of new over-the-counter (OTC) scrap hedging products offer the opportunity for steel buyers to offset price risk volatility? So when we caught up with Freight Investor Services and FIS’s new Senior Derivatives Broker Brad Clark (based in St Louis), we thought sharing a little of his insight via an interview was too good an opportunity to miss.
MetalMiner: For the benefit of our readers, Brad, can you explain what a steel scrap hedge or swap is, and how it works?
Brad Clark: Well, firstly, it may be helpful to explain the difference between a swap or forward contract and a futures contract, as the two are sometimes confused. A futures contract is an exchange-traded product, for example the Copper contract on Comex, where the price discovery, deal making and settlement are all done via the exchange. A swap or forward contract is something different: the newer derivative products such as iron ore swaps, scrap, etc., usually come about by one party bringing a risk to a broker and the broker finding another side to create a bilateral trade. Once the deal is agreed, the broker will take the contract to a clearinghouse such as the CME to take on responsibility for settlement and so to remove counter-party risk. The deal is tied to an index and is cash-settled on maturity, meaning the parties either pay or receive the difference between the position of the index at the time the deal is agreed and the time at maturity.
There is currently no domestic US steel scrap swap contract, but several are under development and the first is likely to be announced within a few weeks, based on an independent index provider such as TSI or AMM and a clearinghouse such as CME. FIS was instrumental in the development of what has rapidly become the world’s largest steel scrap swap, the Turkish contract, based on TSI for the index and London’s LCH.Clearnet as the clearing house.
The steel scrap swap derivative allows any producer or consumer of scrap to offset their price risk by taking out index-linked scrap contracts of this type. More intriguing still, it allows any related producer or consumer with major steel component input costs related to the scrap price to also offset their price risk.
MM: I can see the value for a scrap processor or scrap consumer such as a steel mill, but what relevance do such swaps have for manufacturers consuming steel products?
BC: The key here is the degree of correlation between the steel product and the scrap price; it is this degree of correlation the company will need in order to consider a swap an acceptable hedge. For example, a construction company buying rebar could hedge the forward price of rebar on a fixed price construction project, because rebar has proved to display a greater than 95% correlation to the steel scrap price. By essentially fixing rebar raw material costs, the construction company can proceed with a lengthy project secure in the knowledge that steel prices are not going to derail its budget. Rebar prices could rise or fall during the life of the project, but the company will be protected from the effects by its hedge, essentially fixing its steel input costs.
(The interview continues in Part Two.)