What Metal Buyers Need To Know About OTC Steel Scrap Hedging – Part Two

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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.

(Part Two of the interview continues below. Read Part One here.)

MetalMiner: Can you give us any other examples of swaps’ use by downstream steel consumers or processors?

Brad Clark: Steel pipe producers can also display a significant correlation, but not across the range. Welded pipe, for example, may show a closer correlation to strip prices and hence the NYMEX HRC contract may be a better hedge. Long products generally provide a better correlation than flat rolled, largely because scrap-consuming EAF producers predominantly produce long products.

MM: Does the OTC scrap market need the involvement of these downstream steel consumers to create a successful market, in order to generate sufficient liquidity?

BC: The swaps market, whatever the commodity, needs to be driven by the producers and consumers, and in this case that is the scrap processors and the steel mills. Next come the speculators, traders and tangential participants like financial institutions, so yes, downstream players are important, but they are not the main drivers of the market. Let’s say they’re just lucky beneficiaries.

Which allows me to make an important point: derivative markets come into existence because of volatility in the market — they do not create the volatility. The iron ore market existed for decades without swaps, while contracts were fixed on an annual basis; as price fixing moved to quarterly and now virtually to a spot basis the swaps market grew to cater to the needs of producers and consumers looking to hedge their price risk volatility.

Often the only way sufficient liquidity can be created in any financial market (for trades to be readily made and for spreads to be thin) is for a speculator to take the other side of a trade. It’s a common misconception that speculators cause volatility. They could be said to be the friend of financial markets and in a volatile real world, allow producers and consumers to pass on their price risk to them and hence manage their business in a more sustainable fashion.

MM: Do companies interested in taking advantage of hedging tools need a minimum volume to qualify?

BC: The new scrap contract will likely be for 20-ton lots, so for most significant steel consumers this is a manageable contract size, but firms are not limited to using this contract size. FIS works with firms looking for bilateral deals from 10 to 10 million tons, so it merely requires another party willing to take the other side of the deal, and that is why your broker is there, to find that other party. Once concluded and cleared through the clearinghouse, the firm has the confidence that there is no counter-party risk. The clearinghouse takes the risk.

(The interview continues in Part Three.)

–Stuart Burns

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