Everyone on the Dance Floor – Time to Do the (Con)tango!

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Sourcing Strategies

MetalMiner welcomes guest columnist Brad Clark, a senior derivatives broker who leads the St Louis office of FIS Ltd., the London-based global commodity interdealer broker. Mr. Clark brokers physical and derivative deals on steel, iron ore, scrap and freight with a focus on the domestic US market.

Oftentimes markets seem boring. By boring, we mean a market with flat prices moving very little or with the forward curve very flat. This leaves traders and hedgers with nothing to do but sit on the fence and complain about the sad state of the market. But fear not – the US HRC futures market looks quite a bit different. We currently find ourselves in a state of steep contango.

Contango, a technical term in futures markets, refers to the state in which the market’s forward prices have exceeded the spot or nearer term prices. When, like today, the HRC market reaches contango, we have a situation like this: the Q1 2012 bid at $780 has a spot price of sub $730 (if not closer to $700) with a Q4 price offered at $740 or better. Again, lower near-term pricing and higher forward pricing results in a market in contango. Physical traders like when a market appears in contango.

Over the last couple of weeks, the US HRC futures market has moved into a state of contango. This presents various trading opportunities. I will discuss a few of these shortly. First, I want to highlight that the futures market does not always present good trading opportunities so when it does, market makers will want to jump.

To explain this in greater detail, if you consider yourself a physical steel player and can currently buy HRC close to $700 ton, you could make money in this contango market. How? You would buy $700/ton physical coil and sell the futures contract for Q1 at $780, locking in $80/ton.  Assuming the cost to carry this physical coil, financing plus warehousing costs at five dollars per month, you could lock in $50/ton virtually risk free.

Let’s continue with some additional examples. As a physical steel player who say sits on inventory in a falling spot market, you could sell forward the Q1 futures contract at $780/ton and protect your profit…almost like insurance.

If you have no position, but believe the spot market will pick up and/or sentiment will change sometime before Q4 you can buy Q4 futures at $740/ton and sell Q1 at $780/ton and lock in a $40 dollar time spread (this scenario of course assumes sentiment will turn positive as a price premium will appear in closer-term time periods).

Theoretically this Ëœcash and carry’ scenario should only widen to the cost of financing and storage. However, in nascent inefficient markets like the US HRC futures market, anomalies can occur whereby the spread widens much further than the true cost of carry. When it does, physical steel players need to get on the dance floor and do the (con)tango! It won’t take long before the forward curve flattens and prices stabilize and everyone goes back to complaining about boring markets. In the meantime, now may present an interesting opportunity to “play the market.

I’ll end with a quote from a true modern day American poet that carries on the theme of this column, “life’s a dance you learn as you go, sometime you lead sometime you follow… right now, the US HRC steel market presents buyers an opportunity to take advantage of this contango market, before the competition figures this out….don’t be the last to the dance.

–Brad Clark

Editor’s Note: MetalMiner will publish a follow-up post to this piece geared toward metal distributors and steel buying organizations.

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