What The Current HRC Contango Means for Steel Buying Organizations

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Yesterday, we published a piece by Brad Clark discussing the opportunity contango steel markets present to traders and hedgers. But as MetalMiner readers know, industrial metal buying organizations rarely and we’d argue if ever, have the opportunity to hedge for the sole purpose of making money. In fact, we’d argue that most corporate treasury groups and/or risk management organizations view hedging as a means to mitigate risk either in terms of locking in margins and or providing some price assurance in otherwise volatile markets. Playing the market so to speak is a no-no. Certainly, some small percentage of industrial metal buying organizations can and perhaps do have the technical competence to “make money by playing the market but we’d argue that still represents the exception and not the rule.

Regardless of his angle, we thought Brad did an excellent job of explaining to readers how one in theory could “make money in contango markets. However, we’d like to frame the issue in terms of how both distributors and industrial metal buying organizations may wish to modify their particular sourcing strategy given current prices. Let’s begin with the three scenarios laid out in Brad’s post:

Scenario One:  If your steel intelligence suggests to you that steel prices today may appear in a seasonal trough or sit lower than one might expect prices to go later this year, one can buy HRC close to $700 ton today. At the same time, the buying organization (distributor or otherwise) 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. That statement contains an assumption so the buying organization would have to evaluate if it could indeed finance and warehouse metal at five dollars per month. The larger distributors, with a low cost of capital may have a greater opportunity to take advantage of a contango market than say a smaller player with higher finance costs.

Scenario two: Perhaps a more realistic scenario looks like this one, “as a physical steel player who say sits on inventory (we’d posit that either larger industrial companies and/or distributors often sit on inventory) in a falling spot market, that organization could sell forward the Q1 futures contract at $780/ton and protect the company’s profit¦almost like insurance. Playing this angle more from a risk mitigation standpoint, if a company’s inventory exceeds its order book, it could sell forward a portion of its inventory via a futures contract to “lock-in a favorable margin.

Scenario three: 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.

Scenario four: This scenario doesn’t actually involve “playing the steel futures market. In highly liquid markets, a contango situation tends to provide intelligence as to the direction of the underlying commodity. Though as Brad points out, in markets with less liquidity, anomalies can occur yet still the forward price curve does suggest where markets may head. So the question steel buying organizations may wish to consider involves the timing of purchases and the average price paid for steel throughout 2011.

Buying organizations may wish to consider taking some price risk off the table buying on the spot market now to cover booked demand. That strategy could help lower the organization’s average cost. Savvy organizations and organizations with sizable metal spend have begun to play in futures markets. We’ll see where prices go by the end of Q3. As the old trader’s adage goes buy low and sell high.

–Lisa Reisman

Disclaimer: The author is long ArcelorMittal, ThyssenKrupp, Nucor, Vallourec and Voestalpine

Comments (2)

  1. Scenario three: 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.
    If steel settles in Q4 at $720/ton (costing you $20 on your buy) and then goes up to $800 in Q1 (also costing you $20 on your sell) you will have LOST $40. Without a physical side to your transaction there is no “lock in” margin.

  2. radio says:

    That was a frankly incredible article!

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