MetalMiner guest columnist Brad Clark is 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.
Over the past few years various derivative contracts have been launched in support of the steel complex. First the dry freight FFAs, then the LME Billet, the Midwest HRC, the Iron Ore Swaps, the North And South European HRC and the Turkish scrap swaps contract, as well as various Chinese rebar and HRC contracts. As of Monday, July 25, with CME’s launching of the new Australian Coking Coal Swaps contract, it will now be possible to trade the “virtual steel mill.
A phrase coined by FIS’ managing director several years ago, “the Virtual Steel Mill is about to become a reality. While the barriers and capital costs to fully integrate into the physical steel supply chain can be high, not to mention daunting, having derivative contracts for all aspects of the supply chain — from raw materials to freight costs to finished products — allows market participants to hedge and gain exposure to all aspects of the steelmaking process. It lowers the barrier of entry into all aspects of the steelmaking supply chain.
The possibilities are almost endless with this final piece of the puzzle coming to market. If you are a buyer of HRC you can hedge forward exposure by buying HRC swaps for the region you are exposed to; if you are a buyer of iron ore and coking coal and dry freight, you can now hedge and lock in your input costs. If you are a mini-mill buying scrap you can lock in your input costs with the Turkish scrap swap (and the soon-to-be-launched domestic US scrap contract…stay tuned).
While some argue that the plethora of steel derivatives contracts dilutes liquidity and thus hinders the development of one major futures contract, I would argue otherwise. The global steel market is as diverse and fragmented and specialized as any commodity market in the world. The various processes for making the various steel products demand a variety of derivatives products to support these disparate markets.
The global steel market has the depth of demand to support and to utilize a variety of products. The range of financial products on offer today allows users of the market the ability to tweak their exposures or to hedge out their risks on different parts of the supply chain. They can gain more exposure to those parts of the supply chain of which they have a competitive knowledge, and can hedge away their risk on parts of the supply chain to which they feel more vulnerable.
For example, if you are a fully integrated mill and you have a view that HRC will remain strong for the next 12 months, but you are concerned that iron ore, scrap and coking coal input costs will increase as well, you can choose to trade just one part of the virtual steel mill. You would buy swaps on iron ore, coking coal and/or scrap, thereby locking in your input costs while leaving your output (HRC) un-hedged, gaining any upside from increased HRC price movement.
Another example: if the current spot price margins are squeezed, but the forward curve spreads between finished product derivatives (HRC, rebar) and raw material derivatives (iron ore, coking coal, scrap) are wider, you can lock in forward margins by trading the entire virtual steel mill (buying the iron ore, coking coal swaps for the same periods in the future that you sell HRC swaps.)
While the concept of trading “the virtual steel mill may seem highly conceptual and complicated, the practical applications of the full spectrum of derivatives products offers the cutting-edge steel market participants an opportunity to fine tune their exposures, lock in cash flow, mitigate risk and maximize their company’s competitive strength and bolster any supply chain weaknesses. Over the coming weeks, I will get into more detail on ways to access and utilize the “virtual steel mill.
Exciting times are ahead of us.