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.
Today’s post is a follow-up to a post I wrote on July 8 entitled Everyone on the Dance Floor – Time to Do the (Con)tango!
At that time, the market was in a state of extreme contango, whereby the forward prices were trading at a large premium to the spot price. That week, buyers of physical steel were concluding deals close to $700/ton for spot business and the Q1 2012 futures contract was trading at $780/ton. We gave the following example of entering into the cash-and-carry trade to exploit this contango:
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.
So in the three months since we proposed that example, the physical market has fallen, as has the paper market. If you were to have entered the above trade on July 8 today you could close that position out as follows:
Assuming you had bought 15,000 tons of physical coil at $700/short ton on July 8 and warehoused and financed it for three months till today at $5/ton, you would be effectively long at $715/ton. You would have sold the futures for $780/ton on July 8.
Today, that physical position per the latest index number is worth $681/ton, giving you a loss on the physical leg of $34/ton, a loss of $510,000 if you were to sell that to a customer.
But, today you could buy back your short futures contract on Q1 at $695/ton that you sold for the same quantity of 15,000 tons at $780/ton. Thus making a profit of $85/ton for a total profit on the futures trade of $1.275 million.
Your net profit on this cash and carry trade is therefore $765,000/ton (physical loss minus futures profit); you would have no futures position and would have made your usual margin on the physical sale.
The bottom line is that the physical/paper contango that we wrote about in July has closed over the past three months.
These types of opportunities present themselves to those who have an understanding and the ability to trade both the physical and paper US HRC markets. They don’t always materialize, but when they do, those who are prepared can take a lot of money out of the market with very little risk.
We’ll keep posting our strategies and trading ideas as we see them in the market.
Good luck out there.