With iron ore prices much more volatile than finished steel prices, as we analyzed in Part One of this article, fixing iron ore prices into annual contracts creates almost as many problems as it solves, the TSI argues.
The steel producer faced with a spot or monthly iron ore cost would have to put up considerable margin to hedge their risk with over-the-counter iron ore derivatives, so some mills are literally taking the risk on themselves.
However, human nature being what it is, this puts considerable strain on the relationship when the iron ore spot price gets a long way from the iron ore contract price and raises pressure for one or the other party to renege on the arrangement.
So an alternative is for automakers to purchase their metal with reference to indices based on the price of the steel products they are buying, or to products closely enough related that they can adjust the difference with appropriate premiums.
As an example, the TSI cites index-linked physical contracts linked to a finished-steel index rather than raw materials (such as the monthly average price of TSI’s North European HR coil, with an agreed premium for extras the OEM may require).
The only problem is that these are by nature backward-looking, applying previous quarters’ price averages to forward deliveries and giving rise to the potential for a significant difference between spot and the contract prices. If competitors are offering better spot deals, the temptation to switch suppliers remains huge.
The TSI (with some self-interest, admittedly, as they are promoting the use of their index), reports that gradually some automakers are moving to the use of cash-settled swaps to lock in fixed costs over whatever period they choose.
The forward curve for the North European HR coil swaps market is remarkably flat (above) when you look at the probable impact of mill rationalization a couple of years down the line and at the level of volatility in even the recent past.
Use of swaps in the iron ore market has grown dramatically over recent years, so could we see a similar pattern develop in the finished steel market from buyers seeking greater price certainty over the medium to longer term?
Tell us what you think – leave a comment!