The Mistake of Index-Linked Steel Pricing Discounts

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Ferrous Metals
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Still a weak sector…

As many of us are well aware, after long-term price contracts gave way to short-term ones, steel mills began to incorporate index-based pricing in their contracts. We laid the groundwork here in Part One of this series.

Based on the engagement with customers, either the previous month’s index was rolled over as the next month’s price in the case of monthly pricing, or the previous quarter’s price was rolled over as the next quarter’s sale price in the case of quarterly pricing.

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Following the onset of a gradual slowdown in the US economy after 2011, except for strong auto sector demand, demand from all other sectors started weakening. This was reflected in shorter lead times for steel, with HRC lead times falling to as low to 2-3 weeks in 2012.

While demand was slowing down, steel mills remained slack in lowering their operating rates. Lack of production discipline among mills led to operating rates remaining at 80% by April 2012. The steady flow of imports, mainly from East Asia, compounded this further and resulted in a surplus. Steel mills started losing ground in terms of pricing and to beat the tight competition for limited demand, mills started offering discounts on index-linked price.

 This was a mistake in hindsight, which proved costly to steel mills. Since the adoption of “index-minus” pricing, steel demand failed to recover as expected, resulting in continuous weakening in price. Discounting (“Index minus”) on a falling market compounded the weak steel price and further eroded the price at which steel mills were selling. Such continuous erosion in price adversely impacted the steel mills’ revenues. Steel mills were hamstrung to wrestle out of this situation due to the sluggish demand conditions.

Realizing their plight, steel mills began rolling out measures to pull themselves out of this mess. Mills remained disciplined in their production by not increasing the utilization rate beyond 78% from Q2 2013. Although this was not sufficient to lower the surplus in the market, it led to a gradual increase in lead times, thereby offering scope for other pricing maneuvers.

The disciplined production coincided with gradual recovery in the US manufacturing and construction sectors. The US manufacturing PMI reached 56.4 in October 2013, up from 49 in May 2013; similarly the construction index has reached 124 in October, up from 105 in May 2013. This gradual recovery in these sectors along with continuation of strong automobile sector activity led to a slow improvement in demand for steel.

However, uncertainty over the continuation of economic improvement meant that customers remained cautious in their steel buying.

US-manufacturing-PMI-HRC-steel-price-graph

Source: Beroe

Improvement in demand along with stable production led to a gradual increase in lead times (with the lead times for HRC increasing to five weeks in late November 2013). This improvement in demand has provided the steel mills with the much-needed impetus and room for pricing maneuvers. This made the steel mills hold their ground in their previously announced move to stop with the “CRU-minus” pricing.

Up Next: The road ahead – including 3 key possibilities – in the coming months.

MetalMiner welcomes guest contributor Badri Narayanan, a lead analyst at Beroe Inc., specializes in tracking various steel markets and related alloys. Beroe is the premier global provider of customized procurement services specializing in sourcing, supply chain visibility, financial risk analysis and environmental impact to Fortune 500 organizations. With nearly 400 dedicated procurement specialists in 38 domains, across 9 industries, Beroe proactively invests in knowledge assets to build valuable, real-time procurement insight.

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