LME steel contracts build momentum

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London Metal Exchange

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Steel is the world’s second-largest commodity after crude oil. It is 15 times the size of all other metals markets combined in terms of metric tons. Furthermore, it is worth twice their value.

Yet, until recently, it was an industry that saw little use for a futures market. That is primarily because major steel participants enjoyed stable long-term prices for the materials they needed.

Price material volatility

Prices for iron ore and coking coal, two of the essential raw materials for steel production, have become far more volatile in recent years. That volatility has sent price shocks rippling through the supply chain. In turn, it has created volatility in finished steel prices that consumers are desperate to contain.

Enter the major futures exchanges. For over 200 years, the London Metal Exchange (LME) has provided the trade – producers, traders and consumers – the opportunity to hedge their risk across a growing range of base metals.

However, only recently have exchanges such as the LME, the U.S.’s CME and the Shanghai Futures Exchange (SHFE) in China introduced products allowing the trade to hedge raw material and finished steel price risk.

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Past efforts

Some products have failed to take off.

The LME’s billet contract started off quietly. Despite support from a few large players, like Ford Motor Co., the contract failed to take off. Being based on the Turkish long products market, it likely didn’t work out because it didn’t correlate well enough for safe hedging in flat rolled products.

Undeterred, and maybe encouraged by the success of the SHFE in China, the LME continued to innovate. In 2018-2019, the LME introduced contracts more directly applicable to the U.S. and European manufacturing markets, like hot rolled coil and steel scrap.

With that said, the last year can hardly be said to have been typical, so, comparisons with the year before or using 2020 as a basis for expectations of 2021 trading volumes is perhaps a leap of faith.

However, as some of these contracts only have 2020 as their first full year of trading, it is all we have to work on.

2020 contract numbers

The LME reports in 2020 the four contracts making up the LME’s ferrous suite traded around 4.75 million tons.

The LME Steel HRC FOB China (Argus) exceeded 1 million metric tons of that total. That is impressive when 2020 was its first full calendar year since launch in March 2019 and the world faced a global pandemic.

As the below graph from the LME covering 2019-2020 monthly trades shows, the LME Steel HRC FOB China contract has been building a solid following (a point we will come back to shortly).

Source: LME

SHFE vs. everybody else

The most-traded contract remains, for now, LME Steel Scrap. The contract has traded almost 15 million tons over the last five years.

However, LME volumes pale in comparison to the SHFE.

Source: Statista

SHFE volumes dwarf the LME and CME combined but do offer a vision for the potential Western exchanges offer as traction builds among the trade and, more importantly, for liquidity from investors and the financial community.

The SHFE market operates in something of a vacuum relative to the rest of the world (ROW).

However, it’s not that prices there are not relevant. When Chinese HRC prices surged above global prices in 2020, China sucked in imports. The SHFE-ROW arbitrage, in part, contributed to the import surge. Foreign firms, though, cannot hedge on the SHFE. Furthermore, with a currency that does not enjoy full convertibility, the SHFE will remain a market apart, despite its enormous size.

Industry stakeholders — trade and financial — therefore need the LME and CME to offer liquid responsive markets with efficient narrow spreads and deep liquidity to help mitigate the volatility seen across the iron ore to finished steel supply chain.

MetalMiner previously reported the CME contract became liquid in 2018 and remains so today.

The LME’s contracts now have fully developed forward curves and bid-offer spreads as tight as half a dollar. That is the minimum tick size allowed, supporting the fact the contracts are rapidly becoming widely adopted and trusted as providing fair price.

In conversation with MetalMiner, the LME pointed out the evolution of an active over-the-counter (OTC) market as further evidence the contracts are gaining rapid acceptance. That acceptance goes not just for the financial sector but from across the industrial and manufacturing landscape.

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