Mr. Gloom:
During the past two years, we have seen a proliferating number of articles and news releases about steel futures to be traded at Commodity Exchanges. The Dubai Gold and Commodity Exchange (DGCX), the London Metal Exchange (LME)and the New York Mercantile Exchange (NYMEX) seem to be in the vanguard of introducing trading of specific steel futures, e.g. rebars, in a specified grade and length. These transactions will be very similar to trading in copper, gold etc. The system is advertised as a tool to reduce the risk for steel makers by locking in the price. Sounds good, does it not?
Alas, I am deeply skeptical as to if it will work because steel is a very different commodity than copper, gold or wheat. There are too many products, grades and sizes to all fit into one standard contract. Also, I fail to see how the price volatility will be taken out for the producers. If the commodity traders or hedge buyers smell the slightest amount of risk, they will bid the price down.
In this era of consolidation and the accompanying emergence of these huge global steel companies, the producers have a much better opportunity to control their prices by cutting back on production or shifting their product mix on short notice to better suit a "hot" market segment. And they are locking in their prices for three months anyway, or at times, even longer.
I could possibly see these commodity exchanges as a hedging tool but agree with the top executives of Arcelor Mittal and Nucor, all of whom are deeply skeptical of these exchanges. As Mr. Mittal put it so wisely, "We are working for our shareholders and not for bankers."
Mr. Bull:
Demand for such a service is coming from the consumer of steel products and not necessarily from the producers. As you very well know, price volatility sometimes helps the mills make huge sums of money, so they don't necessarily want to give up that option. No wonder Mittal and Nucor are so against this new idea.
Just imagine that you are an outdoor grill manufacturer and you have a yearly contract with large retailers such as Wal-Mart and Home Depot. Your margins are razor thin and any volatility in your raw materials prices can wipe out your entire year of profits. What's worse, your domestic steel suppliers wouldn't lock your price in and are asking you to pay their cost increases in the form of raw materials and freight surcharges. Steel futures will provide a solution to this dilemma. Through futures, manufacturers will be able to lock in their raw materials cost and better plan their financial results. As a result, they will not be faced with unpleasant surprises at the end of the year.
Obviously some of these benefits can be applied for steel makers as well, but the bottom-line is, futures are valuable tools for steel consumers and they are good the steel industry in general.
Mr. Gloom:
Taking the volatility out of the steel pricing is probably the principal advantage of trading in steel futures. But it is not the definitive answer to all of the problems you presented, at least not for the time being. Your hypothetical manufacturer of outdoor grills will still be subjected to the steel mill's price fluctuations because these steel futures are for the mills only, and whoever picks up the contract will try to get the maximum return in the re-sell.
Also, only limited items of the huge range of steel products will be negotiated on the commodity exchanges, e.g. rebars in a specific grade and length. The only products that can be negotiated on these exchanges are standard products that can be easily sold elsewhere.
Steel futures will only help the producing mill to lock in their profit, which will most likely a rather mediocre one. You are right on one thing -- in most cases this guaranteed return is unacceptable for well-run companies (like Nucor) and globally dominating players (like Arcelor Mittal) who believe that they can do better on their own. They will not be part of this new trend, at least for now.
Finally, at one point, somebody will have to pick up this contract that the steel mill had sold to the commodity exchange. So what happens if there is a slump, and the steel cannot be readily sold? It will have to go into warehouses, and I don't know if the London Metal Exchange and others want to be steel stockists. The pathfinder of this hedging process, Enron, had massive amounts of unsold steel contracts on their hands, and was desperately trying to unload them to raise cash.
I don't think steel is a fungible item such as wheat or pork bellies, and I believe that steel futures contracts will, at best, play only a limited role.
Mr. Bull:
I am not sure where you got the idea that only steel producers will benefit from the new steel futures tools. Yes, through certified warehouses, these commodity exchanges will be able to correctly predict the value of steel inventories. Once the inventories are independently appraised, mills will be able to get loans against their steel stocks and will be able to invest
in plant improvements. This is definitely a benefit for steel producers, but it is hardly exclusive to them. As I mentioned before, steel consumers will most likely be the real beneficiaries of these innovative financial tools.
When you look at LME's business model, warehousing is certainly an integral part of building the exchange. In case of shortage, you can actually physically accept deliveries from LME-certified warehouses. Of course LME hopes the physical deliveries will not exceed one percent of the volume once the exchange takes off. However, this way, buyers will know that they can always count on these physical inventories when they have to.
You are also arguing that steel is a complicated product with many grades, shapes and qualities and therefore, you really cannot paper trade it. You certainly have a point there, since it does seem to be a difficult concept for steel people to understand. But exchanges have been dealing with many grades of commodities with success. You have only a psychological obstacle that you will have to overcome. Just because you don't understand doesn't mean it won't work.
Mr. Gloom:
The steel mills will benefit from these future contracts on the commodity exchanges by locking in a pre-determined price with a fixed profit margin. As I said, it will likely not be the greatest margin, but at least they will know what they got for a certain part of their production. Of course, most mills want to participate in the wild upswings of the market gyrations, and that is why they will have only a limited amount of their overall production being negotiated on these exchanges. They will also stay with their basic items such as billets/slabs or rebars in one length and grade. The margins for these items are traditionally very slim, and speculators will be tempted to pick up these contracts in hopes of making a lot of money.
And herein lays one of the fundamental problems. These wheel-and-dealers are not necessarily experts in steel trading and could possibly lose a lot of money, causing downward spirals with a negative impact on the general steel market. I am also very skeptical about places like the London Metal Exchange owning steel positions in their own warehouses. Again, what do they know about the steel business? Finally, I cannot see how quality claims can be handled efficiently. You know that claims will occur. Who is responsible? The eventual end-user will have to go to his contractual partner as we go down the daisy chain of transactions. By the time the mill gets involved, a lot of time will have been invested and the mill will not want to handle a claim for steel that had been produced months ago.
The large steel mills of the world are definitely not on board yet. The concept might be interesting, but it is far from becoming the standard of the industry.
Mr. Bull:
No doubt; there are a lot of skeptics and naysayers out there. Also, most people still don't fully understand how the futures work. Exchanges have tried to educate the steel market, but the only way to go forward is to start offering these tools. Some contacts are already taking place, but so far it has been a slow start.
Don't underestimate the Wall Street types. They can analyze the steel markets much better than you and I can. We can only see one or two months ahead of us. Crunching all available economic, production, inventory and consumption numbers, these smart guys are right more than they are wrong.
Just look at what happened in 2004. When steel prices took off, we thought it was just an oddity and that the numbers would come back quickly. However, steel company stocks started registering major gains and didn't retreat. Speculators
could be also good for our market. It will bring some liquidity so that no one will get stuck with high inventories have to rely their sales force to get out of a bind. If companies want to, they will be able to unload capacity and production with the click of a button.
We are still far away from that day, but I don't think we are as far away from it as you think.