In her excellent presentation at the SteelOrbis Spring 09 Conference & 60th Irepas Meeting, Ms Lotta Ulfsdotter, Head of Steel at the LME, explained how the LME billet contracts can be used to lock in profit margins, and demonstrated how billet can be delivered in or out of LME approved warehouses. She also informed the attendees that the turnover in the LME's steel billet contracts, which are approaching their first anniversary, has reached 1.42 million tonnes. So far, 40 producers from 12 different countries, representing a combined production capacity of 50 million tonnes, have listed their steel billet for LME delivery. Currently, there are 27 LME approved warehouses for delivery of steel billet.
After her presentation Ms Ulfsdotter kindly answered our questions.
Ex-warehouse activity in Turkey has gained momentum lately. Why do you think this is?
Traders are usually quick to take advantage when a profitable deal presents itself. The billet price on the LME was considered to be low for a time, so buyers quickly took advantage of physical delivery from the LME approved warehouses.
Are there any costs associated with buying physical billet from the LME?
Yes, the buyer has to pay an FOT charge which is set in the local currency. In Turkey this charge is TRY 50/51 or approximately $30. There may also be additional charges for rent if the warehouse company is not instructed promptly to release the billet. Rent is charged at around 30 cents/day. Details are available at http://www.lme.com/.
The LME trades in lot sizes of 65 tonnes. When a buyer wishes to take physical delivery from the LME he is randomly allocated 65 tonne "warrants" (warehouse receipts); in other words, the buyer's required cargo is likely to be of different grades, sizes etc. However, a homogenous cargo can usually be negotiated with your bank or broker. This may result in an additional premium having to be paid. In reality, billet in the physical market should usually trade at around $40-$50 premium to the LME futures price.
What is the advantage of purchasing billet from an LME approved warehouse? Is there any VAT advantage?
One advantage is that the LME will always offer billet for spot/prompt delivery and that any long LME futures position can be converted into physical billet. The delivered LME billet is always produced by one of the producers who have chosen to register their brands. With regard to VAT, the physical billet from the LME is subjected to the same customs regulations and other duties which are applicable to other similar billet. For those of you who are interested, the relevant link is LME delivery - step by step guide.
Why is the LME Official Price so important?
The LME Official Price is usually averaged over a calendar month and subsequently used as a basis/reference price for physical contracts. The advantage of using the LME Official Price as a monthly reference price is that the steel industry can easily and accurately hedge their exposure to price risk as both hedging and physical contracts use the same basis price.
The LME Official Price is established once a day in the Ring (LME Exchange Floor), or to be precise, on the close of the Second Ring. Buyers and sellers from the physical industry, who are pricing physical billet, scrap or debar, place hedging orders with their banks and brokers who execute these on the close of the Second Ring. The LME Official Price is derived in a transparent manner and is anchored in the physical business.
How does pricing using the LME Official Price work?
In essence, it means that the price for the physical material is "floating" and is not known until the month of pricing is over, in other words, the average monthly LME Official Price is not yet established. It is likely that most physical material would be priced during the month of delivery. This means that neither the seller nor the buyer has committed themselves to an actual price, only premiums or discounts referencing the LME have been agreed. When the material is being prepared for shipment the buyer raises a Letter of Credit (LC) for 110-120 percent of the then current forward LME price for the delivery month, plus enough to cover any negotiated premiums, insurance etc.
During the last year, the industry has witnessed a change; physical contracts are regularly being re-negotiated even as late as when the LC is being raised. The result is that nobody in the whole supply chain can trust the price given to them, as the final price is usually not settled until a time close to delivery.
Pricing physical material using the LME enables each counter party to hedge their exposure to price movement and subsequently to lock in their profit margins. Example, a billet producer may have bought scrap at a fixed price but is unable for several weeks to establish the final sales price for billet. To solve this problem, the billet producer could sell LME futures against his purchase of scrap. A hedging example may be found at the link.
In your presentation you mentioned the concept of the LME being "a discount and premium market." Can you explain how this works?
Well, in the non-ferrous industry the LME price is used as a "reference price" for over 90 percent of all upstream and downstream production, in other words, not just for semi-finished metal. For the steel industry in the future, this could mean that ferrous scrap can be priced at a discount to the LME Official Price and debars at a premium to the LME Official Price. The counter parties involved in the physical transaction can establish these discounts or premiums by negotiating and reaching an agreement, or they can use "published" discounts and premiums. At the end of this month, SteelOrbis and Platts will start publishing discounts for scrap and premiums for rebar: these will be referencing the LME billet price.