Steel futures, hedging: Viable models for trading?

Steel futures, hedging: Viable models for trading?

“Steel futures are both desirable and feasible,” Liz Milan, head of the London Metal Exchange's (LME) Physical Operations, told the audience at the Metal Bulletin & World Steel Dynamics 3rd Steel Success Strategies Europe Conference in London. A large proportion of the steel industry sees the need for increased transparency in prices and a central market place to transact financially settled contracts for hedging. Responding to this need, the LME is beginning to compile reference prices for a total of six steel benchmarks that would be used should the board decide to launch steel future contracts. The LME has decided to use hot rolled coil prices from NAFTA, Europe and the Far East as the benchmarks for flat products, while billet prices from NAFTA, Turkey and the Far East will serve as the benchmarks for long products. Ideally, steel future contracts on the LME would be cash settled, Milan explained. This is because settling futures contracts against prices taken from physical transactions helps to achieve price convergence. The LME has not decided upon a final mechanism for settling steel futures yet, Milan emphasized. Offering a slightly different approach to a possible new steel trading paradigm, Jeff Kabel, vice president of Koch Metals Trading, talked about the ability of producers and end users to protect themselves against price volatility by entering into swap agreements with hedging firms. With greater volatility in prices pretty much expected to be the norm going forward, hedging could become an attractive option for market players. Like steel futures on the LME, an unbiased, reliable, robust price index that represents a critical cross section of the market is key to successful hedging. The hedging firm can then develop a forward view of prices based upon the index and other market factors, putting the firm into position to make swap agreements with producers and end users based upon a certain price. So, for example, if a producer signed a contract to supply an end user with 10'000 metric tons of steel per month over a period of two months based on a floating price, then the producer might be inclined to protect itself against price volatility by availing itself of the services of a hedging firm. The firm and the producer could then negotiate a price of say $525/mt. Thus, if the price dips to $511/mt the first month, the hedging firm would pay the producer the difference of $14/mt ($140'000). By the same token, if the price were to shoot up to $535/mt in the second month of the contract, the producer would pay the hedging firm $10/mt ($100'000). Ideally, the hedging firm would also enter into a similar type of agreement with the end user of the contract, but at a slightly different price, say $530/mt. Thus, when the price dips to $511/mt in the first month, the end user pays the hedging firm the difference of $19/mt ($190'000). Then in the second month, the hedging firm would pay the end user the $5/mt difference ($50'000) when the price hits $535/mt. Thus the hedging firm ensures price stability for both the producer and end user, allowing both to better manage their costs.