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The LME has launched two regional, physically delivered steel billet futures contracts. The announcement of the two regional steel contracts is the first part of a long-term plan to bring the benefits of price risk management to the steel industry.
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Steel futures contracts enable the steel industry to hedge against volatility in steel prices:
– Hedging is the process of managing the risk of a price change by offsetting it in the futures market.
The ability to hedge gives producers, consumers and merchants in the industry the choice of how much price risk they are prepared to accept.
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The two regions are the Mediterranean and the Far East. The proposed delivery points for the Far East is Johor, Malaysia and South Korea; for the Mediterranean, Istanbul, Turkey and Dubai, United Arab Emirates.
Market intelligence shows that the largest exporting countries of billet are the Ukraine, Russia, China, and France and the LME delivery points reflect this trade flow. Amongst the largest importers are Vietnam, Turkey and South Korea. The LME is also taking into account freely traded tonnages.
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The two contracts reflect different regional market fundamentals, which means different regional pricing, and therefore two regional contracts are required to reflect this.
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The entire billet market is around 512 million metric tonnes annually. The contract specification the LME is launching focuses on that part of the billet market used for rebar production, which is around 160 million metric tonnes annually, and a large proportion of this is already physically traded internationally with an active merchant class; merchants are trading around 30 million tonnes annually.
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Unlike slab, billet is much more freely traded. In addition, it is easily and relatively cheaply stored, unlike other steel end products. It is not as prone to being damaged and can therefore remain in storage for an indefinite period of time.
Billet is a growing market and has experienced production growth of around 40% since 2000, with analysts suggesting a further 32% growth on today’s annual production of 512 million tonnes by 2010.
Most of the trade in billets is intra-country, and LME contracts are designed to capture that regional trade. Market intelligence suggests that merchant traded billet amounts to around 30 million tonnes per year which, in terms of size, is comparable to some of LME non-ferrous metals contracts. There is also a good degree of price correlation between billet and rebar.
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Trading started on 28 April 2008. However, to enhance liquidity and provide a clearing mechanism, trading on Select and the Inter-office telephone markets has been made available from 25 February 2008. Trading on the Ring commenced on 28 April. The first delivery date is 28 July 2008.
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Trading is out to 15 months. As with all other LME contracts, only members of the Exchange are able to trade; the physical industry and other market participants must access the market and its risk management services through the LME’s membership.
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The LME has been trusted to provide risk management services to the international base metals industry for 130 years and it has an outstanding record of credibility in its contract specifications, price discovery and physical delivery mechanism.
In addition, its unique experience of managing the delivery mechanism of an international network of warehouses puts it in a strong position to deliver a physically delivered contract for steel.
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The option of physical delivery, whilst very rarely used, plays an important role in creating LME price convergence. In effect this means that if the LME price appears too high or too low, those in the market will see favourable pricing opportunity and make use of the delivery mechanism. This presence, or threat, of delivery has the result of constantly ensuring that the LME price is in line with the physical market price.
It also enables industry to sell material via the Exchange delivery system in times of over supply, and use the LME as a source of material in times of extreme shortage.
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There is no evidence to suggest that futures contracts have any effect on price volatility, in fact this is not their purpose. What they do is to provide effective and reliable tools with which to manage volatility.
The reasons that the steel industry is subjected to volatility are similar to those in other industrial metals market.
However, they may be more pronounced in the steel industry due to the fact that many producers are unable to establish fixed prices for their purchase of raw-material well ahead of time. This situation is contrary to many companies in the non-ferrous industry which often have access to their own ore in the ground. The steel producer’s problem is combined with the difficulty for the majority of steel consumers to switch to other substitutes, as well as the lack of risk management tools to reduce price risk. Thus, volatility remains high in buoyant times.
The introduction of a futures market introduces the potential of funds and speculators to invest in the industry; their involvement does not increase fundamental volatility and may dampen cycles by taking the opposite side to industrial clients.
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