SMU Data and Models

Steel Buyers Basics: Index Based Negotiations

January 18, 2014

Many, perhaps most, steel buyers negotiate a new price for flat rolled steel each time they place a purchase order. Other buyers will negotiate a price for all their steel needs over a fixed period (as much as a year) and then, when they require steel, release purchase orders at this fixed price. However, there’s another set of buyers that don’t want to negotiate steel prices each time they place a purchase order but do want to have a price that is reflective of the current market. These buyers will negotiate an “index deal” with their suppliers.

Index deals are the usual practice for non-steel metals. For instance, an aluminum coil buyer will negotiate a long-term fabrication-only price with his supplier. Then, as the buyer places each purchase order, the total price of the metal is the fabrication price plus the current aluminum ingot market price. The ingot market price is set by an open commodity auction.

I think some buyers like index deals for two reasons. First, the buyer’s manufacturing operations often require a long-term supply agreement. If a supplier knows this (and it’s their job to know) then the buyer is at disadvantage and often must just accept whatever price the supplier offers. Second, buyers can be very busy people; an index deal allows them to negotiate a long-term agreement, while removing the risks associated with a fixed price, and then move on to other tasks.

There isn’t an open auction price for Steel such as is the case for Aluminum. However there are multiple steel indexes (the most popular of which is published by the CRU group) that can be used in lieu of a commodity auction price. These steel indexes track the reported transaction price of steel and most steel mills are willing to use one of these indexes as the basis for an index deal.

Index deals work this way: A buyer and a supplier negotiate a price for each steel item under consideration. When the deal is struck, the parties also agree upon the particular index to track and note the current price. (I will use the CRU in this article for my examples.) Pricing on these indexing deals moves higher or lower each month or each quarter (longer periods are unusual but possible) in concert with the change in the tracked index.

As an example, suppose the price for a particular spec. of galvanized steel is negotiated at $1000/ton ($50.00/cwt). At the time the CRU Midwest galvanized price is $800/ton ($40/cwt). Next month the CRU price changes to $810/ton. The increase in the CRU is $10/ton ($0.50/cwt) so the price on the steel spec. also increases $10/ton ($0.50/cwt) to $1010/ton ($50.50/cwt).

There are variations on this theme. First, many buyers and sellers don’t like to change the price (paperwork issues) unless the move is substantial, so some index deals have a “collar.” A $20/ton collar means the price has to move (up or down) at least $20/ton before any change is made. Sometimes there is a cap in the index deal. A $100/ton cap means that over the life of the agreement the price cannot change more than $100/ton from the original negotiated level.

There are also timing variations. For instance, August’s price is set not by August’s index number (since it generally comes out in the second week of the month) but instead is set by July’s price. Thus, the price always lags the market by one month. For quarterly deals, all sorts of arrangements are possible; July through September’s index price can be set by June’s index or May’s, or the average of April, May and June, or some other combination.

Of great interest this year are index deals for steel where pricing is set below (sometimes well below) the index price. So if the index price discount is 5%, then when the hot-rolled index is $600/ton the shipped price becomes $570. This year Mills have made it clear they don’t like these kinds of deals. To be fair, they have a point, because this kind of deal is going to continually drive the price of steel down. The index is an average of all steel pricing, so even in what should be a flat market the discounted deals will make the index drop each month. Mills may (OK, will) give discounts but they are going to do it in a way that avoids pricing the steel they ship lower (perhaps by volume related rebates paid separately.)

Another issue in index deals is the nature of the lagging price – particularly for deals that change each quarter. If a buyer has a quarterly deal, he will know the trend of the market before he has to place orders for the next quarter. This can be a nice advantage for a buyer because in a rising market he can increase inventory now and guarantee a favorable price compared to later. In a falling market a buyer can do the opposite. Steel Mills know about this kind of inventory manipulation and will try to stipulate that volumes must be consistent during each pricing period.

There’s one key point I want to emphasize for buyers – in an index deal, a long term advantage is created not just on the start price negotiated but also on the indexing start point. It sounds backwards but buyers should try to use the highest possible starting index price. If the index starts at $620 this month and is $640 next month, the buyer must take a $20/ton increase. However, if the buyer managed to start the index at $640, then there is no increase. In fact, this effect will be favorable to the buyer for the full life of the deal.

Finally, there’s actually one more reason a buyer may want an indexing deal – it enables the buyer to financially hedge steel. This hedge can be used to fix the price of steel in the future. How to make that happen is the subject of my next article.