Steel Buyers Basics: Managing Price Risk by the Use of a Hedge

A third way to fix the price of steel is to negotiate an indexed agreement with your supplier (or be a spot buyer), and then buy a financial steel hedge.  Let’s do an example to see how this type of deal works.

This month (January) a buyer wants to set the price for 1,000 tons of steel he plans to have delivered in six months (July).  He currently has an indexing deal based on the hot-rolled CRU price.    The buyer’s price for steel in January (using a one month lag) was set by the CRU in December, which was $670/ton.  Looking at the HRC Futures Forward Curve on the bottom of the Steel Market Update website home page the buyer sees the price is $629/ton for June (the June number sets his price for July).  The buyer then decides to purchase the June future for 1,000 tons and thereby locks in a net steel price of $629/ton for steel delivered in July.

No one knows what the market will be in June so let’s look at four cases.   The index rises to $700/ton, stays flat with today’s level at $670/ton, falls to $629/ton (as the market suggests it will) or falls even further to $600/ton.  In each case the total amount of cash the buyer’s company pays for the steel and the hedge will be $629,000 or $629/ton.  

Let’s do the math.

Situation A –– Index rises to $700/ton
1,000 tons cost $700,000 from supplier (1,000 * $700 index price)
Steel future went up and pays $71/ton ($700 – $629) and buyer receives $71,000
Net amount of the purchase ($700,000) less $71,000 received from the future is $629,000 — $629/ton

Situation B — Index stays flat at $670/ton
1,000 tons cost $670,000 from supplier (1,000 * $670 index price)
Steel future is up and pays $41/ton ($670 – $629) and buyer receives $41,000
Net amount of the purchase ($670,000) less $41,000 received from the future is $629,000 — $629/ton

Situation C — Index falls as predicted to $629/ton
1,000 tons cost $629,000 from supplier (1,000 * $629 index price)
Steel future is flat and neither costs nor pays so $629,000 is the full cost of the steel — $629/ton

Situation D – Index falls more than predicted to $600/ton
1,000 tons cost $600,000 from supplier (1,000 * $600 index price)
Steel future went down and costs $29/ton ($600 – $629) and buyer pays $29,000
Net amount of the purchase ($600,000) plus $29,000 paid for the future is $629,000 or $629/ton

What is not shown here are the costs associated with the buying and selling of the futures contract. Costs will include the bank or broker’s fees which can be as low as $1.50 per ton (and escalate from there) as well as the spread between the bid and the ask (what one party is willing to sell a contract for vs. what another party is willing to pay for that same contract). In past years that spread could be quite large but as the market has matured and developed more liquidity the spreads between the bid and ask have declined.

Other flat rolled products besides hot rolled coil can use the HRC Futures markets to manage price risk. Cold rolled and coated steels have a known correlation which would allow for markets to be made on these products thus allowing buyers to protect themselves against future price moves.

Managing price risk does not always mean a buyer should be buying a hedge, there are times when buyers can sell a futures contract in order to protect against valuation changes in their inventory.

For example, a buyer’s inventory is worth $670/ton today (January) and he wants to protect the price of 100 tons against market fluctuations through April.  Right away the buyer has a problem because the June HRC Futures are priced at $629 and the market is in backwardation (futures prices are cheaper than current prices).  Backwardation means his inventory value is already dropping.  Nevertheless the buyer can sell a hedge for $629.  If the market drops to $600 then the other party to the hedge owes him $29/ton and at least the buyer has recovered $29/ton of the $70/ton drop.  Of course if the market rises the buyer now has to pay the counterparty but that is the nature of the hedge. When markets change, hedging will eliminate the risk of losing money but at the cost of eliminating the possibility of making money.

I have two final thoughts about hedging.  First, don’t hedge simply based on your guess about market conditions – that is called speculating (an educated form of gambling).  For those of you in management, make sure your company has the proper controls on any hedging strategy being conducted through your purchasing or financial departments.  Let’s let the commodity traders do the gambling – taking those risks is their business.

Hot rolled steel futures at this moment are in backwardation. This is not always the case. As markets ebb and flow we will see the HRC market in Contango, which means the price of the future contract is higher than the current print price of the CRU. Steel buyers need to be prepared to exercise the proper strategies for both situations – backwardation and contango.

Written by: Mario Briccetti

SMU Note: Steel Market Update in conjunction with Andre Marshall of Crunch Risk, LLC are in the process of developing a new managing price risk workshop to deal specifically with trading strategies for buyers, sellers and speculators of HRC of BUS contracts. Our first Managing Price Risk 2 – Strategies & Execution workshop is anticipated for early April 2014 in Chicago. If you are interested and would like to learn more please send us an email: info@SteelMarketUpdate.com.