Hedging with Steel Futures!! In LME Perspective

Lets start with the following scenario:

• Seller – HRC Steel Mill, with 100,000 tons per month to sell
• Buyer – Pipemaker, with capacity to produce 10,000 tons per month
• LME steel futures contracts are monthly contracts, expiring, say, on the 15th of the month before the month of delivery. What this means, for example, is
o All February delivery futures contracts will expire on the 15th of January.
o Any futures contract, issued at any time in the preceding 12 months, for August
delivery will expire on the 15th of July.

First week January

• The pipemaker is negotiating an order to supply 5,000 of base grade pipe to a pipeline project in Q4. He will require the tonnage in September, hence demands shipment from his supplier in August.
• The mill wants to produce the steel, and over the next few days negotiates with the pipemaker all the details of the specification – various widths & thicknesses, specific coils weights etc. They sign a forwards contract to this effect, committing the mill to deliver the 5,000 tons in August.

January 10th
Now lets look at the LME steel futures pricing table we looked at in our ‘Interpreting Futures Prices’ section, where we suggested, lets say its January 10th, and the LME steel futures screen for base grade HRC on our computer or in the Financial Times states:

Period Cash 3-month 6-month 12-month
Price $300 $310 $280 $255

For the steel mill, it does not know what the price of August delivery HRC will be. It may think it will be more than US$ 280 ton, or maybe it will be less. It’s a gamble, because at the end of the day the mill does not know what the price will be. No-one does. The mill can not determine its cashflows for Q4. It does not know whether it will make a profit or a loss. And an equity provider does not know whether the mill will be able to repay its loan on time, or even at all.

These are the risks associated with volatile pricing. These are the risks that hedging with futures can eliminate. Using LME steel futures, our mill can lock-in the price of US$ 280 ton.

Step 1

To match his price exposure relating to his contract for delivery of 5,000 tons in August, the mill needs to find the price for 50 futures contracts (1 futures contract = 100 tons of base grade HRC) for August delivery. August delivery contracts expire on the 15th of July, so on January 10th the mill goes to his broker and to secure the 6-month futures price of US$ 280 ton

• Note, for August delivery the mill would be quoted the 6 month price on all days from 16th December to 15th of January. If the mill went to his broker on 17th January for an August delivery contract, he would be quoted the 5-month price.

Step 2

The mill instructs his broker to sell 50 futures contracts (‘lots’) of 6-month futures @US$ 280 ton. The mill is now ‘short’ 5,000 tons in the futures market for August delivery

July 15th
This is the day the mills August delivery contract expires. Futures market now looks like this

Period Cash 3-month 6-month 12-month
Price $260 $240 $250 $295

The price the market is willing to pay for August delivery contracts – remember, that’s what the mill sold in January: 50 futures contracts of 100 tons for August delivery – is the cash price, US$ 260 ton. Remember too, that the cash price is the price that steel buyers in the physical market are willing to pay for August delivery also. So neither the mill nor the pipemaker is faced with the awkward situation where the steel can be bought more cheaply elsewhere. On July 15th US$ 260 ton is both the physical market and futures market price for August delivery.

Step 3

The action the producer takes is to buy back an equal number of identical futures contracts ie 50 lots of 100 tons for August delivery at the cash price of US$260 ton. This has two important consequences.

• First, by selling 50 futures contracts for August delivery in January, the mill was committing itself to deliver 5,000 tons of base grade steel via the exchange in August. However, by buying 50 futures contracts for August delivery on July 15th, the mill has cancelled its obligation to deliver steel via the exchange. 50 contracts sold, less 50 contracts bought, equals zero.
• o This is what is known as ‘closing out’. The ‘open’ position – the commitment to deliver 50 lots ie 5,000 tons of steel underlying 50 futures contracts in August – has be ‘closed’ by taking an equal (50 lots) and offsetting (originally sold, now buying back) position, to take delivery of 50 lots ie 5,000 tons of steel underlying 50 futures contracts in August. The two equal and offsetting positions have cancelled each other out. The mill no longer has any obligation to deliver or take delivery steel across the exchange.
  

• Second, the mill has made a US$ 30 ton profit on his futures contracts – the mill sold 50 lots at US$ 290 ton, and has bought back an identical quantity (50 lots) of identical contracts (August delivery steel futures) at US$ 260 ton. That’s a US$ 30 ton profit

August

But what about the physical steel – the API grade coils wanted by the pipemaker?

Remember, back in January the mill and the pipemaker agreed a forwards contract committing the mill to deliver 5,000 tons of HRC in the specific dimensions etc required. Since January the mill has had 6 months to program his rolling schedule, ensuring the coils are produced at the optimal point for maximum production efficiency.

And Remember last month, in July, August delivery coils were trading at US$ 260 ton. So that’s the base price the pipemaker is going to pay for his August delivery coils, no matter where he gets them from. US$ 260 was both the physical market and futures market price for August delivery.

Step 4
So the mill now makes delivery of the 5,000 tons. The price the pipemaker pays is the August delivery cash price – US$ 260 ton.

The Result

The mill has made a gain of US$30 on his futures transaction.

And the mill has produced and delivered the HRC to the pipemaker under their forwards contract. The pipemaker has paid US$ 260 ton.

The mill’s net income therefore is US$ 260 + $30 = $290, the price at which he hedged this 5,000 ton order back in January.

What if Prices had Risen, rather than Fallen ?

What if, between January 10th and July 15th, the Q1 price rise had continued, and prices on July 15th were actually higher, maybe something like this

Period Cash 3-month 6-month 12-month
Price $340 $340 $350 $315

Well, the mill would take exactly the same set of actions

Step 1 – January 15th
Get a quote from his broker for August delivery futures ie US$ 290 ton.

Step 2 – January 15th
Sell 50 lots of August delivery LME steel futures at US$ 290 ton.

Step 3 – July 15th
Buy 50 lots of August delivery LME steel futures at (the ‘cash’ price of) US$ 340 ton.

• Mill incurs a net loss of US$ 50 ton on the futures transaction.

Step 4 – August
The mill makes delivery of 5000 tons of steel as specified in the forwards contract, and gets paid US$ 340 ton.

The Result

US$ 340 ton from the physical sale, less US$ 50 ton loss on the futures transaction, realizes a net income of US$ 290 ton. Again, the level at which the original hedge was taken out, US$ 290 ton, has been achieved.

Thus, it can be seen, that by using futures, the mill has achieve the August delivery futures prices for his transaction. Even though, back on January 10th the price of US$ 290 was just the culmination of peoples opinions, it turns out that that is the price the mill achieved. It is irrelevent whether the actual August delivery price was higher or lower. The mill eliminated the risk of achieving less than US$ 290 ton, and rather achieved its objective of US$ 290 ton.

But wouldn’t it be good for the mill to have eliminated the downside risk, of achieving less than US$ 290 ton, but was able to participate in (at least some of) the favourable upside of pricing at US 340 ton ?

Yes, it would.