LME bets on new contracts to force steel industry change

It’s been almost a decade since the iron ore market abandoned the annual benchmark system of pricing. The Global Financial Crisis (GFC) caused such dislocation between annual and spot prices that even sceptics such as Brazil’s Vale joined the revolution.

Ten years on and the iron ore market is a changed landscape, producers now selling most of their product basis spot, monthly or quarterly prices.

This collective shift towards spot pricing has driven an explosion in iron ore futures trading.

The Singapore Exchange (SGX), which was the first to launch iron ore products in the form of swaps, registered turnover of 17.6mn tonnes in 2010, the first full year of trading. Last year activity on its core iron ore futures contract exceeded 1.28bn tonnes and that on its options contract 295mn tonnes.

SGX’s steel swaps and futures, by contrast, haven’t traded at all since the end of 2016 and 2014 respectively. The revolution in iron ore pricing has largely failed to travel down the steel value chain, producers reluctant to lose their pricing power and fearful that futures trading will open the door to speculative price drivers.

The London Metal Exchange (LME) is betting three new contracts will help change the collective hostility.

The new index contracts, all for hot rolled coil (HRC), one for each major geographic region, will be launched early next year.

LME officials seem quietly confident that at least one of the new HRC contracts will find traction.

Expectations have been buoyed by the success of the LME’s steel scrap contract, launched in 2015. Volumes grew from 49,000 contracts in 2016 to 308,000 contracts last year and were up by another 74% in the first nine months of this year.

More significantly, open interest hit a fresh high of 13,129 lots at the end of September with positions open up to 15 months forward.

“The presence of open interest on further dated prompts often suggests that the financial derivatives have been used to hedge physical exposure to the underly- ing commodity,” according to the LME’s “Ferrous Monthly Update”. The LME’s steel rebar contract has less open interest, just 805 lots at the end of September, but what it does have is also distributed down the futures curve.

Rebar volumes have failed to match those of scrap, suggesting that steel producers are much more willing to use futures markets to hedge inputs such as scrap and iron ore than their outputs such as rebar. Or hot rolled coil.

Which is why the LME’s new contracts are an interesting gambit. The LME is not the first exchange to promote steel product futures.

The Shanghai Futures Exchange (ShFE) launched its rebar contract in 2009 and its HRC contract in 2014.

Both are highly liquid with constructionuse rebar popularly traded as a proxy for China’s property sector.

Speculators rule in Shanghai. And most of them do not hold positions for very long. The ratio of open interest to volume on the Shanghai rebar contract was under 5% at the end of October.

That on the LME’s rebar contract is usually well in excess of 20%. If there is industrial hedging activity taking place in Shanghai, it’s hard to discern beneath the ebb and flow of investment money.

Shanghai, moreover, is a domestic Chinese market with little direct pricing impact on steel supply chains in the rest of the world.

In the United States CME unveiled an HRC contract in 2010 and a steel scrap contract in 2012.

The latter looked in danger of extinction in early 2016 with several months of zero volumes and open interest. However, this year has seen a transformation with activity surging to 17,087 contracts in January-October from just 1,220 contracts in the same period last year. Open interest has jumped from 680 contracts to 3,988 over the same time frame.

Given this lift in activity has coincided with the fast growth in the LME’s scrap contract, the inference is that an arbitrage trade between the US Midwest (CME) and the Black Sea (LME) scrap markets is evolving.

The turnaround in the CME’s HRC contract has been less pronounced but after nearly a year of falling activity, trading volumes started growing again around the middle of last year.

In the first 10 months of this year over 2mn tonnes traded, a year-on-year jump of 89%.

The mechanics of which contract on which exchange is driving the collective pick-up in trading activity are unclear but it’s a sign that something is starting to stir in the steel pricing world.

But don’t expect steel producers to stampede into this fledgling futures arena. This will be no revolution as happened to iron ore, more a gradual creep.