The Benefits of Hedging Steel Price Risk

Prior to 2004, the lawnmower manufacturer with an annual contract with Wal-Mart, the automotive door panel provider with a model-year contract, and the contractor bidding on the construction of a new office complex all locked down their steel costs, either directly or indirectly, through long-term pricing agreements with steel mills.

This process began to unravel when hot-roll prices doubled in the first half of 2002 because the threat of 15-percent Section 201 import tariffs dried up the foreign steel pipeline. Steel mills gave back some purchase orders and failed to deliver others in an attempt to avoid missing out on the much-needed increase in revenues.

The death blow for contract pricing with a mill came when hot-roll prices tripled from the fall of 2003 to the fall of 2004 because of China’s enormous increase in consumption. U.S. mills boldly added surcharges to their contract prices to achieve this dramatic price increase, all the while maintaining they had honored their original contract agreements. This caused enormous cost overruns for steel users committed to providing a fixed price product to their customers. Steel consolidation has given the mills the backbone to say that they will no longer bear the risk of long term price agreements without a built in adjustment for cost fluctuations.

The net result has been to leave steel users without a viable means to lock down total steel costs for extended periods. Steel hedging provides steel users the ability to offer fixed-price contracts to their customers. Utilizing futures for any other reason is not hedging, it is simply speculating on the part of the buyer, betting that they can out-guess the market. If your customers don’t need their prices tied down, don’t play in the futures market. Craig Bouchard, Wheeling-Pittsburgh Corp.’s vice chairman and president, is correct when he says, “There has to be an underlying piece of steel somewhere. The underlying component adds the tangible, measurable guts to a product that is traded across the world. And a synthetic can be manipulated with bad information. The synthetic, I don’t think, will have the confidence with the real derivative players.” This was most evident in November 2004, when CRU International Ltd. and Purchasing Magazine, two of the world’s most respected steel indices, published hot-roll prices with a $74-per-ton difference. This became a $740,000 difference of opinion on a 10,000-ton hedge.

The only way to avoid this problem is to base all transactions on only one index. This is essentially what the aluminum industry has done with the London Metal Exchange. Virtually all purchase prices are based on LME plus or minus some factor. That is why Nucor Corp. chairman, president and chief executive officer Dan DiMicco says steel futures will allow the financial markets to set steel prices rather than steel mills.

Lakshmi Mittal, ArcelorMittal’s president and chief executive officer, is absolutely correct when he says that steel futures will not curb price volatility. They won’t. They might even make it worse. They simply will allow users the opportunity to avoid the impact, plus or minus, of that volatility. That is a benefit worth pursuing.

Jonathan C. Putman

Birmingham Futures

Published in the June 28, 2007 issue of American Metal Market