Steel prices over the past four years have been heavily impacted by raw material price volatility making fixed price negotiations with producers difficult.
Customers often need to provide forward price commitments on their products to their customers and would like to reduce their exposure to market price volatility.
Steel futures contracts can offer an alternative means for customers to lay-off forward price risk. The mill can serve the customer by providing market-indexed priced agreements. This contracting approach allows the customer to use steel futures contracts to stabilize forward prices in lieu of the mill providing a fixed price contract.
Customers are likely to prefer making longer-term commitments for physical steel delivery from mills that offer reliable product and shipping performance. Steel futures contracts provide the customer the means to fix their forward price in the quantity and timing of their choice.
When market prices are high, steel futures contracts can provide the mill an opportunity to lock prices forward. While a fixed price physical contract can do the same, the guarantee of the price commitment is at times not the same.
The payment performance of steel futures contracts is guaranteed by the exchange clearing house (i.e. NYMEX) to each side of a futures contract transaction. The exchange mitigates the risk of payment by proactively marking forward positions to market and requiring that companies maintain adequate trading margins.
Mills can avoid offering fixed-priced customer contracts that become, in effect, "call options" in favor of the customer by requesting that customers use steel futures contracts to fix forward prices.
Since both the mill and customer can use steel futures contracts to lock forward steel prices independent of physical steel contract commitments, mill-customer relationships are expected to become stronger. This expectation is based upon the fact that reaching agreement on fixed prices in volatile priced steel markets is often a contentious issue. Since each party will be able to choose the timing and quantity of their forward price commitments using steel futures physical contract negotiations will not get bogged down with trying to convince each other that their view of the forward market is correct.
The biggest fear for steel distributors and steel traders, due to market price volatility, is devaluation of inventory.
Steel futures contracts will allow steel distributors and steel traders to fix the forward value of their inventory. This practice should allow more discipline in the adjustment of inventory and may result in less spot market price volatility from distressed inventory reductions. The resulting cash flow from steel futures contracts in a declining price market will reduce the need for inventory to be converted into operating capital. Less inventory liquidation in a declining market should have less negative impact on market prices.
Reductions in overall market price volatility and improvements in individual company inventory price performance should allow financial institutions to lower financing costs for steel inventories. Banks will be able to reduce premiums they charge as inventory valuations are proven to more stable as a result of more rationale market behavior and the use of price risk tools such as steel futures contracts.
The forward selling price portfolio of a mill can be adjusted over time by adding or reducing steel futures positions. Physical contracts remain price indexed while a price risk management team decides the appropriate forward portfolio position based on current events in the market, internal budgets and input costs.
Spot price patterns have become more erratic and are less predictable in recent years regarding the timing of when to negotiate favorable steel contracts. Decoupling the timing of forward price commitments from physical steel contract negotiation deadlines provides the steel mill with more timing flexibility on when to commit to forward price positions.
The concerns that have been expressed about the loss of mill pricing power and the fear of speculator driven price volatility are based on the trading experience from other metals. These concerns appear to be overstated.
The final settlement price that is used in financial swaps and the upcoming NYMEX steel futures contracts is determined by the price opinions of only physical market participants. Speculators are not involved in the determination of the final settlement price in the trading of these steel futures contracts unlike their involvement in other metals futures contracts.