Hedging for a downturn

Features - Operations Focus | metals recovery

Emerging steel scrap trading contracts allow demo contractors to lessen the impact of a scrap price downturn.

May 3, 2019

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The profit and loss on a large industrial property demolition job can be dependent almost entirely on the price of iron and steel scrap at the time the cost estimate and bid is prepared. If the price of scrap drops considerably during the job—and stays in a lower range—the fortunes of a globally priced commodity can turn the profit picture sour.

Backers of Nasdaq Futures Exchange (NFX) and London Metal Exchange (LME) ferrous scrap contracts are optimistic that demolition contractors, general contractors and property developers (along with scrap processors, brokers and steel mills that buy ferrous scrap) are on a path to use hedging as a risk minimization tool the same way buyers and sellers of copper, jet fuel or soybeans use such contracts.

Exchange services and brokers who have a stake in ferrous scrap trading contracts can look back on 2018 as a year when activity and interest in using the contracts as a hedging tool grew considerably. Looking ahead, they see 2019 as another year when new adherents—some of whom are in the demolition sector—are likely to test the waters of these hedging options.

Start me up

The contract offered by New York-based NFX launched in the first quarter of 2019. John Conheeney and Mike Frawley of the Englewood Cliffs, New Jersey-based World Steel Exchange Marketing (WSEM), which seeks to develop and support the NFX Midwest Shredded Scrap Steel Futures Contract, say it may take a while for a community of steel futures traders to develop.

“Acceptance of new futures contracts takes time,” says Conheeney. He adds, however, “We have broad interest across the entire ferrous industry developing in these contracts.”

In addition to offering its shredded scrap contract since January 2018, NFX also launched a hot-rolled coil (HRC) steel contract in December.

Demo contractors poised to take on large jobs yielding high tonnages of ferrous scrap are ideal candidates to take advantage of the risk management aspects of hedging and contract trading, Conheeney says.

“If the contractor has a demo job where he expects to pull out 1,000 gross tons a month from July through December 2019, he has two options: a) Do nothing and speculate that the market will rise or remain the same, or b) Lock in the price for some of the scrap on the exchange at a price of about $310 to $315 per ton,” states Conheeney, quoting the prices as of April 16.

Regarding the flexibility of hedging services, Conheeney adds, “One of the luxuries the contractor has is that he can add to the hedge or take some contracts back if he wants to.”

Conheeney says there are additional details that help determine the exact price per ton.

“This hedging is done with the understanding that the NFX shredded steel contract is being used as a proxy for the grade of scrap [the demo contractor] is recovering,” which often is a plate and structural (P&S) or heavy melting steel (HMS) grade, Conheeney says.

“Those obsolete grades have a 99 percent price correlation with the shredded grade,” adds Conheeney, who also notes that “regional month-to-month price differences tend to average out.”

For demolition contractors and scrap processors alike, taking the first steps into the world of contract trading can be imposing. According to Conheeney, an initial conversation between those two parties can help lay out the specifics of a contract.

“The contractor will want to come to an understanding with the scrap dealer who is buying his off-take that it will be priced based on the AMM Index price published on the 11th of the month,” he says, referring to FastmarketsAMM monthly ferrous scrap index pricing.

“This does not mean it has to be at the exact price, but at a price plus or minus the index [price],” he adds. “This will remove the ‘basis risk’ for the futures side of the transaction. Next, if the contractor does not have a futures account open, there are several excellent brokers out there that cater to this business and can provide the hedger with some strategies.”

Eliot Rose, CEO of Houston-based Asset Lifecycle Management (ALM), has taken an interest in ferrous scrap hedging because of the nature of his business, which involves dismantling obsolete industrial properties, including oil and gas refineries and power plants.

ALM’s projects “are typically iron and steel dominant,” Rose says. “We did one recently and the percentage was probably 95 percent ferrous, and one we’re working on now is 70 percent. I would say the average ALM project may be two-thirds [ferrous scrap material] or better.”

Rose has been meeting with Houston-based risk management advisory firm Mobius Risk Group to initiate the ferrous scrap hedging process.

“We are determined to do it and have spent some time with Mobius on it,” he comments.

Hedging can be helpful, Rose says, because demo contractors are “far better at predicting their costs than they are at predicting their revenues.”

“People are often guided by what they sense the [ferrous] market is at the time and what the competition is likely to bid,” in the estimating process, he says, but “there is more seat-of-the-pants estimating than we think is healthy.”

Despite his interest in hedging, Rose still sees a disconnect between the current contracts and the needs of demo contractors.

“The grades that are having some legs in terms of ferrous scrap trading are not the grades traded in the demolition sector,” says Rose. He notes that prompt factory grades and shredded scrap are attracting exchange market attention, while HMS and P&S are grades of interest in the demo sector.

Light traffic but a slow road

The London-based LME launched its steel scrap contract in late 2015. The contract is tied to Platts obsolete scrap pricing for import shipments purchased by Turkish buyers.

Alberto Xodo, a vice president of sales with the LME, says 2018 proved to be a breakout year for the contract.

“In 2018, we saw traded volumes of LME steel scrap reach around 5 million metric tons, roughly double the previous year’s volumes and equivalent to about one-quarter of scrap imports into Turkey for the year,” Xodo says.

According to Xodo, the 5 million metric tons traded on the contract in 2018 surpasses the total of less than 4 million metric tons traded from late 2015 through 2017 combined.

In addition to increased volume, Xodo sees positive momentum from conversations with current and prospective clients in terms of how they view hedging ferrous scrap.

“If we look at the annual accounts of certain large recyclers, four or five years ago, they would have mentioned a desire to manage steel price risk that was frustrated due to the lack of a suitable instrument,” Xodo says.

New York-based trader and consultant Nathan Fruchter of Idoru Trading Corp., however, says prodding processors or mill buyers to try contract trading can require patience.

“I have suggested plenty of times to recyclers to dip their toes in the water; it usually falls on deaf ears,” he comments. Regarding steel mill scrap buyers, he adds, “You would think this would already be part of each mill’s DNA, but it’s not. The road ahead is long.”

Advocates of ferrous scrap contracts point to several reasons why recyclers and mill buyers alike can benefit from the risk management aspects of making trades tied to the contracts. “Price opportunity and volatility are key drivers,” states Frawley of WSEM. He cites price drops in the second half of 2018 as a perfect example.

“In early June 2018, second half of 2018 futures could have been sold at a $395 per ton average price,” Frawley says, adding that sale figure could have been realized even though “shredded steel scrap prices dropped under $320 per ton in September.”

Regarding such scenarios, Frawley states, “The tipping point for many will come when the pain of not being hedged will outweigh the fear of taking the plunge.”

Sparking a real change

While acknowledging that firmly establishing new trading contracts is hard work, those contacted say they see momentum building for the ferrous scrap contracts.

Fruchter sees a glimmer of hope based on 2018 LME activity but repeats his assertion that the timeline for acceptance may be longer than some anticipate. “There were several months with new record volumes [of LME scrap] traded, so that does suggest additional acceptance. Again, though, the road ahead is long,” he says.

Frawley says the NFX contract, tied to FastmarketsAMM Midwest shredded scrap pricing, “seems like the ideal scrap product to list,” since “obsolete scrap makes up about 80 percent of the U.S. scrap market and almost all of the 90-million-metric-tons-per-year export market.”

Xodo says a few major players in the recycling sector “have been exploring how to effectively structure long-term physical supply transactions referencing the LME prices for steel scrap.” He adds, “This is standard practice in a number of commodity markets and extremely common in copper, aluminum, nickel and other metals sectors.”

Conheeney says most steel producers are also familiar with hedging and contract trading.

“Most mills use futures to hedge their energy, currency and interest rate exposures,” he remarks.

Between these mill practices and the nonferrous trading experiences of larger recycling firms, “a big percentage of the folks we want in this market have in-house expertise and existing accounts with a broker,” Conheeney says. “That’s a big plus for these products.”

While it might not happen overnight, Frawley is bullish on the future of hedging in the steel and ferrous scrap sectors. “Those who work to develop their expertise in this space will reap significant rewards,” he predicts. “To us, it feels like the tinder is dry, and we are just looking for a spark.”

Conheeney says he sees a “100 percent” likelihood that hedging a percentage of the ferrous scrap sales in large demo projects will become commonplace.

“We can’t think of one commodity market even one-tenth the size of the ferrous markets that does not have liquid futures contracts,” Conheeney says of WSEM’s assessment of the future of the practice. “Copper futures have been integral to the industry for over 100 years, and it’s been said that there is not a pound of mined copper that has not been hedged.”

Conheeney cautions, however, that habits change slowly.

“It took about 10 years before the LME aluminum futures [market] took off,” he says. “Today, however, as a multiple of the physical market, aluminum futures are among the highest trading futures in the world.”

The author is a senior editor with the Recycling Today Media Group and can be contacted at btaylor@gie.net.