Case Study: Hedging semi-finished steel while reducing storage costs and protecting profit margin
Client:
Steel service center providing fixed price solutions to an OEM, in a market traditionally based on floating prices
Challenge:
Hedging semi-finished steel for a future order while also reducing unnecessary storage costs and protecting profit margin.
Overview
A trader at a steel service center is managing risk for a complex supply chain of physical, semi-finished steel products. Steel sheet prices are often volatile in any year, but the volatility has become extreme with pandemic-related supply chain disruptions.
While sheet prices have started falling from the 2021 record high, excessive price volatility is far from over and price moves have intensified.
The steel service center is now faced with the risk of rising prices when it comes time to purchase semi-finished steel from a steel mill to fulfill an order months away.
Instead of purchasing all the necessary semi-finished steel now (and incurring extra storage costs until production time), the steel service center has decided to purchase semi-finished steel as needed for production beginning in May.
Scenario
In January, an OEM places an order with a steel service center for 10,000 short tons of processed steel due in eight months and agrees to a fixed price of $1,120 per short ton.
Semi-finished steel is currently priced at approximately $600 per short ton.
U.S. Midwest Domestic Hot-Rolled Coil Steel (CRU) Index futures (HRC futures), from CME Group enable participants to protect profit margins while minimizing risk associated with adverse price movements.
To limit the risk between purchasing semi-finished steel at a variable price and delivering processed steel at a fixed price, the steel service center can hedge by buying the HRC futures contracts.
In order to hedge 10,000 short tons, they would need to buy 500 HRC (500 x contract unit of 20 short tons = 10,000 short tons). Since purchasing of semi-finished steel is to begin in May, the steel service center could purchase equal amounts of HRC futures in May, June, July, August, and September.
May HRC Steel futures are offered at $1,070. The steel service center could either lift the on-screen offer of $1,070 for 100 lots, or reach out to a broker, negotiate a price, and then clear the trade via CME ClearPort as a block trade. Additionally, the steel service center simultaneously buys 100 lots each for June ($1,040), July ($1,025), August ($999), and September ($980).
Results
In May, the service center buys 2,000 short tons of semi-finished steel at $620 per short ton and simultaneously sells 100 May HRC futures contracts at $1,090. The increase in cost of the underlying is offset by the increase in the price of the futures, as the underlying drives the price of the derivative. The $20 per short ton profit on the derivative should compensate for the increase in the price of the underlying commodity.
As the steel service center continues to purchase semi-finished steel to process, it reduces the amount needed to hedge, and can sell the equivalent amount of HRC futures contracts until all the needed material is purchased and the entire hedge is liquidated.
If the price increases, the service center has covered their risk with the purchase of HRC futures, which they can sell at a profit to compensate for the increase in the underlying price.
If the price goes down, the service center will buy the semi-finished steel from the steel mill cheaper, which will compensate for the loss on the futures contracts.
Regardless of the direction of price, the variable price risk is covered with a hedge using HRC futures, and the steel service center can deliver finished steel to the OEM at the promised fixed price eight months after agreeing to a price.
Conclusion
The steel service center’s profit margin is protected. It is important to note that by hedging, a company is trying to mitigate risk, NOT make additional profit through speculation. Therefore, if properly hedged, adverse and favorable price fluctuations will net the same result.
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