- 23 Jan 2020
- By Jon Lynch
Steel prices have always fluctuated, yet it is extremely difficult to forecast when and in which direction those price moves will occur. One can offset the risk of adverse price fluctuations through hedging.
Risk management tools, such as NYMEX Hot-Rolled Coil and Busheling Steel Scrap Futures Contracts, enable steel companies along the entire supply chain to protect profit margins and minimize risk.
Hedging is essentially protection against negative price events. Just as you protect your home, car or health, hedging guards against having to incur unforeseen, extra costs. If properly hedged, changes in the underlying prices will be mostly offset by the hedge, thus protecting profit margin and asset value.
The typical participants of a hedge strategy include the producers of the commodity, and the companies that needs to purchase that commodity sometime in the future.
Some potential participants:
Buyers: OEMS, Service Centers, Construction firms, Pipelines, Investors
Sellers: Producers, Service Centers, Holders of Inventory, Investors
Underlying asset
The physical product to be hedged, on which a derivatives product is based.
Derivative
Derivatives are financial instruments whose prices move concurrently with the underlying asset, such as NYMEX Steel Futures Contracts. (HRC, BUS)
Derivatives enable steel companies to obtain fixed-price solutions, reduce risk, lock in profits, and protect margins.
Scenario:
On March 1st 2020, an OEM would like to place an order with a Steel Service Center, for 10,000 short tons of processed steel due in 8 months and would like to agree a fixed price on this order today.
The Steel Service Center, in order to provide outstanding service to its customer, agrees to a fixed price for this order. Instead of immediately purchasing all the necessary semifinished steel, and incurring extra storage costs, the Steel Service Center has decided, in order to fulfill this order, to purchase semi-finished steel as needed for production, beginning in July.
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 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 NYMEX HRC Futures Contracts. Should prices rise, the Steel Service Center will make a positive return on the value of the futures contracts, which will offset the additional expense.
Example:
The NYMEX HRC Steel contract has a contract size of 20 shorts tons. In order to hedge 10,000 short tons the Steel Service Center therefore needs to purchase 500 HRC Contracts.
Current NYMEX Hot Rolled Coil November Futures Price $560
Negotiated fixed price for delivery in 8 months $610
Current cost of semi-finished steel $280
On March 1st, 2020, the Steel Service Center Buys 500 November 2019 NYMEX HRC Futures Contracts (8 months forward) at $560 per short ton.
On July 15th, the Service Center Buys 2000 short tons of semi-finished steel at $300 per ton and simultaneously sells 100 NYMEX HRC futures contracts at $580 to reduce their hedge. 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 Service Center continues to purchase semi-finished steel to process, it reduces the amount needed to hedge, and can sell the equivalent amount of NYMEX HRC Futures contracts until the entirety of 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 NYMEX HRC Futures contracts, 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 contract.
Regardless of the direction of price, the variable price risk is covered with a hedge using NYMEX HRC Futures contracts, and the Steel Service Center can deliver finished steel to the OEM at the promised fixed price 8 months after agreeing to a price.
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
U.S. Midwest Domestic Hot-Rolled Coil Steel (CRU) Index Futures
Commodity Code HRC
Contract size 20 Short tons
Price 1uotation U.S. dollars and cents per short ton
Minimum tick size $1.00 per short ton-$20.00 per lot
Contract listings Monthly contracts listed for the current year and the next 3 calendar years. Monthly contracts for a new calendar year will be added following the termination of trading in the December contract of the current year.
Trading hours 6:00 p.m.-5:00 p.m. New York time. Sunday-Friday
Termination of trading Business day prior to the last Wednesday of the named contract month
Settlement type Financially Settled
Options available Yes – commodity code HRO- Tick Size $0.25 per short ton
Floating price The floating price for each contract month is equal to the average price calculated for all available price assessments published for that given month by the CRU U.S. Midwest Domestic Hot-Rolled Coil
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