Steel certainty

By Chris Sleight17 April 2008

Martin Abbott, CEO of the LME

Martin Abbott, CEO of the LME

New steel futures contracts being launched on the London Metal Exchange could help contractors enjoy more price certainty for rebar. Further down the line, the contracts may form the basis of a new system of global benchmark prices for rebar. Chris Sleight reports.

The exotic jargon and bewildering complexity of the city of London seem a far cry from the down-to-earth practicality of the construction industry. However, this spring the two worlds will come a little closer together with the launch of two new steel billet futures contracts on the London Metal Exchange (LME).

A futures contract is a commitment to buy or sell something at a fixed date in the future at a price agreed today, so one of the things they can be used for is hedging. This is to say that people can use futures contracts as a way of guaranteeing a price in the future, regardless of how the day-to-day market moves.

Futures have been traded on the LME for more than 130 years, but the focus has been on non-ferrous metals in the form of aluminium, copper, lead, nickel, tin and zinc as well as certain plastics. In some senses it seems strange the LME hasn't got involved in steel futures before, given that it is a more widely used material. However, according to chief executive Martin Abbott, until a few years ago, the nature of the market meant conditions were not right for the LME to get involved.

"Five years ago there were a few things that were changing the steel market fundamentally. There were macro economic changes taking place through the industrialisation of China. There was growing demand for steel as a result. There was also the emergence, in world terms, a new steel sector in Eastern Europe, particularly in Russia and the Ukraine.

"Once we had the emergence of new suppliers and new demand we started to see more international flow of steel and more price volatility."

"Once you have volatility in a market it becomes almost impossible to do long-term pricing, because someone has to take the risk. That's where we step in, because what we are very good at is discovering the price, and providing the tools to manage price risk - hedging. There's no point in us moving into a market unless there's risk to manage," he said.

Billet and rebar

Steel is of course used to make a massive range of products, and the decision to build contracts around billet, an intermediate commodity that is used to make products like rebar that are long with a small cross-section, was informed by the LME's model of offering contracts that can be physically delivered.

This mechanism means the futures traded on the exchange are anchored in the real world. It means that if there is a discrepancy between the current (‘spot') price on the exchange and the physical market price, it can be ironed-out.

"If you're going to have a physically deliverable contract, you need products that are stored easily, can be stored for a long time and can be moved without the risk of damage. Billet was a beautiful fit with what we do. It is easily stored, it is very much a commodity grade and it links us into scrap and rebar. Rebar is very important to us, because I believe it is the great economic indicator today.

"So billet is a type of steel which fits our model. Second, it is an international benchmark commodity, and, because of the long-term industries it is going into, it carries a lot of price risk," said Mr Abbott.

Although the LME did not set out to set up a futures contract for use by the construction industry, the decision to focus on billet gives contractors a new mechanism to protect themselves against fluctuations in the price of rebar.

The price of billet, rather than rebar itself, being established on the exchange but according to Liz Milan, director LME's Steel Project, a 96% correlation has been found between the prices of billet and rebar. This means the dominant influence on the price of rebar will be the cost of billet. There will be additional costs for rolling, delivery and so on, but these are likely to be relatively small and much less volatile.

How to hedge

Not just anyone can stroll into the LME and start to trade. Only LME broker members can do this, so contractors wishing to hedge their rebar prices should get in contact with one of these - a list is available on www.lme.com - or work through their current bank (which may well be a broker member of the LME anyway).

This may be viable for larger contractors, but for most in the construction industry, the influence of the new steel contracts will probably be felt in a more subtle way.

"I would be surprised if there was a rush of construction companies to the LME anytime in the near future," said Mr Abbott. "However, I think that they will be using LME pricing, even if they don't know it, before very long."

He continued, "The first thing that will happen is that the producers of billet will be using the contracts from day one. Then you have the merchants, who will be able to lock-in prices with forward prices being discovered on the exchange. That means they will have less risk and also that they will be able to do more business.

"The smaller and mid-tier construction companies that wouldn't have the capacity to run a hedge department - and there's no particular reason why they should - will find that they are being offered forward fixed prices for rebar. They won't necessarily know it's because of the LME, all they know is that they're getting what they want."

Future certainty?

The LME's steel futures contracts are already being traded electronically and by phone, and late April will see face-to-face ‘open outcry' deals start to be done in the ‘Ring' - the exchange's trading floor. It will not change the face of the steel market overnight. In fact, the LME's expectations are for slow growth in acceptance.

"The best products in the world in the futures industry do not take off overnight. If you look at the aluminium contract here, which is our biggest contract, you had from launch (in 1978) to what you might call ‘serious activity', an eight to ten year period. The world is different today, and I hope we're not looking at the same sort of period. But the fact is that people will wait and watch, and it will build slowly," said Mr Abbott.

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