Hot Rolled Futures: Volatility - Here to Stay?

SMU contributor Tim Stevenson is a partner at Metal Edge Partners, a firm engaged in Risk Management and Strategic Advisory. In this role, he and his firm design and execute risk management strategies for clients along with providing process and analytical support. In Tim’s previous role, he was a Director at Cargill Risk Management, and prior to that led the derivative trading efforts within the North American Cargill Metals business. You can learn more about Metal Edge at www.metaledgepartners.com. Tim can be reached at Tim@metaledgepartners.com for queries/comments/questions.

Recent movements in the futures markets have been violent. We’ve seen a surge in the past few days in the U.S. HRC curve as mills implemented a fresh round of price increases. We’ve been thinking about volatility lately, and what drives it. We think there are a number of structural reasons for the volatility that seems to be inherent in the ferrous markets. First off, the way iron ore and met coal is priced has changed significantly. Back in the 1980s and 1990s both of these commodities were commonly sold on long-term fixed-price deals from the suppliers. This enabled steelmakers to give their customers long-term fixed prices without taking a huge margin risk in doing so. When demand from China started to explode in the early 2000s, some of the big ore and coal producers decided they’d rather not do these long-term deals, and instead wanted to sell on more of a spot basis. This was the start of a surge in volatility, as ore and met coal pricing saw massive increases and decreases. Futures markets, particularly in ore, gave buyers and sellers a way to manage this volatility. However, it required a new set of skills to properly structure the trades. This new way of marketing ore and coal has become the way business is done in many parts of Asia, but has had a ripple effect into our markets here in the U.S. Many of the Cliffs ore supply contracts had escalators built into them tied to the seaborne ore price. This made it tougher for U.S. mills to offer as many fixed-price deals as they used to. Ore also caused scrap to become more volatile, and thus impacted the minimills’ ability to manage price risk as well. One other reason is the tendency for buyers to cut inventories to extremely low levels in down markets and then build too much inventory into the peaks. This exacerbates volatility because when inventories are high and prices seem to be peaking, buyers disappear, and the slide down gets exaggerated. We don’t see these underlying pricing mechanisms changing—and thus we will likely continue to see pretty wild swings in pricing. Couple this with the potential for more buyers to shy away from contract deals and go to spot, and 2021 could be interesting. The good news is that the futures do offer you tools to manage at least some of the market swings.