Poor margins in the steel industry have been the norm

The steel industry has put up with poor margins for many years on the back of a structural over-supply situation. Indeed, Europe and the USA have been very slow in adjusting to the development of domestic production capacities in Asia (China, Japan, Korea and India) leading to as sharp reduction in their exports [1].

The steel sector is slow in adjusting to volatility in raw material prices.

But the steel sector has been slow in reacting to external changes as well. Once the system of yearly benchmark prices for raw materials was abandoned (process started in Asia in 2006), the steel industry has found itself unprepared to face - and cope with – an environment of much higher volatility in input costs despite standard practice in the sector being to be 100% exposed to spot prices.

Moreover, given the large availability of suppliers fighting for the same business, steel consumers have been able to push back on requests from steel producers to adjust sale prices accordingly when raw materials increased.

Last but not least, many steel producers have been caught on the wrong side when dry freight rates collapsed in 2008 – either by directly owning vessels or via long term CoAs [2] - meaning they haven’t fully benefited from the downturn in commodities prices.

Steel margins have increased in 2017. Why ? Is this the the new norm ?

From May 2017 onwards, however, steel margins have improved significantly because of measures taken by the Chinese government to reduce the environmental footprint of the steel industry and resulting in shutdowns (of up to 10% of global capacity).

The steel industry is therefore offered the opportunity to lock into significantly better than average steel margins.

But this can’t be done. On the one hand, because of a lack of liquidity and depth in the steel derivatives market. On the other hand, because many steel producers can't or won't pull the trigger.

This note attempts to answers a few questions:

Why no hedging in the steel industry ?

Why is the steel derivatives market so thin ?

What can be done to change this ?

[1] Given its contribution in terms of employment and its strategic role during the cold war (and after), the steel industry in Europe and the US has always been kept alive by subsidies provided by governments and supranational bodies. Ownership of steel companies has changed several times with the public sector going back and forth. But the core problem of excess capacity and competitiveness has not been properly addressed for way too long.

[2] A contract of affreightment is a contract between a ship-owner and a charterer whereby the former agrees to carry a cargo on behalf of the latter in a ship (or to give the charterer the use of the whole or part of the ship capacity) on a specified voyage or voyages or for a specified time. The charterer agrees to pay a specified rate for the service or the use of the ship.

The steel industry has been suffering from over-capacity and poor margins for several decades now (capacity utilization was in the low 50% in 2009 and averaged 70% in 2017). This has forced some steel mills to close, big groups to right-size and consolidate. Lots of famous brands have disappeared (albeit some have made a come back – like British Steel).

In addition to this, standard practice in the steel industry is to be 100% exposed to spot prices, both in terms of procurement costs and revenues from sales. To be fair, this is consistent with what happens in the mining sector: companies like BHP, Rio, Anglo and Vale don’t hedge forward the output of their operations. The official rationale behind this is that their shareholders want to be exposed to the underlying markets. Having said that, these same shareholders often forget about commodities cycles.

Anyhow, this approach is more or less manageable when raw materials are not subject to sudden and large swings in prices.

This was ‘artificially’ the case when coal and iron ore prices used to be settled yearly so the cost structure was more or less the same across the industry – except for premia and discounts required to account for specs and location. This was achieved via price negotiations driven by a pool of large consumers meeting with representatives of the main producers, leading to the agreement over a benchmark price – usually valid starting on April 1st for the following 12 months.

But the coal and iron ore industry have moved away from this convention, meaning most supply contracts are now concluded on a floating price basis settling against one of the relevant spot indices assessed by Platts, TSI, the Metal Bulleting, Argus, McCloskey and others. The price for a given cargo is then fixed basis the average over a week, month or quarter.

But considering that raw materials are priced basis supplies out of a handful of countries and eventually travel across the oceans while steel sales are often set basis supply & demand in many different deadlocked regions, price swings don’t always compensate each other [3].

For reasons that we are not going to discuss here [4], over the past few years, both iron ore and coking coal prices have been in backwardation (that is: spot prices are higher than deferred prices). This hasn’t necessarily been reflected in steel prices – as a matter of fact, these have been flat along the curve if not in contango (that is: spot prices are lower than deferred prices) in extreme situations.

In other words: not only steel margins have been low because of an over-supplied steel market, but by leaving both legs of the spread open into the settlement/pricing window, steel mills have been leaving money on the table.

Below a table summarizing steel margins against FOB Back Sea Billet over the end of 2016 [5].

USD/t	August 15th	September 15th	October 15th	November 15th
Dec 2016	145	121	53	55
Q1 2017	159	130	89	86
2017	184	155	145	120
2018	206	197	191	179

The picture (taken on 4 different dates for 4 different forward contracts) is clear:

spot margins are indeed lower than deferred margins (the Dec 16 margin is smaller than the margin for following time buckets – whatever date is taken)
margins narrow further as we get closer to settlement (all margins decrease as we move further in the time from left to right on the table)

[3] Coking coal is a good example. Against a global production of 1.1 bio tons/year, the seaborne market is a mere 300 mio tons (27%) of which approx 60% is supplied by Australia. Hence the sharp rise in coking coal prices experienced in Q1 2017 and Q1 2018 on the back of heavy rainfall in the mining regions of Australia with few options for replacing lost tonnage and little time to arrange for new logistics. Suppliers can call Force Majeure (FM) in these events but it is not always easy for steel producers to argue that their plant in France or Turkey (for instance) could not run because of bad weather in Australia.

[4] But happy to suggest the following topics if you want to explore this further:

the supply-chains of these markets are very complex, often very stretched, and – therefore - likely to experience sharp and sudden unbalances (see above for coking coal);
contracts defining the sale and purchase of these commodities are ‘old’ and refer to specs than are no longer representative of the average and certainly not the marginal ton being mined; so good quality material commands a premium to be secured;
the price of coal and iron ore impact the price of many other commodities along the supply-chain;
consumers (buyers) don’t cover all their requirements via term contracts meaning there is constant demand for spot tons; given that consumers have commercial commitments on their side and can’t afford stopping operations (costs and lead-time associated to restarting what is often pretty old equipment), they often have to give in on what producers (sellers) require as these don’t always sit on large stocks (this is expensive to finance); alternatively, consumers (buyers) can’t sit on too large stocks themselves because of financing costs and other technical constraints (space + cost of space ..).
the underlying iron ore and coal physical markets are NOT regulated;

[5] The margin is calculated basis the following formula (all prices in USD/t): Margin = Steel – 1.6 x Iron Ore – 0.43 x Coal – 0.20 x Coke

Where:

Steel = Platts FOB Black Sea Billet
Iron ore = TSI 62% CFR China
Coking Coal = Platts Premium Low Vol FOB Australia
Coke = Coking Coal (as per above definition) adjusted for energy content and coke oven efficiency

Please note:

Prices for raw materials are NOT adjusted for seaborne freight.
Iron ore component is assumed being 100% fines – no pellets/lump adjustment.
Energy costs (gas and power) are NOT accounted for.

Why is there no hedging in the steel industry?

As mentioned above, it is pretty unusual to read about commodities hedging when going through annual reports of steel makers [6]. In any case, this is never about the margin as such: steel against raw materials.

True, some large steel companies have invested into captive mines thousands of miles away from the mills and secured shipping contracts to move tonnage across the oceans. This – at best – can be defined as vertical integration. But unless this acquisition has been matched by a forward sale in steel production or the sale of swaps/futures to float back the price of the iron ore or coal mine (which, unfortunately, is never the case) [7], this is equivalent to taking a position on the back of a view (prices will go up) rather than locking margins.

So why haven’t steel mills locked margins forward? Indeed, this is a very common practice in the utilities sector and with refiners [8] - where shareholders are also investing in order to be exposed to the underlying business.

Please note that if you have access to a reliable database (which, unfortunately, is not always the case), the cost structure and therefore the margin of a steel mill is very simple to replicate via a formula (see above). Adding the energy components and some time-lags to account for shipping and slippage through inventories is also pretty straight forward if you know your business and operations.

There are several reasons for this:

Inertia: competition doesn’t do it, why should we?
Lack of understanding of what hedging really means and how it works; for many professionals within finance and senior management, “hedging” stands for “speculation” – which obviously has a negative connotation. This is ironic given the nature of some of the investments made by steel mills (captive mines and freight contracts, for instance) – where both volumes and price are locked.
Lack of visibility of the steel margin within steel companies themselves: procurement, sales and production departments don’t talk to each other. One team buys what another team needs to produce on the back of what is sold by a third team, but there is no overall coordination. One question worth asking to a sales team in a steel company: how often are sales prices updated and basis what? Also worth asking procurement: how often do you pick up the phone to call sales and inform them about a sharp rise/drop in prices?
If commodities prices and their volatility are not considered as a risk for the company, there is no incentive to look at the margin and take actions to freeze it: if the realized margin is eventually lower and a profit has been locked, there will be no reward; if, instead, the realized margin is higher, management and/or shareholders will ask the reasons for the opportunity cost.
Lack of a decent steel index to look at. Indeed, the coking coal and iron ore exposure is often easy to identify in a supply contract via a clear reference to a spot index in the commercial terms of the document. For the steel leg, this is not really the case, as most of the business is done fixed price.

The first 4 points may explain why steel mills don’t manage steel margins. But by working on a company’s culture and its management and by setting up a decent database to run analysis and correlations, these obstacles can be removed. Point 5, on the other hand, may prove more challenging.

Indeed, if there is a relatively well developed derivatives market for iron ore and – to a lesser extent – for coking coal, there is pretty nothing available for steel.

A mentioned above, raw materials such as coking coal and iron ore travel across the globe from a handful of major exporting hubs to the different steel mills. It is therefore pretty straight forward to assess their spot value on a FOB basis and to make adjustments via freight rates and bunkers to calculate the relevant CFR or CIF prices (or the opposite).

With steel it is different, as steel mills often service domestic markets. Steel flows in terms of exports and imports do not account for a large proportion of total consumption/production and, very often, when this happens, there are talks of dumping campaigns (so prices of such deals are not relevant). There are many different sorts of steels: flat products vs long products to start with … but there is plenty to cover within these two categories as well.

Within this scope, there is some liquidity in US steel derivates on CME. But CME delisted its European contracts in the summer of 2017 because of a lack of flow and open interest. Only the LME still quotes European contracts, but there is only scrap and rebars [9] – nothing for the flat business such as HRC [10]. Needless to say, there is activity in Chinese futures but access for foreigners is relatively difficult.

Anyhow, it is pretty obvious that the lack of natural buyers (steel consumers prefer fixed price physical transactions for small lots or pass-thru pricing mechanisms when there is a larger project at stake) [11] and the absence of substitution (you can’t replace rebars with HRC and you can’t really replace US rebars with their Indian equivalent) leads to a market that would be pretty much skewed to the sell-side.

[6] Annual reports from large steel producers are pretty clear here:

commodities prices and their volatility are rarely dealt as a stand-alone risk category: very often, these are mentioned along operational or other financial risks;
when reported, commodities hedges put on to mitigate risks represent a very small fraction of the overall physical commodities exposure – especially if you look at the net amounts;
very often, a significant proportion of the commodities hedges are off-setting EUAs allowances – just to square books off;
in many occasions, commodities hedges are against ‘residual’ risks such as base metals – copper, nickel, zinc, aluminium – instead of the core exposure;

[7] It is key to understand the difference between price and volume risk in commodities hedging. If you buy a swap or a future, you cover the price risk by protecting yourself against the rise of a specific index representative of the commodity you are exposed to. If you enter a physical supply contract, you cover the actual tons. In a tight market, you may have to pay a premium to the index to secure the tons; in an over-supplied market, you may settle at a discount to the index.

[8] Utilities:

Coal and gas power generation is usually hedged forward when this can be achieved at levels agreed upon by management and/or the board: power is sold and fuels are bought – in the right proportion basis the plant efficiency. The resulting margin covers operational, maintenance, capital and other financial costs.
For coal, we talk about dark spreads while for gas we talk about spark spreads.
Using the right currency is also key: coal is often priced in USD and so is LNG while pipe gas and power are priced in the local currency (USD, EUR, GBP ..).
Last but not least, you may want to account for the environmental component (EUAs in Europe) and you end up looking at clean dark or spark spreads.

Refiners:

Here focus in on the spread between refined products (diesel, heating oil …) and crude. Again, more sophisticated spreads include the energy and environmental components.

[9] Short for reinforcing bar – benchmark for the long products business.

[10] Short for hot rolled coils – benchmark for the flat products business.

[11] Options could actually help steel consumers (construction works) when participating in tenders: they could buy short dated at-the-money or slightly out-of-the-money call options from the steel mills to make sure they can bid at no risk. Given the size and the price of these of such options, steel mills could actually decide to allocate a certain wallet to this sort of business in order to achieve the goal of locking some of the steel margin.

Steel margins have recently recovered. Is this the new norm ?

Over the past 12 months, however, steel prices have experienced a sharp rally, driven by measures adopted by Chinese authorities to fight pollution and leading to a curtailment in steel production - especially as far as poor quality factories and illegal operations are concerned.

This has also translated into higher prices for high Fe content iron ore [12] - actually leading to the establishment of a two tier market, with companies such as Fortescue (producing 56% Fe material) only managing to capture only 65% of the value of the reference TSI or Platts 62% Fe content index – instead of 90% basis a 56/62 Fe content ratio.

But in terms of steel margins, no doubt, the situation has improved considerably as depicted by the table below summarizing steel margins against Platts FOB Turkey Rebar [13] over the past 12 months:

	Mar 2017	USD/t	Jun 2017	USD/t	Sep 2017	USD/t	Dec 2017	USD/t	Jan 2018	USD/t
M+1	Apr 2017	180	Jul 2017	228	Oct 2017	297	Jan 2018	263	Feb 218	278
M+3	Jun 2017	183	Sep 2017	235	Dec 2017	303	Mar 2018	281	Apr 2018	270
M+6	Sep 2017	191	Dec 2017	235	Mar 2018	304	Jun 2018	291	Jul 2018	273
M+12	Mar 2018	214	Jun 2018	233	Sep 2018	297	Dec 2018	288	Jan 2019	273
M+15	Jun 2018	214	Spe 2018	233	Dec 2018	303	Mar 2019	291	Apr 2019	275

The trend is clear:

Steel margins have improved considerably – but are off the 50% peak increase;
Nearby steel margins have improved more than back-end margins;

So the question is: what’s left for steel margins going forward? Should steel companies lock these?

The worse case scenario is that steel mills, seeing margins rise, start feeling complacent about the situation and even begin letting loose on costs’ controls.

When thermal coal prices rose in 2008 (reaching a peak at a premium of approx 150% to current levels on the back of demand from China for power generation), miners in Australia, Indonesia and South Africa were obviously extremely happy and did not even consider for a second about locking some of the unexpected gains. In the US, miners had to re-learn how to export coal and ended up bidding long-term rail capacity with CSX and competing with farmers exporting grains. Unfortunately, most of the smaller miners were no longer there 18 months later (as a matter of fact, they had locked their fuel costs and export capacities anticipating the entire energy complex would continue to rise so they were hit twice when the opposite happened).

At the start of 2016, base metals prices and iron ore collapsed. Several global diversified miners were trading close to their all time lows and were forced to sell assets and pull out of markets.

The best case scenario (according to this note), is that steel mills seize the opportunity to lock some of the steel margin in order to generate enough cash flows to cover debt – especially anticipating a rise in interest rates.

The fact that steel prices are now in backwardation and that steel margins are higher at the front-end than at the back, suggests that market consensus is for the rise in steel prices not to be permanent.

Indeed, if we focus on the main reason behind the recent rise in steel prices, the risk is that once we are out of the winter period, China will rein in on the restrictions it has imposed. This means steel capacity coming back on and more demand for raw materials.

Also worth noting that the Chinese steel industry has been riding the latest construction and infrastructure boom unleashed by Beijing at the start of 2016 to revitalise a flagging economic growth rate. The lifecycle in these sectors are rather long (so no need to replace this steel) and Chinese authorities have often stressed their intention to shift towards a more consumer-oriented economy.

Moreover, steel mills in China have gone through a learning process during these 6 to 9 months, becoming more efficient.

But even if these capacity cuts should stay, we should not forget that, globally, steel mills have been running at a mere 70% in 2017. With steel demand forecasted to rise by a mere 2% in 2018, there is still slack in system.

As far as raw materials are concerned, the picture is complex.

The big 4 (Vale, BHP, Rio and Fortescue) can certainly increase iron ore production but there are no plans to do so in the near future. Instead, they will focus on capturing the premium of high Fe content material over lower specs (this will be especially challenging for Fortescue). Also, consumers will try to get their hands on lumps and pellets to increase efficiency and reduce coking coal consumption.

Here, the outlook is different. Indeed, the coking coal seaborne market is small both in absolute terms and relative to global consumption. Moreover, Australia accounts for 60% of total exports. In other words, the risk is that prices will continue to experience sharp rises (driven by weather related disruptions) followed by periods when they slowly drift lower.

Finally, coke is likely to be an issue for steel mills shutting down coke ovens as there isn’t really a secondary market for this.

Of course, it is pretty difficult to predict what markets will do – especially if you need to include Chinese policies and weather forecasts for Australia.

Nonetheless, what steel companies should ask themselves is a very simple question:

(a) Are they in this business for good with the intention – among other things – to generate a decent (and agreed upon) return on capital for owners and/or shareholders?

(b) Or are they in this business to make a quick buck, so take risks to maximize profits?

If the answer is (b), there are easier and cheaper ways to speculate.

If, instead, the answer is (a) – like it should be – then steel companies should indeed lock margins now or, at least, make sure they are set up to do so if they decided to take action. That is: run analysis to come up with the appropriate margin formula, identify the right indices and assess proxy risks, negotiate docs and credit lines/facilities with banks and/or clearing houses to put deals on, learn how to book and account for hedges ..

[12] Low Fe content iron ore requires extensive sintering with coke to improve the iron content prior to use in a blast furnace, which is a polluting and energy-intensive process. So steel mills favour higher-purity iron ore that increases blast furnace efficiency. Moreover, coke is expensive. Hence the advantage of consuming high Fe content iron ore.

[13] This is indeed a different steel reference than in the previous table. Why? As mentioned above, liquidity in steel derivatives is pretty poor hence it is difficult to rely upon data sets lasting over many years. The first table referenced to FOB Back Sea Billet prices as per closing levels on CME. This contract is now discontinued. The second table references to closing prices for FOB Turkey Rebar on the LME. The formula for the steel margin is the same and the coking coal and iron ore references are also the same. Given that the purpose of this table is to show the evolution of a given spread over time, the change in the steel reference doesn’t change the fact that margins have increased.

How to lock steel margins if steel derivatives markets are thin ?

As discussed, steel derivatives markets are thin.

How could steel mills still lock their margins without using derivatives?

(a) By selling steel forward on a fixed price basis – and locking the price of raw materials against that.
- Fact is: what if steel prices then come off? There are credit risks and/or performance risks to consider on the steel contracts: clients may not be able to pay the price agreed upon in the contract or may well do so but would expect the price to be adjusted to reflect changes in market conditions. In this case, either you give up on the client going forward or – if you give in - the steel mill sees its margin erode (as costs have been fixed). Same discussion as above about price and volume risks in commodities hedging.
(b) By selling steel forward basis a formula reflecting a basket of costs than can be hedged (therefore raw materials but also energy) plus a constant (possibly adjusted for inflation) to cover fixed costs and other elements.
- Fact is: this would give away a lot of information and may be used by clients to put suppliers in competition.

Alternatively, how could liquidity be enhanced in the derivatives markets at a time when banks are limiting their presence in the commodities space and those who stay committed to it have reduced their appetite to warehouse risk?

(c) Stack and roll the steel leg.
- Example: you want to hedge 25k tons/month of steel margins over 2018 (a total of 300k tons of steel).
- On day 1, you buy raw materials (iron ore and coking coal) futures in the right proportions over 2018 and then sell 100k tons/month of the first quarter steel future (you could also consider 300k tons of a prompt month future).
- As time goes by and liquidity shifts along the curve, you then roll the steel hedge over – you buy the time spread.
- But you need to adjust the volumes to account for what has priced on the raw materials side. That is: you only roll ¾ of the initial hedge during the first quarter, then a mere ½ and finally just ¼ respectively during the second and third quarters.
- You are obviously exposed to the spread and the shape of the curve but this allows you be active were liquidity is.
- There could also be some collateral benefit here to the extent that steel could be finally included in the basket of the different commodities indices used by private investors – the DJ Commodities Index, the GSCI, the UBS Commodities Index Total Return tracker… In this way, you would create depth on the buy side.
(d) Include steel swaps in deals aimed at raising capital (so sell debt/equity + swaps)
- If an investor is either buying equity or lending money from/to a steel mill, it obviously believes steel prices are going up or that this specific steel mill will be managed better than its peers.
- So buying a steel swap from the steel mill makes sense – even more so if subject to the steel mill buying iron ore and coking coal futures against that to lock the margin. The OTC swap could be done basis a margining agreement (CSA: Credit Support Annex).
- Steel mills could offer a “discount” on the package to attract interest.
- If steel prices go up, the investor wins on both legs: share price and steel swap. The steel mill will probably suffer from the opportunity cost on the production for which it has locked the margin. But this should be viewed as an insurance.
- If steel prices go down, the investor will bear losses on both legs: share price and steel swap. However, all other things being equal, losses on the share price will be mitigated by the fact that part of the output has been hedged in terms of margin.

Conclusions and recommendation

Steel margins are not easy to lock because of thin steel derivatives markets. For steel margins, hedging the steel leg often entails taking a proxy risk between the hedge and the exposure in the underlying physical market.
Everyone would gain from liquidity and depth in the steel derivatives markets
Steel companies should lock steel margins now. Current levels are high on an historical basis. But we are already off the highs experienced in Q4 2017 and there are no reasons to believe the correction will stop soon.
Considering that steel margins are high compared to historical levels and that steel margins tend to narrow as we get closer to pricing/settlement, there is money to be made by selling forward steel margins and buying them back later for investors.