Hedging the Risk of Raw Materials Price Fluctuations 19 th - th November Presented to: 8 th Steel Markets Asia Conference Presented by: G. S. Slavov Managing Director Research (Basic Resources & Dry Bulk Freight)
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5 1. Why do we need to hedge? - Macroeconomic conditions unstable - Production costs keep rising - Seasonality & re/de-stocking cycles - Changing trading environment on the underlying physical markets - Trade patterns constantly shifting (FOB/CIF arbitrage) - Raw material prices volatility - Changing correlation between the asset classes
6 Short term macroeconomic conditions: Global overview Percent points % Industrial capacity utilization Index points Index Global manufacturing sentiment 7 9% 8% 8 6 7% 6 5 6% 4 4 5% 3 4% 8 Jul 8 Jul Jul Jul Jul USA China World EU Japan (Index) Macroeconomic conditions remain challenging with Capacity Utilization flattening and PMI below levels We remain long-term positive but at the same time we cannot ignore some warning signals: 8 USA EU JAPAN CHINA 4 3 2 1 Global Risk Aversion - Industry capacity utilization still below pre-crisis levels - Debt and de-leveraging driven slowdown worldwide - USD strengthening not US government policy but rather flight to quality - Stagnant manufacturing and sluggish lending - EU27 demand is weak, not expected to pick up this year -1-2 -3-4 8 Jul 8 Jul Jul Jul Jul ICAP Shipping International Limited
7 Short term market outlook: Profitability of steel industry is the key Steel production cost structure (BF) per tonne.5t Coke (domestic) 1.5t Brazil FOB 1.5t C3 Steelprice basket $9 $8 $7 $6 $5 $4 $3 $ $ $ - Jul- - Jul- - Jul- - Jul- Blast margins imports from Brazil per tonne $4 $35 $3 $25 $ $15 $ $5 $ - Jul- - Jul- - Jul- - Jul- US steel production cost structure (EAF) per tonne 1.15t scrap.44 MWh/MT Rail VA - IN margin Steelprice basket $1, $9 $8 $7 $6 $5 $4 $3 $ $ $ - May- Sep- - May- Sep- - May- Sep- - May- Sep- Blast margins US production per tonne $4 $35 $3 $25 $ $15 $ $5 $ - Jul- - Jul- - Jul- - Jul-
8 Short term market outlook: Seasonality in play Iron ore imports seasonality Domestic iron ore production seasonality Mt 7 14Mt 6 5 4 3 8 6 4 Feb Mar May Jul Aug Sep Oct Nov Dec 8 7 6 5 4 3 Average 5 6 7 8 Domestic production of iron ore subject to strong seasonal fluctuations But prices well supported on the back of higher production costs The import trend when seasonally adjusted suggests that imports should rise towards Q4 ICAP Shipping International Limited
9 Short term market outlook: China s iron ore re/de-stocking cycles The iron ore production costs in China are generally 2-3 times higher than that in Australia / Brazil. The price differential between domestic ore and international ore will affect China s import appetite. A falling international iron ore prices will eventually push China to rely more on the international market. $/tonne 45 4 35 China s iron ore imports & price differential China IO Imports Price Diff Mln Tonne 7 65 The current port stocks are available for around 32 days of consumption, whereas this level was 21 days in average during 6-7, and 28 days in average during -. The average level of iron ore stocks at China s large and medium-sized steel plants is around 21 days, the current level is only 13 days. 3 25 15 6 55 5 The poor profit margin explains why steel plants postponed their restocking activities. 5 Sep- Dec- Mar- - Sep- 45 Days 4 3 Iron ore stocks at plants & plants profit margin Large and medium-sized steel mills Monthly profit margin (rhs) 5% 4% 3% 45 Days 4 35 3 Iron ore stocks at China s major ports Days of production IO stocks (rhs) Mln T 8 2% 1% 25 6 15 4 % -1% 5-2% Sep- - May- Sep- - May- Sep- - May- Sep- -6-7 -8 - - - - ICAP Shipping International Limited
Market volatility & uncertainty: Price formation & Capacity utilization FOB-CIF Arbitrage China s iron ore imports & price differential $/tonne 18 $/tonne 45 4 China IO Imports Price Diff Mln Tonne 7 16 35 65 3 14 25 6 15 55 Chinese domestic 62% adjusted India CIF 62% adjusted Aus CIF 62% adjusted Brazil CIF 62% adjusted 5 5 8 Sep- Nov- - Mar- May- Jul- Sep- Nov- Sep- Dec- Mar- - Sep- 45 The breakdown of the annual contract system created many opportunities It also introduced high volatility to a market which was traditionally extremely stable Many still struggle to adapt Chinese steel production capacity is the most volatile amongst the top 5 producers Bearing in mind that China is also the biggest producer in the world, this introduces significant volatility to the market Different approach to cope with that is needed Source: ICAP, Steelhome, The Baltic Exchange
2. Forward markets overview - Paper iron ore trading volumes - Correlation between spot & forward for steel, iron ore and coking coal - Market volatility
ICAP Shipping International Limited Iron ore swaps market: Trading activity The trading volume has increased significantly over the past years Q2 registered the highest so far trading volume on record (23mln tonnes). Q3 is expected to far exceed that record Around 8mln tonnes are traded each month as cleared swaps We understand that the share of the bilateral transactions keeps falling gradually and it is currently at around 15-% of total We estimate that in the annual US$ value of the market will exceed $bn with volume in metric tonnes reaching nearly 14mln tonnes This represents around % of the underlying physical market (seaborne import flow into China) Monthly trading volume (Mln tones) Mln tones cleared bilateral 24 22 18 16 14 8 6 4 2 - Oct- - Oct- - Oct- - Oct- 14 Mln mt 56 8 6 4 52 48 44 4 36 32 28 24 16 8 4 Mln mt 16 Quarterly trading volume vs. Annual US$ value Market volume (mt) Annual market volume (us$, rhs) Bn us$ $22 $ Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q4 Annual trading volume vs. Annual US$ value Market volume (mt) Annual market volume (us$, rhs) $ $18 $16 $14 $ $ $8 $6 $4 $2 Bn us$ $22 $ $18 $16 $14 $ $ $8 $6 $4 $2 $
13 Steel: Correlations & Volatility Dynamics Correlation between Spot & Forward Market volatility % 5% Cash 3M 8% 45% 6% 4% 4% 35% % 3% % 25% -% % -4% 15% -6% % -8% 5% -% Jul Oct Jul Oct Jul Oct Jul Oct % Jul Oct Jul Oct Jul Oct Jul Oct Correlation between the cash and forward market can vary enormously from -8% to +95%... Due to number of factors discussed above, over time the correlation have weakened and stabilized around +5% (fairly weak) Steel market volatility declined over the last couple of years but pockets of nervousness remain The average cash market volatility is only marginally lower than the forward market (9.95% vs. 9.98%) Source: ICAP, Bloomberg ICAP Shipping International Limited
14 Iron ore swaps market: Correlations & Volatility Dynamics Market volatility Correlation between Spot & Forward % % 14% Cash +1Q 8% % 6% % 4% 8% % 6% % 4% -% 2% -4% -6% May Sep May Sep May Sep Correlation between the cash and forward market can vary enormously from -35% to +99%... Over time the correlation has been steadily weakening (linear regression line in red) % May Sep May Sep May Sep Iron ore market volatility declined over the last couple of years but pockets of nervousness remain The average cash market volatility is marginally lower than the forward market (3.8% vs. 3.93??) ICAP Shipping International Limited
15 Coal: Correlations & Volatility Dynamics Coal swaps market correlation Coal swaps market volatility % 25 % 8% 6% 15 4% % % 5 -% 8 Sep 8 Dec 8 Mar Sep Dec Mar Sep Dec Mar Sep Dec Mar Sep 8 Sep 8 Dec 8 Mar Sep Dec Mar Sep Dec Mar Sep Dec Mar Sep Spot vs +1M Spot vs +1Q Spot vs. +1Cal API4+1M API4+1Q API4+1Cal API4-Spot physical Correlation between spot physical and the front month contract is strongest The periods of high correlation appear to be diminishing in terms of duration, as illustrated here by the steadily reducing size of the grey areas This suggests that we are entering higher risk environment and therefore there will be stronger need for risk management Several pockets of high volatility have been identified over the recent years Their duration has been fairly steady over time, varying between 6 and weeks each Understanding the structure and duration of volatility is vital for both successful hedging and proprietary trading ICAP Shipping International Limited
16 3. Statistical arbitrage between the spot & paper steel production margins - What are the cost elements for producing 1 tonne of steel? - Which production cost centers can be hedged against future adverse price movements? - Trading scenarios
17 Arbitrage: Steel producers cost structure Emissions Ferroalloys 2% 3% Fluxes 3% Depreciation 6% Electricity Other costs 2% 2% Refractories Labour IO freight 1% 2% 2% Coal freight 1% Oxygen 1% Scrap freight % Iron ore 23% Interest 7% Scrap 9% Margin 22% Coal 13% The major five production cost centers are: iron ore, coal, scrap, interest on existing loans and asset depreciation These are however not the most volatile one Volatility of -15% is normal for cost elements such as alloys, emissions, electricity or freight The diagram above shows in dark blue the costs which can and should be hedged We also include these in our statistical arbitrage model ICAP Shipping International Limited
18 Arbitrage: The alchemy of hedging the steel price Iron ore Iron ore can be hedged through the available swaps market The average daily swaps volume is 45-5, metric tonnes which gives sufficient liquidity for a small/medium size steel mill to hedge its exposure out Coal Coal can be hedged through the nascent coking coal swaps market The liquidity is poor with many bilateral transactions typical for the early stages of any market development Using thermal coal swaps as a proxy should not be excluded as an option on this stage Freight Freight can be hedged through the available swaps market The average daily swaps volume is 4-4.5mln tonnes which gives sufficient liquidity for any hedging operation Scrap Scrap can be hedged through the available swaps market The liquidity is poor with many bilateral transactions typical for the early stages of any market development Ferroalloys Ferroalloys can be hedged through the available futures markets for base metals Two of the most important alloys in the steel making process are ferroaluminum (FeAl) and ferrochrome (FeCr). The spot market price for FeCr is >+95% correlated to aluminum future price therefore we choose aluminum to hedge also the ferroalloy exposure Electricity & Emissions Electricity can be hedged through the available futures European power markets Emissions can be hedged through the available futures EUA markets These are very liquid markets which give sufficient liquidity for any steel mill to hedge ICAP Shipping International Limited
19 Arbitrage: Spot (cash) vs. Forward (paper) margin usd/t 35. 3. Cash vs. Paper production margins FORWARD MARGIN SPOT MARGIN Trading scenarios Scenario 1: Both steel price and raw material costs likely to increase Buy the raw material components in the forward margin Leave your steel price exposure open 25.. Scenario 2: Both steel price and raw material costs likely to fall Buy steel futures Leave your raw material exposure open 15.. 5. Scenario 3: Paper margins > Cash margins Buy raw material components Sell steel futures Scenario 4: Paper margins < Cash margins Sell raw material components Buy steel futures. Aug Oct Dec Feb Aug Oct Dec Feb Both the spread between the margins and the ability to trade in/out each of the components create attractive opportunities ICAP Shipping International Limited
Arbitrage: Conclusions 4. Reasons to trade the paper margins: - Challenging macroeconomic conditions - Mitigating the underlying physical market uncertainty / volatility - The forward curve provides market transparency - Improve profitability through locking attractive raw materials price - Improved liquidity across the asset classes involved in the hedge
Produced by ICAP Shipping Research Chief Knowledge Officer, Global Head of Research, Consultancy and Information Strategy James Leake Managing Director of Research (Dry Freight & Basic Materials) Georgi Slavov, FICS Dry Freight & Basic Materials Analysts - Rui Guo, Stefan Ljubisavljevic Head of Oil & Tanker Research Simon Newman Senior Tanker Analyst - Stavroula Betsakou Tanker Analysts Oliver Burdick, Lichun Zhang ICAP Shipping International Limited, 2 Broadgate, London EC2M 7UR United Kingdom +44 7459 shippingresearch@icap.com www.icapshipping.com ICAP Shipping Derivatives Limited and ICAP Shipping Tanker Derivatives Limited are authorised and regulated by the Financial Services Authority ICAP Shipping International Limited. This report has been prepared by ICAP Shipping or its affiliates ("ICAP Shipping") and is addressed to ICAP Shipping customers only and is for distribution only under such circumstances as may be permitted by applicable law. This information has no regard to specific investment objectives, financial situation or particular needs of any specific recipient. It is published solely for informational purposes and this information is not, and should not be construed as, an offer or solicitation to sell or buy any product, investment, security or any other financial instrument. ICAP Shipping does not make any representation or warranty, express or implied, as to the accuracy, completeness or correctness of the information contained herein, nor is it intended to be a complete statement or summary of the securities, markets or developments referred to in the report. Neither ICAP Shipping, nor any of its directors, employees or agents, accepts any liability for any loss or damage, howsoever caused, arising from any reliance on any information or views contained in this report. While this report, and any opinions expressed in it, have been derived from sources believed to be reliable and in good faith they are not to be relied upon as authoritative or taken in substitution for the exercise of your own commercial judgment. Any opinions expressed in this report are subject to change without notice and may differ from opinions expressed by other areas of the ICAP group. ICAP Shipping is under no obligation to update or keep current the information contained herein. This report may not be reproduced or redistributed, in whole or in part, without the written permission of ICAP Shipping and ICAP Shipping accepts no liability whatsoever for the action of third parties in the respect. Certain companies in the ICAP Shipping group are authorised and regulated by the Financial Services Authority. This information is the intellectual property of ICAP Shipping. ICAP Shipping and the ICAP Shipping logo are trademarks of the ICAP group. All rights reserved.