Using The Steel Index Price Risk Management Prevent runaway margin erosion on fixed price contracts Gain access to spot prices, without exposure to spot market volatility......with the safety-net of contracts (certainty of supply, price certainty, regularity of supplier, etc.) Focus on value-added (product premiums, service etc.) Improve supplier/customer relationships Gain a time dividend put your freed-up negotiation time to better use As the steel market has moved away from the characteristic gentle price cycle generated by pre-china capacity overhang, price volatility has increased substantially. This has created new challenges for the steel industry, and separate opportunities for companies looking to manage their downside risks. Whether you are producing steel, adding value and re-selling it, or using it as a manufacturing raw material, the following methods can deliver benefits to you. Use The Steel Index for: 1. Contract indexing 2. Variable cost contracts 3. Surcharge contracts 4. Over-The-Counter (OTC) steel price hedging A key part of their appeal is that they are equitable to all parties: no one party is favoured by employing them: a genuine win, win situation. At the heart of all of the following index-based strategies is the desire to reduce the potential for poor financial performance through sales, or purchasing of steel, in rising or falling markets. Essentially, this is achieved by gaining exposure to the spot market. At the same time, by structuring this exposure, the spot market s major drawback (its volatility) is removed. 1
By harnessing spot in this way, price risk is controlled, enabling companies to achieve the usual benefits of long-term contract partners. These include: 1. Knowing the price of steel, i.e. what you will be either selling or buying for. This predictability enables corporate planning to be performed in a meaningful way. 2. Certainty of supply. A critical issue for manufacturing companies. Idling manpower and machinery due to a lack of materials is extremely inefficient. 3. Regularity of supplier. This provides familiarity with the material being delivered, and the delivery systems and capabilities of the supplier. It also provides both parties leverage through relationship-based contacts at the supplier or customer; shifting to a non-price focus allows companies to focus on relationships. People often go the extra mile for a long term contact, but not very often for a one-off, opportunistic, price sensitive sale. By focusing on noprice areas, companies can compete on performance objectives of quality, speed, flexibility and dependability. 4. Time savings. In addition, individuals in both companies can harness the time dividend freed up from constantly scanning the market for prices to concentrate on other activities. Many times, apparent savings from spot buying are cancelled out by the cost of manpower hours expended on sourcing. 5. Find an appropriate and profitable mix. Finally, gaining all the advantages above need not mean that companies who have a competitive advantage in sourcing need give up their spot market buying. Many companies devise a mix appropriate to their needs of spot and indexbased contracts, sourcing their bare minimum materials on hand via index deals and getting the balance through spot. A crucial part of designing an indexing program is to select a time period which is appropriate to you. The majority of companies decide to adjust prices either on a monthly basis, or on a quarterly basis. A monthly basis gives greater exposure to spot movements, while a quarterly change reduces the volatility. The Steel Index Qualifications for use in Price Risk Management It is imperative that a company looking to use an index in any one of these forms of contract selects the price series most appropriate for use. The Steel Index is uniquely well positioned to provide this information: Transaction deals not conjecture: it is essential for indices to be grounded in reality. Volume weighted mathematical formula applied, not decided by analysts or journalists. Deep, wide pool of data providers Over 400 data providers, spanning the industry (mills, service centres, end consumers) provide a large quantity of data points. Independent reporting body The Steel Index reports the price accurately and impartially with no bias to any end of the industry. Whole month reporting every business week in a month is captured as data, so our monthly prices tell the whole pricing story. Robust A wide enough data provision to provide statistically significant results. Steel industry focussed developed by steel industry professionals, for the steel industry. Widely accepted People throughout the steel industry accept the accuracy and impartiality of The Steel Index, so it is accepted for use at all levels. 2
1. Contract Indexing There are a great number of ways in which to enter contract indexing, but the simplest methods are the easiest to begin with. As companies become more familiar with indexing in use, it is not uncommon for contracts to be adjusted to reflect their needs more closely. This customisation means there are a lot of individualised index based contracts, however the most commonly used examples are: direct replication and change lagging. Direct replication The Steel Index monthly average price is used as the starting point. Thereafter, the prices paid or charged for steel follow the index price. Hence, if monthly prices are used, if the start date is January 09, the monthly price follows an obvious, linear route as reported by The Steel Index. The application of the reported steel index price is simply lagged by a month. This provides a window of knowing what your paid prices will be. Having agreed to start in February 09, the price paid for that month is the last months : US$536. March: US$517 April: US$475 May: US$422 Whilst some companies want as much exposure as possible to the monthly spot price, the majority seek to damp down volatility as much as possible. Direct replication on a quarterly basis can easily be set up using our website, which will automatically produce a 3 month average for each business quarter. 3
Direct replication continued Both examples take place during a period of falling prices. Obviously this means that the purchaser is paying more than the prevailing spot price. However, in rising markets, they pay less than the spot price. Neither party wins or loses on prices as long as the period which the index is implemented over is sufficiently long. It would be extremely unusual to enter an indexed deal for less than a period of 12 months. Change Lagging For companies buying or selling products with prices that carry premiums (or discounts) to The Steel Index reference products (whilst showing a good correlation in price movements), it makes no sense to directly replicate the index. Instead, a common approach is to negotiate a price between themselves and their supplier/customer, which is business as usual. This mutually agreed position, which recognises the approximate volumes and margins agreeable to both parties on that day, becomes the starting price. From that point on, the initial start price will be adjusted by the change in The Steel Index s reported monthly, or quarterly price from the prior period. This lag in the changes to steel price adjustments and the time period of that lag are what provides companies with a known window of steel price stability. Every adjustment thereafter is made referring to the index change and the prior adjusted price. This example uses monthly pricing changes to make lagged changes to an agreed starting point. The agreed start price is used as the buy/sell price for the program start date, February 2009. In February, the difference between The Steel Index s average monthly price (US$517) and TSI s prior monthly price (US$536) is US$19. This is applied to the starting monthly price (US$513) to give March 2009 s price monthly (US$494). This is repeated on a monthly basis. 4
Change Lagging continued In a rising market, it delivers one month s grace to the buyer. In a falling market it delivers one month s grace to the seller. Once an initial agreeable price has been reached, neither party has to make readjustments; the price increases or decreases simply reflect what the market is doing. This is the basic method of change lagging, but there are variations on this. Some companies enter a minimum steel price volatility clause. If the period-on-period change does not exceed that minimum value (whether upwards or downwards), the price paid will remain unchanged from the previous period. The example below uses a minimum value of US$8/tonne. In this example, the month-on-month price changes always exceed the minimum volatility, hence the final price does alter each month. If the upward or downward movement had been less than US$8, the expired month s price would be rolled over to the current month. 5
2. Variable cost contracts In a number of industries, contracts are tendered far in advance of the commissioning and delivery of the order. Classic examples are the construction, shipping, oil-rig and defence industries. A tender, when made, has to be competitive vis-a-vis other proposals. However, months or years can elapse between contract award and delivery. Where a large proportion of cost is tied into steel, these companies have traditionally had no way of managing the price risk and as can be seen in the graph following, they were exposed to a large amount of this in mid 2008. With steel price volatility set to continue, this will be an ongoing risk facing these industries. One method of mitigating this risk is to enter into variable cost contracts. This is equally beneficial to the buyer and seller, as each party also gets exposure to the upside of price risk. Whilst the shipmaker is protected against price rises eroding his margins, the buyer can get a lower priced product if the steel price falls during the contract time. The buyer wants a quality, competitively priced product and the seller wants to concentrate on making quality products at an acceptable margin. By entering into a mutually equitable variable cost contract, the seller gets to share the price risk with the buyer, and the buyer gets an opportunity (reduced end-price) in exchange for sharing that risk. The Steel Index can be used as a robust, transparent price series which both parties can refer to as an independent reporter of steel prices. By entering The Steel Index prices into contract agreements, the price on final delivery will adjust to reflect the steel cost portion of the purchase. The example below uses the example of an agreed contract, using The Steel Index prices as the agreed steel price between the two parties. Contract signing date is Q2, with the steel buying occurring during Q4. As above, the cost of steel falls during this period, with the steel purchases in Q4 2008 costing significantly less than in they would have in Q2. The buyer benefits from a (downward) adjustment of US$ 1,775,000 to his initial price making them happy. 6
The shipbuilder maintains the margin he built in at the beginning of the contract. Some would point out that he could have made more had he not entered into a variable cost contract, but he would point out that he is a shipbuilder, not a speculator he is paid to deliver ships, at an acceptable margin, not gamble on steel prices. It can be pointed out that had he not entered into a variable cost contract at point 1 (when the example contract was signed i.e. Q2 2008), he would have benefitted. 2 1 However, had he tried to do that at point 2 (a few quarters previously), he would seen his margin eroded, then transformed into a huge loss. 3. Surcharge Surcharge contracts are a similar method of sharing risk. An example would be a manufacturer of office chairs that has a fair proportion of its production cost tied up in the cost of steel. The manufacturer wants to ensure it maintains an acceptable margin, whilst the buyer wants regularity of supply of their particular product at a competitive price. Because the price of steel is so volatile, it makes sense to agree a product price (with acceptable margin for the manufacturer), and reference The Steel Index prices rather than renegotiating prices on a monthly basis. Since the buyer needs as stable a price as possible to quote to customers, it makes perfect sense for a minimum steel price volatility clause to be entered into their surcharge contract. The below example uses a trip price of US$620. This steel price marks the point at which they need to implement a surcharge on their products to prevent their sales price becoming unprofitable. They have determined that a trip price charge of US $4 will cover their margin needs up to a steel price level of US$650. In this example, during May, The Steel Index s reported price does not exceed the agreed trip point. Hence, the sales price remains the same. In June, the trip point is breached, and a surcharge of US$4 is levied on chair prices. In September, it falls below that trip point, so the price of their chairs reverts to the originally agreed price of US$280. 7
It is normal for a list of trigger points to be included. For example: Trip point US$620, surcharge US$4.00 Trip point US$660, surcharge US$4.30 Trip point US$700, surcharge US$4.60 As long as the manufacturer has a good understanding of the effect of steel prices on its margins, it can construct a list of surcharge trip points that will protect its margins. The manufacturer has protected its margins and the customer has ensured security of supply from the manufacturer. Both parties benefit from reduced negotiation time and have the benefit of a clear and mutually agreed series of outcomes of steel price volatility. Of course, in this example, it would make sense for the manufacturer to enter into a monthly change lagging or index replication contract arrangement with their steel supplier, also using The Steel Index prices. Precisely because they use the same price series to adjust both buy and sell prices, they effectively lock in an attractive margin. 4. Over The Counter (OTC) steel price hedging Some companies seek absolute stability in the margins they achieve, for guaranteed quantities over a specified time period. It is possible to achieve this, using The Steel Index prices, by matching contracts both for buying and selling steel on our reference prices, as in the previous example using surcharge contracts. Alternatively, it is possible to effectively lock-in a purchase or sales price by using financial tools (e.g. OTC swaps) to hedge a physical transaction. In OTC deals, arrangements are made principle to principle. In other words, they are entered into between two parties, the buyer and seller of the steel. A third party broker then arranges an OTC derivative contract for one of both parties. In recent times and due to the concerns about counterparty creditworthiness, there has been an increased demand for cleared OTC deals. This refers to an institution taking the risk of default out of the OTC deal for both parties. In a cleared OTC contract, counterparty credit risk is mitigated, ensuring that the agreement is not defaulted on. Institutions providing OTC derivatives are typically banks and brokers, who require an index which is accurate, robust, transparent, independent and reliable in its timely reporting. The same characteristics which make The Steel Index ideal for the physical steel industry to use in price discovery and index linked contracts, also meet the stringent requirements of institutions wishing to offer OTC derivatives in steel and iron ore For more information on steel and iron ore price hedging opportunities, contact you financial advisor or banks and brokers offering OTC contracts. Disclaimer: This document does not constitute an offer of solicitation to buy or sell any investment product(s). It does not take info account the specific investment objectives, financial situation or particular needs of any person. Investors should seek advice from a financial adviser, he/she should consider whether the product in question is suitable for him/her. The investment product(s) discussed herein are subject to significant investment risks, including the possible loss of the principal amount invested. Past performance of investment products is not necessarily a guide to futures performance. Contact The Steel Index for more information Email: info@thesteelindex.com UK + 44 (0) 20 7645 9415 Asia + 65 6227 7811 China + 86 21 5110 5490 USA +1 412 431 0584 8