Singapore Exchange

ASEAN HRC Steel Commoditization Across the Steel Value Chain

ASEAN HRC Steel Commoditization Across the Steel Value Chain The past decade has seen a structural shift in steel output to Asia. Today, the region accounts for around 70% of global steel production, up from less than 50% ten years ago, with the growth primarily driven by China. The industry currently faces severe overcapacity as demand has been faltering amidst the rebalancing of China’s economy towards more consumer-driven growth. Regionally, however, much of Asia – and particularly southeast Asia – is expected to see sustained demand growth in the medium-term as the region continues to urbanize and industrialize. The ‘Asia price’ for steel is increasingly setting the price for steel around the world, even as far afield as America. Correlations between ASEAN and U.S. HRC prices used to be around 71% since 2011. Since the beginning of 2014, however, the correlation has increased to 93%, while correlations with MENA and Turkish prices are even higher. Another major structural trend has been the commoditization of steelmaking raw materials and a shift to more market-orientated pricing mechanisms. Indexation has become the dominant pricing model in the seaborne iron ore industry, and the international iron ore derivatives market has grown exponentially in recent years. Coking coal is also currently undergoing a very similar transformation. While less common than in iron ore and coking coal, and from a low base, indexation in finished steel is increasing. Indexation allows steel market participants to focus more time and attention on other key value-add aspects of their business and worry less about price alone, while the more standardized price formation also reduces counterparty risk. As steel mills increasingly utilize iron ore and coking coal derivatives as part of their raw materials price risk management strategies, finished steel derivatives represent a key complementary product and provide the industry with a greater array of price risk management tools across the steel value chain. This report provides views from stakeholders The Steel Index (TSI), Singapore Exchange (SGX), Cargill and a Chinese steel mill on the current and future development of indexation and derivatives in the Asian steel industry.

SGX Commodities Team

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The Steel Index (TSI) Tim Hard – Director, TSI

When companies tie to an index, they can stop having customer-supplier relationships based only on price.

Finished-steel indexing is simply less common than raw material indexing, though that is changing.

Such a move will allow for greater clarity and visibility, giving actors confidence in market value.

What are the main benefits of indexation in steel?

When companies tie to an index, they can stop having customer-supplier relationships based only on price. Instead, they can focus on other value-added areas, such as service, quality consistency or just-in-time delivery. Indexing also removes ‘timing-related risk’ from purchasing decisions. As steel indexing normally utilizes the monthly average of daily price values, the possibility of buying ‘at the top’ is removed, smoothing out price volatility.

When tying to an index, volumes are usually fixed. For a trader, that means they can match their offtake and intake numbers, reducing exposure to price risk on inventory. For both producers and buyers, when steel prices are volatile, trade can ‘seize up’ as counterparties become reluctant to commit to transactions. If tied to an index, the usual business of a ‘flow’ of steel tons is maintained as both sides know that any increase or decrease in price will be reflected in the index used to settle pricing, at month-end. This regularity of deliveries is useful for planning at both steel producers and manufacturers.

Is the market too fragmented to see adoption of a benchmark Asian index?

Not really. Steel trade flows in North Asia are huge, and TSI’s index consolidates fragmented markets. The adoption of a central price point brings clarity to this fragmented market and allows for actors to differentiate themselves on service, efficiency and product. Chinese steel exports in 2015 are anticipated to be around 110 million tonnes, which is approximately equal to total Japanese annual crude steel production. As a result, Chinese export prices (by sheer volume alone) dictate the pricing dynamics of other exporting nations within Asia. If Chinese export prices fall, so too do Japanese, South Korean, Indian or Taiwanese export prices, as well as ASEAN import prices.

For example, our index is for Chinese-origin SAE1006 hot-rolled coil, CFR Singapore (a free port). TSI’s methodology allows it to accept transaction prices from any origin-point that is delivering into ASEAN. Meanwhile, the diverse buying locations are freight-normalized back to a free port (Singapore) basis. Deliveries of hot-rolled coil to Vietnam, Indonesia, Malaysia, the Philippines and Thailand are all included in the index.

Why hasn’t it taken off yet (i.e. when it did so easily in iron ore and coking coal)?

Finished-steel indexing is simply less common than raw-material indexing, though that is changing. The index is already being used in some index-linked trade and mills within ASEAN use it during price negotiations. After all, these domestic mills compete against import markets, and their domestic pricing moves in relation to import price levels. Index-pricing with a premium applied allows them to produce steel knowing that it has a ‘home’ to go to and allows customers to know that they will receive internationally-competitive prices.

The ASEAN index is a slightly more ‘complex’ index product to understand compared to iron ore or coking coal. It normalizes different grades of coil (SAE1006 and SS400), as well as origin premia for different loading countries (i.e. for Japanese or South Korean mills) and destination premia (which accounts for the tariffs applied by certain regions). That being said, it is something which companies from any part of the supply chain quickly understand.

Lastly, steel is an upstream process, and much of its value will depend on downstream pricing. Iron ore and coking coal indexation and hedging is a relatively new phenomena, and given that steel is one of the world’s largest industries it will take time for new risk management practices to feed through to end users in the steel industry. Having said that, iron ore hedging has matched physical trade on an annualized basis already, and coking coal indexation is now fully established. Steel indices will tie all three products together and help move the industry to better manage the risks inherent in volatile ferrous markets.

What are the next steps in developing the ASEAN HRC steel index?

TSI will begin publishing the normalizations that are used in the calculation of the index, which will allow companies to much more easily link to it. For example, an SS400 buyer can easily link to this SAE1006 index once they know the premium/discount between the two grades. This refers back to the fragmented nature of the steel market. Such a move will allow for greater clarity and visibility, giving actors confidence in market value.

The index is simplest to use for a Vietnamese buyer. Like Singapore, they too are a ‘free port’ and the majority of buyers there are taking Chinese-origin SS400 or SAE1006 hot-rolled coil. For a Vietnamese SAE buyer, it is simply a case of arranging a premium/discount to the index. For an SS400 buyer, they simply apply the SS400 normalization (currently $5/t). If they buy Japanese, rather than Chinese-origin SAE, they link to the index and apply the Japanese-material premium. For buyers in, say, Indonesia, they do the same, but apply the destination premia for Indonesia (and the non-China origin premia if they buy from S.Korea, for example). For buyers or sellers in ASEAN or North Asia, the publication of premia will be extremely helpful in entering into index-linked deals.

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Singapore Exchange (SGX) Adrian Lunt – Commodities Analyst, SGX

With the increasing commoditization of iron ore and coking coal, the emergence of a credible Asian steel benchmark is a natural next step for the industry.

Derivative markets play a crucial role in improving price discovery through enhanced liquidity and transparency.

Effective price risk management tools enable companies to manage underlying earnings and cash flow risks more efficiently.

How do steel derivatives fit alongside your iron ore and coking coal products?

ASEAN HRC steel is highly complementary to our existing ferrous derivatives. Iron ore has grown exponentially in just a few years. Coking coal derivatives are on the cusp of growth, and the market is currently going through a similar development to iron ore several years ago. Separately, our dry bulk freight suite has also seen a transformational increase in liquidity over the past year.

Steel is a natural complement to these products. Iron ore and coking coal typically account for around 60-70% of steelmakers’ operating costs. Collectively, iron ore, coking coal and steel derivatives enable steelmakers to better match up their raw materials purchases and steel sales. Essentially, they enable mills to manage their cash flows more effectively while reducing earnings volatility and uncertainty.

Can we expect a successful seaborne steel derivative product? Why haven’t we seen one already?

Yes, though it will take some time. The global steel market is highly fragmented by region, company and product. This is one factor that slows the development of ‘benchmark’ prices and derivative contracts in steel. The move towards indexation in steelmaking raw materials is also a relatively recent phenomenon. For example, indexation and the growth of derivatives in iron ore have developed very quickly in the space of just a few years. This development is now taking place in coking coal as well.

Over the past decade, the global steel industry has seen a structural migration Eastward. The Asia-Pacific region now accounts for approximately 70% of global steel output. However, Asia is not just China or Chinese exports alone. An index which unifies North Asia (JKT, China & India) will represent the majority of world steel. In the past, indices tended to be national in nature (U.S./China/Turkey), but low freight rates and overcapacity have been driving increasing volumes of seaborne finished steel. With the increasing commoditization of iron ore and coking coal, the emergence of a credible Asian steel benchmark is a natural next step for the industry.

What value do steel derivatives offer the broader industry?

Derivative markets play a critical role in improving price discovery through enhanced liquidity and transparency. Unlike more mature commodity markets, this is still totally lacking in the Asian steel industry. Indexation together with a corresponding derivatives market contribute significantly to improving transparency over the price formation process. Furthermore, effective price risk management tools enable companies to manage underlying earnings and cash flow risks more efficiently. This is increasingly relevant as greater volumes of raw materials are linked to an index.

The steel industry faces not only higher volatility in raw materials costs, but also tremendous uncertainties over pricing amidst chronic overcapacity, rising Chinese steel exports, and growing trade frictions and protectionism. Steel derivatives provide the industry with useful risk management tools to better manage these uncertainties.

In short, a well-designed hedging program offers a number of benefits, including reduced short-term earnings volatility, more reliable forecasts and budgeting (facilitating easier business planning), improved capital access and enhanced valuations.

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Cargill Willy Wee – Steel Trader, Cargill

It takes away their fear that prices will continue to fall after booking the cargo. They can focus on what they do best – processing and selling the finished steel.

We will continue to do our part to educate our customers and in the development of the steel market.

How have you used the index?

We price some of our physical sales off the ASEAN index to our customers within the region. We first have to educate our customers within the region on the index and explain the benefits of buying on index pricing.

How is the feedback and what are the benefits for your customers?

From the feedback our customers give, they are very happy with indexation. One of the biggest benefits is that it takes away their fear that prices will continue to fall after booking the cargo. They can then focus on what they do best—processing and selling the finished steel domestically. Furthermore, their margin is more secure because they are assured that the price of their imported steel matches the time period of their sales. Lastly, their preference is always to work with a reliable trader, but low prices from other small traders are very tempting and it is difficult to justify even paying a dollar more. But with indexation, not only can they purchase regularly at a fair market price from a reliable trader, they actually often achieved a much lower price at the time of delivery than if they had booked a fixed-price cargo.

How do you think the index will develop in the steel market?

I think it will be an evolving/maturing process as more participants understand the index. We have had the advantage of experience in the iron ore market which went through the same process around five years ago, and therefore we were amongst the first to offer physical steel on the index and the most active participant in the swaps market. We will continue to do our part to educate our customers and in the development of the steel market.

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Chinese Steel Mill A director from a China-based steel mill

With an index, it is possible to make more effective use of futures to guard against market risks, and it provides more flexibility compared to a single fixed-price model.

Indexation should be attractive to both Chinese exporters and international traders; pricing cargoes becomes easier and it is conducive to trade.

How could indexation be used by Chinese steel exporters?

If there is an index relevant for steel exports, this can of course provide more pricing tools to the Chinese steel industry. When bullish on the market, companies can use the index to price their goods; when bearish, they can use the index together with futures to protect themselves against unfavourable price risk. With an index, it is possible to make more effective use of futures to guard against market risks, and it provides more flexibility compared to a single fixed-price model. If there is a steel index with a similar methodology to that of iron ore, it can be beneficial to steel mills that import iron ore and export steel, enabling them to better manage market risk.

Following its adoption in steelmaking raw materials, is indexation in steel pricing a natural next step for the steel industry?

Currently, steel sales in eastern China are essentially based on a type of index price, it’s just that these indices are created by each individual steel mill and there is no index with any breadth across the market.

Although there are many different specifications of steel, it can also become more standardized and commoditized like iron ore has done. Exported steel doesn’t have the kind of price differences that exist across different regions domestically in China, and exports are also less brand-specific. As such, the introduction of indexation to steel exports should be popular.

Indexation should be attractive to both Chinese exporters and international traders; pricing cargoes becomes easier and it is conducive to trade. As the industry continues to financialize, we will also see a greater trend towards indexation in steel pricing, which I believe will become commonplace in the not too distant future.

How could a benchmark Asian steel derivative contract benefit Chinese steel exporters?

The SHFE rebar contract is very successful and is already used well by steel mills. With the increasing scale of Chinese exports, and with both Chinese steel mills and international traders already possessing a deeper understanding of derivative markets, an international Asian steel derivative contract can certainly flourish.

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Contacts Janice Yap – Steel Product Manager E: janice.yap@sgx.com T: +65 6236 8925 Adrian Lunt – Commodities Analysis & Research E: adrian.lunt@sgx.com T: +65 6236 8365 With special thanks to the third party contributors to this article.

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