Responding to New Market Volatility

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Four major developments are driving a significant increase in the price volatility of both steel products and steelmaking raw materials. First among these developments is the overall financial and economic volatility across the globe. Secondly, global markets are increasingly subject to emerging country macroeconomic decision making that is prone to frequent, abrupt changes. The third factor driving a significant increase in price volatility involves timing. The time frame for raw material pricing contracts has shifted from annual to quarterly, monthly or even shorter periods. Finally, global steel industry consolidation has stalled, increasing competitive intensity in the face of weak demand and making it more difficult to remove excess capacity.

The increase in volatility in recent years can be seen in Figure 1, which shows the quarterly percent price deviation from the prior 12-month average for selected commodities. Managing this increased volatility has become a major day-to-day challenge for steelmakers. Additionally, it is eroding investor confidence in the industry’s ability to manage the spreads between input costs and output prices, which is essential to generating adequate returns over the cycle.

As a result, debate is intensifying as to the best ways for steel companies to respond and, in particular, whether the industry should actively embrace futures markets and other hedging mechanisms, or rather wait to see how they mature.

In this paper, we discuss the impacts that increased volatility has on steel companies; the issues and challenges that need to be addressed in adopting a more proactive posture toward the use of emerging tools and financial instruments; and the key capabilities that companies need to build as they enter this world.

Regardless of the rate at which tradable exchanges for steel inputs and products develop and gain acceptance, Accenture believes that companies that build advanced risk management and trading capabilities will enjoy a first-mover advantage and be better positioned to prevail in this era of increased volatility.

New capabilities for pricing, trading and risk management can help steel producers protect margins and pursue high performance

Steel (HRC) Iron Ore

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Figure 1. Metals price volatility (1990-2012).

Source: Accenture research.

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Increased volatility adding to pressure on steelmakersThe fundamental challenge posed by increased volatility results from the persistent potential for asynchronous pricing movements since the timing of changes in market prices of raw materials and steel are rarely in sync. An increase in the spot or quarterly contract price of iron ore does not imply that a corresponding increase in sales price for steel can be achieved in the same time horizon. Although volatility may also benefit steelmakers (as when steel prices rise faster than raw material costs), industry experience suggests these conditions occur less frequently and are shorter in duration.

As a consequence, steel companies are exposed to a number of adverse impacts, including:

Accelerated commoditization—Steel companies have long battled against commoditization by emphasizing attribute uniqueness and differentiated services. In a highly fragmented industry, the high number of competitors frequently undermines attempts at differentiation. Increased pricing volatility potentially accelerates commoditization by heightening the focus of price in commercial negotiations to the detriment of other considerations such as product attributes, service differentiation and total cost of ownership.

Structural margin erosion—Commoditization and asynchronous pricing movements put a squeeze on steel company margins. Producers, in effect, become cost-plus converters of raw materials with insufficient “plus” to generate adequate shareholder returns. Moreover, customer pressures for longer-term product pricing agreements can further squeeze margins.

Diminished forecasting ability—Price volatility on both sides of the mill-conversion equation undermines earnings stability and visibility that can weaken the ability to secure financing. Other commodity industries where earnings can be forecasted more reliably and hedged from unfavorable market conditions are potentially more attractive to sophisticated, risk-conscious investors.

While these challenges affect the steel industry as a whole, there are differential impacts across individual steel producers based on their product mix, market position and technical and operating capabilities.

Building momentum to take actionFor company leaders beginning to see the need for better pricing management, the place to start is by understanding the basic concepts of commodity trading and risk management, as well as comprehending the potential benefits.

Steel producers need to see this issue at a strategic level. What is needed, first of all, is acceptance among top executives across the procurement, planning, commercial and financial organizations that the enterprise has lost some power and market control, and that something needs to be done to avoid giving up more ground.

Many other industries—agribusiness, copper, oil, aluminum, gas and power—have faced similar challenges related to commoditization and lack

of pricing power. After surmounting early resistance to change, companies built trading and risk management capabilities to protect their revenues, stabilize performance and reassure investors. They also created increasing demand for financial instruments that are in common use today.

Experience from other industries suggests that there are measurable benefits to be derived from active (and intelligent) participation in market exchanges and use of price risk management tools. Later in the paper, we discuss how some of these benefits may be materialized in the steel industry, but first we need to consider the general topic of risk.

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In response to increased volatility and the upstream shift in margin capture, many steelmakers are actively attempting to acquire mines.

The logic of this strategy is straightforward. However, the reality is that raw material self-sufficiency will remain unattainable for most steel producers due to a scarcity of quality mine development opportunities, as well as severe competition for those properties from sovereign wealth funds and established mining companies with deeper pockets and existing leveragable infrastructures. At the same time, the recent—and perhaps protracted—decline in raw material prices due to China’s economic slowdown highlights the inherent riskiness of a “be the company” upstream integration strategy.

Even as the mining industry adds more capacity in the coming years, the industry structure and market dynamics are expected to remain intact, thus perpetuating pricing volatility.

In this context, all steel producers—even those with some measure of self-sufficiency—need to look to other mechanisms to manage volatility.

Escaping upstream?

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Rethinking risk and risk managementAssess appetite for riskA key early step in building organizational consensus is to assess and articulate the company’s appetite for risk. For example, is the enterprise engaging in commodity trading to reduce risk of loss or eroded margin due to unfavorable market price movements (pure hedging)? Or is there a desire to take views on future price movements or attempt to extend margins?

This can be thought of as a risk appetite scale. At one end are the risk-averse companies, where an enterprise seeks to reduce, or remove entirely, exposure to market price volatility. These types of companies are termed “volatility minimizers.” At the opposite end of the scale, those companies that seek financial gain from taking on exposures and confidently invest capital (“risk capital”) in market positions are termed “market makers and speculators.”

The middle band is populated by those companies that seek to take on some risk, but with the agreed strategy of optimizing the value and earnings from their inherently natural market positions. Those positions usually arise from asset ownership and the need to convert materials in terms of form and value. In all examples along this scale of reducing or taking on risk, companies are required to complete some commercial activity, and this is essentially through engaging in hedging and trading.

The risk appetite also should not be classified exclusively according to the degree of speculation an enterprise wants to take. Rather, it should be based on an appraisal of the competitive landscape and the insights on how markets for raw materials and products are developing.

Implementing a risk management and control frameworkRegardless of a company’s chosen risk profile, hedging and trading capabilities require a risk-control function that is not incentivized by favorable market price movements. Internal controls should be designed to enable risks to be taken within

established boundaries that confirm limits to potential downside financial outcomes, as well as support the transparent pursuit of profit-enhancing opportunities. Essentially, the trading activity needs to be part of a comprehensive framework for enterprise risk management that interlocks the concerns of more enterprise-wide activities governing finance; industrial operations; logistics; counterparty performance; health and safety; environment and sustainability; and corporate relations, as well as the causal commercial execution of procurement, sales and trading.

The risk framework is the means by which categories of risk are measured and controlled, aligned to the risk appetite. It consists of clearly defined policies and directives that disseminate into measurements of risk, limits to risk levels using those measurements and how those limits are quantified and applied to any sub-categories of the organization such as business units, divisions and portfolios. Operational processes and procedures enacted by specific roles and responsibilities are also defined, including key roles that sit within the trading function tasked with executing daily commercial market activity that manages the risk. Meanwhile, a risk control function monitors and analyzes the frequently changing risk profile of the enterprise’s exposures and confirms compliance with policy. Segregation of these two key types of roles are an important principle in whatever scale or design of organization structure is most suitable for the particular enterprise.

Developing a trading functionWith a strong risk management and control framework in place, the next step is to develop and begin to implement a business unit or function to handle trading and hedging for the organization. For optimal benefits, the trading unit must be thoroughly integrated with the business. It serves as the interface between procurement, production planning and sales and marketing. A core commercial component the trading unit handles is one of setting the pricing of raw material purchases, product sales and commodity-market hedges that then become part

of a portfolio of varied but interrelated positions throughout the value chain, linked by a common denominator of measurable commodity market exposure.

Built upon a core of managing pricing and associated risk, there are many activities that trading units perform to improve and assure results. Some or all of the following apply to specific companies, depending on their level of integration throughout the steel value chain:

•Managepricingandtimingofrawmaterial purchases.

• Influenceproducevs.buydecisionstoprotect or enhance economic value.

•Recommendandexecutemedium-andlong-term hedging strategies, such as locking in raw material-to-product spreads where differentials are favorably wider than when budgeted or forecasted.

• Innovateinproductpricing.Forexample,through offering flexibility of volume and price to customers and capturing the value that such flexibility introduces.

•Decomposestructuredsalescontractsinto commodity-market transactions that serve as hedges so as to provide offsetting value should sales prices in the future move unfavorably.

•Disseminateinformationgainedfromdaily activities in globally linked markets that may greatly assist the enterprise’s short- and medium-term strategy.

•Provideinputtoforecasting,planningandbudgeting functions.

These activities all include focus on the core component of setting prices. The focus then shifts to what actions are needed to enact risk management strategy and, finally, to taking those actions. In many cases, these actions would involve entering into further transactions with other counterparties, including non-industry market participants such as financial institutions and commodity exchanges that provide a means to offset price risks via hedging. Essentially, the trading unit becomes the operational mission control for enlivening the commercial aspects of risk management strategy and supporting more confident forward planning of production schedules and steel output.

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Some steel company leaders may worry that adding trading capabilities will be seen as encouraging speculation. “We don’t want a bunch of casino people in here,” might be the argument.

The reality is that doing nothing or conducting business as usual in the face of increasing market volatility is already a form of speculation—just not an overt one. On the most basic level, it represents a bet that conditions will revert to the old ways or at least swing in a more favorable direction.

Every time a steel company enters into a sales contract at a fixed price without a corresponding fix on raw material costs, it is making a bet that its costs will be below what is required to generate its target margin. Executives might believe raw material costs will decline, but this amounts to operating on hunches. And likewise when the company locks in a raw material supply contract in the face of steel market uncertainty, it is betting on its ability to cover margins through higher sales prices.

In contrast, hedging of assets and commitments presents far better mitigation to new market volatility than taking no action at all. To avert “casino behavior,” organizations can develop procedures that integrate business intelligence, risk controls and oversight.

Considering what constitutes speculation

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Benefiting from new tools and instrumentsUntil recently, there were virtually no means to hedge in the steel industry because of a lack of trading tools. Now a variety of financial instruments exist, and many are similar to what has proved valuable in other commodity markets such as base metals, oil, energy products and agricultural resources.

Commodity exchanges and financial organizations have established tradable financial contracts that can serve as iron ore, coking coal and steel hedging offerings. (See far-left column in Figure 2.) Pricing platforms are available for upstream as well as for downstream transactions.

If the core strategy of steel companies is to protect margins from erosion, then this can be aided by establishing a link between sales prices and raw materials costs wherever possible—and vice versa. This linkage can be in terms of both input and output prices,

as well as the timing of when the prices are fixed on each side. Where a raw material (iron ore) shipment price is fixed at a different point in time to the sales price of steel output, the facilities of a commodity market via purchase or sale of financial hedging contracts can be used to lock in a margin between raw material cost and product sale.

For example, a typical steel mill may hedge by buying “financial” iron ore swap contracts to lock in the purchase cost of its core raw material at the time when a steel product sales price is fixed with a customer. Conversely, when the purchase price of its iron ore shipment is fixed with its supplier, the mill could use an exchange hot roll coil, billet or rebar contract to lock in a “proxy” sales level of its product by selling that corresponding financial contract. The delivery months of trades executed in each case can be chosen in such a way as to account for production schedules and lead times (for example, March 2013 on the iron ore

side and May 2013 on the product side).The principles of this approach leverage the price structure of the commodity market in the forward price curve and the differentials between the iron ore and steel product prices for a given price point/delivery date pairing.

The reality is that steel products are characterized by a wide variety of specifications, while commodity exchange futures and swaps contracts are limited to a narrow selection of median specifications. This should not be an excuse for avoiding the use of benefits these hedging illustrations present. Other well-established commodity markets also have wide varieties of specifications. But premium and discount structures evolve relative to the core commodity index, and participants routinely avail themselves of the protection such hedging offers.

Physical contracts

Price fix on ore spot price at T1

T1

Iron ore

Physical contracts

Price fix on steel spot price at T2

T2

Steel output

Time flow—processing chain

T0

Iron ore miners Steel mills Steel stockists and users

These hedges illustrate potential for the mill to take advantage of favorable financial market prices to lock in a margin in advance of any physical material pricing.

Lock-in margin

Financial ContractsICE, NYMEX-CME, SGXBanks and brokers

Financial ContractsLME, NYMEX-CME, NCDEX, MCX, SHFE, DGCX

Sell hedge on steel forward T2 price

Sell or (roll)hedge on steel forward T2 price

Buy/unwindhedge at steel spot price

Buy hedge on oreforward price

Sell/unwind hedge on orespot price or proxy for ore blast date

T1

T2

T0

The ore hedge at T1 only applies as an unwind of an ore financial position exists from buy hedge at TO.

The sell steel hedge at T1 is fundamental to protecting margin and locks a spread based on physical ore cost. If done at TO it is “rolled” to further date if necessary.

The buy/unwind steel hedge at T2 closes the financial steel sale/short position opened at T1.

Figure 2. Simple hedging potential in the iron ore to steel value chain.

Source: Accenture research.Note: CME – Chicago Mercantile Exchange; DGCX - Dubai Gold & Commodity Exchange; ICE – Intercontinental Exchange; LME – London Metal Exchange; MCX – Multi Commodity Exchange of India Ltd.; NCDEX – National Commodity & Derivatives Exchange Ltd.; NYMEX – New York Mercantile Exchange; SFX – Shanghai Futures Exchange; SGX – Singapore Exchange.

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Potential benefitsGreater flexibilitySome exchanges and financial players provide facilities for warehousing, delivery and financing of the commodity. Producers can sell standardized grades of production into the exchange when lulls in demand occur or when customers request delayed delivery.

This activity occurs on the London Metal Exchange (LME) with other metals and now extends to steel billet. It presents an alternative sales channel for product and even provides improved cash flow and reduced payment delays or defaults, as the exchanges are generally backed by financially sound cash-clearing facilities.

Conversely, the same warehousing can provide a source of product to buy back when production outages occur or demand ramps up ahead of output schedules or raw material availability. In times of increased demand in base metals markets, exchange warehouse stocks have been the source of material for the very producers who made it.

Having options on when and where to deliver or receive materials can be a differentiator in serving customer needs and can be a decisive factor in contract negotiations.

Protect and enhance margins Some steel industry participants will not be satisfied with merely protecting revenues. In a globally competitive, shareholder return driven landscape, they are considering enhancements to profit potential. Commodity market pricing can enable such opportunities through the very volatility companies seek to manage.

Reshaping the terms on how steel producers set prices by using market-reference pricing can provide opportunities to manage and improve margins. These tools can provide opportunities to lock in lower prices on the buy side or higher prices on the sell side.

Using widely available published references, commodity market-based pricing introduces improved transparency. The relationship between future raw material costs and sales revenues can be largely fixed today; the alternative is that one or both sides of the equation are left open and suffer the consequences of uncertain future price directions. This approach might be a more opportunistic move than the spread mechanism used to lock in a margin defensively.

First-mover advantageTrading platforms and financial instruments are evolving to suit the needs of market participants. Perceived pain points typically result in new products and services being developed to provide relief. To date, trading offerings are fairly regional in focus and no single platform dominates. (See Figure 3.) Also, based on some attributes of steel, including heterogeneity of products (even at the semi-finished stage) and the tendency of some products to degrade over time in storage, the adoption of large-scale trading exchanges faces severe challenges.

Whatever the speed of steel commodity market evolution, Accenture believes those enterprises that embrace the changes early on and develop strategies and business enablers accordingly are likely to benefit the most.

For most companies, the cultural change will be significant. The earlier that companies take initial steps, the more embedded the needed capabilities will be when the market ‘tipping point’ occurs. Companies late to the game will be at a competitive disadvantage when commodity pricing and risk management have permeated the industry. The leaders will have more developed capabilities, systems and experience to reap a larger number of benefits. They also will be further along the scale of maturity and sophistication in price risk management, and better placed to shape the next wave of competitive practice in commercial transaction structuring.

Growing coverage of hedging instrumentsExecutives have recognized the importance of fuller coverage of the materials portfolio of steel mills. As a result, the available contracts offered by exchanges on their own trading platforms and as centrally cleared, over-the-counter contracts now extend to a wider range of raw materials, including coking coal and ferrous scrap.

Provision of existing energy derivatives and freight futures and forwards also extends the mix of total coverage of the typical steel-related risk portfolio. Further depth and flexibility is provided by options contracts on iron ore and HRC, which were introduced in 2011.

Essentially, options provide, at a cost, the means to participate in favorable price moves while simultaneously locking in levels that protect from unfavorable moves. It remains to be seen when the industry will reach the level of portfolio risk management sophistication to realize the benefits associated with collective use of all such tools.

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Figure 3. Exchanges and banks offer growing number of instruments for trading and risk management.

*Denotes options contracts are also available.Note: CME – Chicago Mercantile Exchange; DGCX - Dubai Gold & Commodity Exchange; ICE – Intercontinental Exchange; LME – London Metal Exchange; MCX – Multi Commodity Exchange of India Ltd.; NCDEX – National Commodity & Derivatives Exchange Ltd.; NYMEX – New York Mercantile Exchange; SFX – Shanghai Futures Exchange; SGX – Singapore Exchange. Updated as of February 2013.

Market Platform

Commodity Grade Venue / Region of Platform

Contract Product Type

Contract Size

Forward Delivery Intervals & Horizon

Reference / Fixing Price Index at Settlement

Region of Commodity Delivery

Settlement (physical delivery or financial)

ICE (OTC) Iron ore 62% Fe Fines

Global Over the counter (OTC) swap

1,000 MT Monthly out to 24 months

Platt’s iron ore 62% CFR China – month average

CFR China Cleared OTC financial

NYMEX CME

Iron ore 62% Fe Fines

Global OTC swap * 1,000 MT Monthly out to three calendar years

Platt’s iron ore 62% CFR China – month average

CFR China Cleared OTC financial

NYMEX CME

Iron ore 62% Fe Fines

Global OTC swap * 500 MT Monthly out to three calendar years

TSI iron ore 62% CFR China – month average

CFR China Cleared OTC financial

SGX Iron ore 62% Fe Fines

Singapore OTC swap 500 MT Monthly out to 48 months

TSI iron ore 62% CFR China – month average

CFR China Cleared OTC financial

SMX Iron ore 62% Fe Fines

Global (Singapore)

OTC index 100 times index price

Monthly out to six months

MB iron ore 62% CFR Qingdao – month average

CFR China Exchange cleared financial

Banks, Brokers

Iron ore 62% Fe Fines

Various OTC swap 1,000 MT Monthly TSI, Platt’s, others CFR China Cleared via LCH Clearnet OTC financial

NYMEX CME

Coking coal Australian HCC 64 mid volume

Global OTC swap 1,000 MT Monthly to 24 months

Platt’s month average FOB Australia Cleared OTC financial

NYMEX CME

Coking coal Australian Premium HCC low volume

Global OTC swap 1,000 MT Monthly to 24 months

1) Platt’s

2) Argus

month average

FOB Australia Cleared OTC financial

NYMEX CME

Steel Scrap #1 Ferrous Busheling

US Exchange Cleared Swap Futures

20 Tons Monthly to 24 Months

AMM US Midwest #1 Busheling

Midwest US Exchange Cleared Financial

NYMEX CME

Steel scrap MS I & II 80:20

Europe OTC swap 50 MT Monthly to 24 months

Platt’s month average CFR Turkey Cleared OTC financial

LME Long steel Billet GOST 380-94

Global (London)

Exchange-cleared futures

65 MT Daily to three months, weekly to six months; monthly to 15 months

LME settlement price at Expiry

LME warehouse Europe, Far East

Physical delivery on matured open positions

NYMEX CME

Flat steel Domestic HRC

US Exchange-cleared swaps *

20 short ton

Monthly to 24 months

CRU US Midwest domestic HRC index

Midwest US Exchange cleared financial

NYMEX CME

Flat Steel HRC Europe OTC Swap 50MT Monthly to 24 months

Platt’s Months Average Ex Works, Ruhr Cleared OTC Financial

NYMEX CME

Long steel Billet Europe OTC swap 100 MT Monthly to 24 months

Platt’s month average FOB Black Sea Cleared OTC financial

NYMEX CME

Long Steel Rebar HRB400

China OTC Swap 100MT Monthly to 12 months

MySteel HRB400 Month Average

China Cleared OTC Financial

DGCX Long steel Rebar BS 4449 W 460 B

Dubai UAE Exchange-cleared futures

10 MT Monthly to four months

DGCX settlement price at Expiry

Dubai Physical delivery on open matured positions

SHFE Long steel Rebar Shanghai Exchange- cleared futures

10 MT Monthly to 12 months

SHFE settlement price at Expiry

Listed warehouse China

Physical

SHFE Long steel Wire rod Shanghai Exchange- cleared futures

10 MT Monthly to 12 months

SHFE settlement price at Expiry

Listed warehouse China

Physical

NCDEX Long steel Ingot / Billet

India Exchange- cleared futures

10 MT Monthly to five or six months

NCDEX settlement price at Expiry

Ghaziabad, plus others

Physical delivery on open matured positions

MCX Long steel Ingot / Billet

Mumbai Exchange- cleared futures

10 MT (max. trade size applies)

Monthly out to three to four months

MCX settlement price at Expiry

Ghaziabad, plus others

Physical delivery on open matured positions

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Building trading and risk capabilities for a new eraSteel companies have an opportunity to improve performance by adapting to the new era of price volatility. Use of emerging hedging tools can enable this transition, and companies need to begin developing their capabilities to benefit from use of these new instruments. These capabilities are essentially about being in a position to identify, measure and manage risks arising from price volatility in a regular and repeatable manner. Managing those risks is best achieved through assigning responsibility to a controlled commercial function, which executes contracts in the markets to offset or transform the risk, traditionally termed the trading function. The benefits include revenue protection, enhanced visibility into future cash flow and improved ability to forecast earnings and anticipate investor concerns.

Doing so will move the enterprise forward from reliance on a cost-plus model. This step can help protect margins from intense and increasing global competition in both raw materials and finished-product markets. In the coming years, integrated trading and risk management approaches are likely to become standard practice for leading steel producers.

There are several organizational and operational considerations that contribute to successfully implementing effective trading and risk management capabilities. As well as the strategic and commercial aspects outlined in this paper, there are designs to be made regarding the organizational and capital structure of the enterprise, in addition to the operating model and people, processes and technology platforms that best

support delivery of that strategy. There is no one generic, off-the-shelf model that guarantees quick implementation, but the most suitable and effective models will be delivered by those steel enterprises that take positive steps to recognize the challenge, begin to expend the effort and design what is appropriate for them. The alternative of waiting and watching while markets become no less forgiving or volatile is no longer an option.

About the authorsJames Ghazala is based in London and leads the metals and mining focus of the Commodity Trading and Risk Management group, as well as being involved with client engagements in the energy space. His experience spans 20 years in commodities, commencing as a physical metals trader and marketer having daily dealings with industrial producers, consumers and merchants, as well as with the metals futures and options markets. This experience has been followed by roles in consultancy and investment banking centered on enabling metals and energy businesses to expand, improve and adapt their trading portfolios and risk management capabilities through applying his firsthand understanding of commodities business strategies and market structures, as well as the platforms on which the business is processed.

james.d.ghazala@accenture.com

John E. Lichtenstein is the Managing Director of the Accenture Metals industry group. He has more than 20 years of experience as an industry executive and consultant to the global metals and mining industries. He works with leading companies in the areas of strategy, technology, mergers and acquisitions, globalization and business transformation. He is a recognized specialist on industry issues, has written numerous articles for industry publications and regularly appears as an invited speaker at World Steel Association, China Iron and Steel Association and Brazil Steel Institute events, as well as the Steel Success Strategies conferences.

john.e.lichtenstein@accenture.com

About AccentureAccenture is a global management consulting, technology services and outsourcing company, with approximately 259,000 people serving clients in more than 120 countries. Combining unparalleled experience, comprehensive capabilities across all industries and business functions, and extensive research on the world’s most successful companies, Accenture collaborates with clients to help them become high-performance businesses and governments. The company generated net revenues of US$27.9 billion for the fiscal year ended Aug. 31, 2012. Its home page is www.accenture.com.

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