tsi the role of indices june 2016

HEDGING & PRICE RISK MANAGEMENT WORKSHOP

www.thesteelindex.com

The Role of Price Indices

Vaseem Karbhari TSI Regional Head, EMEA Barcelona June 29, 2016

DISCLAIMER

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Agenda

- Introduction

- Methodology: How an Index is Compiled

- The Role of Price Indices and How They Are Used

- Physical Market Price Discovery

- Index-Linked Pricing

- Settlement of Financial Contracts

- Ferrous Financial Contracts Available

TSI is a specialist price information service

• Impartial organisation focused on compiling prices for ferrous metal products

• Founded in in 2006 as subsidiary of the Steel Business Briefing (SBB) Group, acquired by Platts in July 2011

• Continues to operate under TSI brand as a separate unit within Platts, part of S&P Global

• Data-driven methodology using transaction data to calculate volume-weighted price indices

• TSI “Data Providers” submit spot transaction data to TSI under confidentiality agreement; physical market participants only (over 650 registered today)

• Submission direct to TSI database through secure on-line channel

• Data normalised and “cleaned”, minimising opportunities for manipulation/data bias

• Volume-weighted averages calculated for the day or week based on actual spot market transaction data

The Steel Index (TSI)

The Steel Index (TSI)

TSI pioneered a methodology which uses actual spot transaction data to produce price indexes for use by the ferrous market

European HRC and plate steel indices referenced in supply contracts. ASEAN steel benchmark referenced in floating priced deals

62% iron ore index is used by numerous exchanges to settle the overwhelming majority of all global iron ore derivatives trade

Scrap indices are used as the basis of settlement for futures and swaps contracts on LME, LCH.Clearnet, CME Group and Borsa Istanbul

Our FOB Australia Premium coking coal price is entered into the majority of all index-linked supply contracts between producers and customers

Iron Ore

Scrap

Steel Coking Coal

Key Principles

To maximise industry participation and the accuracy of data submitted

To minimise opportunities for manipulation or subjectivity in the compilation of each index

To apply a consistent approach: TSI uses the same approach for compiling all its iron ore, steel, scrap and coking coal reference prices worldwide:

• legal agreements with relevant Data Providers active in the physical market

• secure confidential on-line data collection of actual transactions

• prices normalised to reference product specifications

• data ‘cleaned’ with outliers excluded

• volume-weighted averages calculated and published

Methodology

TSI “Data Providers” submit spot transaction data to TSI under confidentiality agreement

Physical market participants only (over 650 registered)

Representatives from all relevant points of the supply chain, buy and sell sides

Submission direct to TSI database through secure on-line channel

Data normalised and “cleaned” before volume-weighted averages calculated for the day or week

Legal Agreement

Submits price data through a secure

online system

Transaction data sample

Prices normalised 1

Outliers & high/low excluded

2 Buy/Sell balance 3

Volume–weighted averages calculated 4 Final

data set

TSI Prices Published

Methodology

Trades normalising to MORE and LESS than one standard deviation from the mean are excluded. So too are the unique lowest and highest prices

Data set included in index calculation proceeds to volume-weighting stage.

Data submissions exhibiting inexplicable trends or inconsistencies are also excluded

- - LP

+ +

+ 1 Standard Deviation

Data Submissions

HP

- 1 Standard Deviation

Introduction

• Companies are exposed to a range of ‘economic’ risks over which they have no direct control

– interest rates, foreign exchange, commodity prices, ...

• Companies are rewarded for reducing their exposure to these types of risk

– valuations

– improved access to capital / lower cost of capital

• Well-established financial tools (futures contracts and derivatives) have existed for many years to manage most of these risks, but until recently not to manage steel, ferrous scrap, iron ore or coking coal price exposure

Price Volatility

Northern Europe Hot Rolled Coil (HRC) Price Ex-works (€/tonne)

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Steel prices have become increasingly volatile and difficult to predict

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Regular Cycle Irregular, Volatile Movements

Source: TSI

Price Volatility

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Turkish Scrap Imports - HMS #1&2 (80:20) CFR Iskenderun port (US$/tonne)

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Benchmark ferrous scrap prices have also become more volatile as price sensitivity to Chinese-origin billet heightens

Source: TSI

Managing Price Risk – The Challenges!

• Price volatility and future price uncertainty is detrimental to all companies participating in the supply chain in many ways:

– commercial negotiations

– supplier/customer relationships

– investment and project planning

– production planning

– raising finance, cost of capital

• Steel industry consolidation and upstream integration will not remove price volatility or uncertainty (in the foreseeable future)

Managing Price Risk – Historical Approaches

• Historically companies have looked to manage steel price risk in various ways:

− entering into long-term fixed price contracts

− breaking long-term fixed price contracts

− integrating upstream and downstream

− branding products

− adjusting inventories

− scheduling production downtime/maintenance

• Many companies are finding that these strategies/tactics are not sufficient to meet the challenges of today’s pricing environment and are looking to new approaches

Managing Price Risk - Developments

• Availability of spot price indices for steel, iron ore and scrap

– produced with robust, verifiable methodologies

– timely, reliable

– reflect transactions from all participants in supply chain

• Collapse of iron ore fixed price mechanism

– 40 year-old system

– annual contract price

• Adoption of index-linked price contracts

• Emergence of financial tools

– OTC swaps, options and futures

– iron ore, ferrous scrap, long products and flat products

Agenda

- Introduction







Role of Price Indices: Price Discovery

• The role of a spot price index is to provide:

− clarity and confidence in spot market prices

− a firm foundation for index-linked floating price arrangements for physical trades

− the settlement prices for Over-the-Counter (OTC) financially-settled contracts and futures, trusted by the physical market and financial community, providing the industry with effective price risk management tools

Role of Price Indices

• Index providers (price reporting agencies) are objective observers of the market,

responding to the rising need for a clear, accountable and transparent approach to

price discovery

• The quality of an index depends on the strength of its methodology and the quantity of

data it receives

An Index Providers Responsibilities…

Implement a robust, transparent and consistent methodology

Encourage market participants to submit accurate, timely data consistently

Put in place checks and balances

Be impartial and objective

Publish indices that are representative of the spot market

An Index Provider Cannot…

Control the size of the underlying spot market

Compel companies to contribute their transaction information

Compel any company to use their index to benchmark contracts

Role of Price Indices

Price indices are now widely used in both the physical and financial markets

Trades in the physical market feed into price indices

Indices are used as the basis for physical contracts and to settle futures and derivatives. Using the same index for both eliminates basis risk.

TSI

Physical spot trades

Settlement of futures

and derivatives

Index-linked pricing in physical

contracts

Agenda

- Introduction







Role of Price Indices: Index-Linked Pricing

• Index-linked pricing arrangements typically involve:

− agreeing long-term supply volumes

− agreeing basis product prices will be determined by a published spot price index for a given reference product

− agreeing premium/discounts for the specific material to be supplied, compared to the ‘basis’ reference product

• Iron ore contract supply agreements since April 2010 have moved almost entirely to index-linked price arrangements, not only in China but around the world

• Steel contracts are following this trend. The US has led the way in the use of steel index-linked pricing, but this is becoming increasingly widely adopted in Europe and Asia.

Role of Price Indices : Index-Linked Pricing

• Index-linked pricing arrangements can be structured in a variety of different ways to fit the purposes of buyers and sellers

• Different approaches for the index basis:

− ‘direct’ index, e.g. HRC for HRC (single or a basket of indices)

− ‘indirect’ index, e.g. scrap for billet (single or basket of indices)

− combination of ‘direct and indirect’ indices

− etc.

• Different approaches for time periods:

− index average over a quarter (preceding or current, or lagged by a month)

− index average over a month (preceding or current)

− index average over preceding rolling 15 days, or 5 days, etc.

Index-Linked Pricing: Quarterly Example

TSI 62% Fe Fines Price – CFR Tianjin port (US$/dry metric tonne)

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TSI daily spot reference price

TSI average Q-1M price

Source: TSI


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Q1-1M average price applied as basis for Q2

contract pricing



Source: TSI



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contract pricing


contract pricing



Source: TSI



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contract pricing



and so on…

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Source: TSI



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Average Current Quarter index price (adopted Oct 2011) TSI daily spot

reference price

Source: TSI


Index-Linked Pricing: Monthly Example

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Average monthly index price (current month)

Source: TSI


Indexing and Hedging – Direct Indexing

Trading firms view logistics, storage and other transformations as their core businesses, and so do not have an advantage in bearing price risk

Secondary benefits therefore arise from price indexing – as having secured a price acceptable to both parties, focus can shift to other areas of the customer-client relationship

Price

Quality

JIT delivery

Credit Lines

Single Invoicing Point

Consistency of Material

Spot Trade

Service

Quality

JIT delivery

Credit Lines

Single Invoicing Point

Consistency of Material

Indexed Trade

Index Linked Pricing: Users

Physical market users include steel mills, miners, scrap yards, traders, distributors, service centres, steel processors and steel consumers

Physical market players use TSI prices in a variety of ways, including:

- for reference in price negotiations

- to track performance against the market

- for benchmarking

- as escalators and in clauses within supply/purchase contracts, triggering a price adjustment or renegotiation if the index moves by more than a defined amount

- to identify opportunities to take trading positions

- in index-linked pricing arrangements

- for hedging physical price exposure (locking in future revenues, costs or margins)

- for speculation (traders)

Financial market users include brokers, banks and exchanges

Index-Linked Pricing: Benefits & Implications

• Removes need for protracted negotiations to agree annual fixed price each year

− difficult when market prices are volatile and unpredictable

− price indexing can be equable to both sides

• Enhances supplier/customer relationships

− focuses commercial discussions on specific premiums for value-added products or services, not where the price cycle will be in the future

− removes feeling of ‘winners’ and ‘losers’ as spot market prices move during the period of supply (a key cause of tension between suppliers and customers)

• But leaves both sides exposed to floating price market volatility

Financial Price Risk Management Tools

• Is there a way to smooth the impact of the ‘floating price’ volatility?

Yes!

• Use financial price risk management tools (swaps, futures, etc.) in parallel with the index-linked physical pricing arrangements

• This is known as ‘hedging’

• Using the same index for both the physical index-linked price and for the financial hedging contract enables clients to mitigate any basis price risk

Agenda

- Introduction








The emergence of financial tools (swaps, futures, etc.) offers companies the opportunity to hedge iron ore, steel, scrap and coking coal price risk

There are 3 key types of financial tools emerging to manage steel, scrap and iron ore price risk:

− Over-The-Counter (OTC) swaps and other forward contracts

• Bilateral agreements, using brokers (carry counterparty credit risk)

− Cleared OTC swaps, options, etc.

• Bilateral swaps, using brokers, financially cleared through a clearing house (mitigating bilateral counterparty credit risk)

− Futures contracts

• Traded transparently on exchange and cleared through a clearing house (mitigating bilateral counterparty credit risk)



Swaps, options and futures contracts can either be financially-settled or offer a delivery option

Financially-settled (“cash-settled”) contracts will mature (close out) when the contract date is reached (if not closed out before then)

Contracts with a delivery (and sometimes warehouse) option do not have to be closed out

− by not closing out a position, buyers can choose to take delivery of the standard physical product at the settlement price (and sellers can choose to make delivery of the standard physical product) if they do not wish to close out their position before then

− typically an option of last resort (<1% of trades)

Financial Contracts: Settlement


Financially-settled contracts require robust independent price indices (such as The Steel Index) to determine the settlement prices

− it is essential that they accurately reflect physical market transactions (otherwise there is a risk for users of the futures contract that the hedge is ineffective) and are not open to manipulation

For contracts with a delivery option, the settlement prices are ‘discovered’ in the financial trading process

− the delivery option ensures price convergence

Indexing and Hedging – Dispelling the Myths!

Indexing does not commoditize products as it allows for preferences to be built into the index price.

If material produced is considered a value-added product then it can be sold at a premium fixed value or a percentage to the index value.

Discounts or premiums can be built in to the index price for credit lines, or any number of commercial terms buyers or sellers value.

Using futures/derivatives contracts as a price risk management tool is not speculative measure!

On the contrary, it carries a myriad of benefits to users throughout the steel supply chain. It allows for forward planning, fixed price certainty and (certainty) of cash flows as well as an efficient allocation of capital resources.

Agenda

- Introduction







Financial Tools Available: Steel (Europe & US)

Steel: European HRC

‒ N. Europe: OTC swaps, clearing on LCH.Clearnet, basis TSI

‒ N. Europe: OTC swap-futures, clearing on CME Group, basis TSI and Platts

‒ S. Europe: OTC swaps, clearing on LCH.Clearnet, basis TSI

Steel: US HRC

‒ US Midwest, OTC swap-futures and options, clearing on CME Group, basis CRU

Steel: Billet

‒ Global billet: LME futures

‒ Black Sea billet, OTC swap-futures, clearing on CME Group, basis Platts

Steel: Turkish Rebar

‒ Turkish Rebar Exports: LME Futures*, basis Platts

Financial Tools Available: Steel (Asia)

Steel: ASEAN HRC imports (US$-based)

‒ OTC swaps and futures, clearing on the Singapore Exchange (SGX), basis TSI

Steel: Chinese Rebar

‒ Shanghai Futures Exchange (RMB-based)

‒ OTC swaps, clearing on LCH.Clearnet (London), basis Cleartrade/Umetal

Steel: Chinese HRC

‒ OTC swaps, clearing on LCH.Clearnet (London), basis Cleartrade/Umetal

Financial Tools Available: Scrap & Met Coal

Turkish Scrap (US$-based)*

‒ Futures, clearing on LME, Borsa Istanbul, basis TSI

‒ OTC swaps, clearing on the LCH.Clearnet and CME Europe, basis TSI

‒ Swap-futures, clearing on CME, basis Platts

US Domestic Scrap (US$-based)

‒ US Midwest, swap-futures and options, clearing on CME, basis AMM

‒ US Midwest scrap futures, clearing on Nasdaq, basis TSI

Coking Coal (US$-based)

‒ Premium Hard Coking Coal, FOB Australia & CFR China OTC swaps and futures, clearing on Singapore Exchange, basis TSI

‒ Premium Low Vol Coking Coal, FOB Australia, swap-futures, clearing on CME Group, basis Platts

Coking Coal (China): Futures

‒ Dalian Commodities Exchange (RMB-based)

Financial Tools Available: Iron Ore

Iron Ore: cleared OTC swaps, options and futures (US$-based)

‒ Singapore Exchange (SGX AsiaClear)

‒ LCH.Clearnet (London)

‒ CME Group (Chicago)

‒ Nasdaq OMX (formerly NOS Clearing) (New York)

‒ Intercontinental Exchange (ICE Clear Europe)

‒ Singapore Mercantile Exchange (SMX)

Iron Ore (China): Futures

‒ Dalian Commodities Exchange (RMB-based)

Futures & Derivatives Volumes: Iron Ore

Over 3 billion tonnes cleared cumulatively since launch (2009) across all exchanges and clearing houses

Over 99% of total cleared volume basis TSI’s 62% Fe Fines benchmark

2015 volumes reached 1.17 billion tonnes; 2016 YTD: 875 million tonnes

Open interest at an all-time high - approximately 240 million tonnes

Trading activity overwhelmingly concentrated on SGX, tonnes also cleared on CME.

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Iron Ore Futures and OTC Derivatives Contracts - Volume Cleared and Open Interest* (million tonnes)

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Iron Ore Futures and Derivatives Contracts - Cumulative Volume Cleared (million tonnes)*

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Futures & Derivatives Volumes: LME Scrap

LME Turkish Scrap Futures

Cleared Volumes (metric tonnes)

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Launched November 2015 alongside LME’s Steel Rebar contract (basis Platts) Cash-settled futures contract with a 12-month forward curve and a lot size of 10 tonnes

Over 50,000 tonnes (5,000 lots) traded since launch

First voice-brokered trade executed in May by INTL FCStone Ltd on behalf of Stemcor – indicating contracts are being accepted as risk management tools for the steel industry

“Based on the development so far, Stemcor feel these launches have been the most successful in the commodities space since iron ore swaps.” Phillip Price, Head of Market Risk Management and Derivatives Trading at Stemcor

Senior Leadership Team

Oscar Tarneberg Shanghai Regional Head, APAC Office: +86-139-1788-4804 Email: [email protected]

Kurt Fowler Pittsburgh Regional Head, Americas Office: +1-412-431-0584 Email: [email protected]

Tim Hard Singapore TSI Managing Director Office: +65-6530-6413 Email: [email protected]

Vaseem Karbhari London Regional Head, EMEA Office: +44-20-7176-7657 Email: [email protected]