Ferrous Futures and Derivatives Markets: Entering the ‘Steel Age’

As economic demand rises, so does the consumption of oil. From the billions of new employees reaching their workplace by car or motorcycle, to the web of seaborne transportation moving finished goods around the globe, to the wheat collected from fields and air miles getting foods to markets, oil is inextricably linked to global growth. So too, however, is steel.

From the cars and trucks moving human capital and capital goods overland, to the ships transporting grain and commodities, to the farm equipment powered by oil and the buildings we inhabit, steel is all around us – crucial to industrial production and growth. If it is not made of steel, it is made with it. The world has just experienced its most explosive period of growth since the industrial revolution. Oil consumption between 1998 and 2008 moved from between approximately 75 million barrels a day to 85 million barrels per day (13% increase). In contrast, crude steel production rose from 778 million tonnes in 1998 to 1.3 billon tonnes in 2008 – almost a 71% increase.

Figure 1: Global Crude Steel Production Long-term Growth Pattern, 1950-2010

Source: World Steel Association (WSA)


Steel is a huge industry. Crude steel output of 1.42 billion tonnes (forecast by Steel Business Briefing (SBB) for 2011) requires a lot of raw materials. Steel can be produced either from iron ore, or through recycling old steel. In 2008, nearly 900 million tonnes of steel was produced from iron ore and over 400 million tonnes recycled.

‘Virgin’ steel is typically produced by combining iron ore, metallurgical coal, limestone and other materials in lesser quantities. Approximately 1.6 tonnes of iron ore is needed for a tonne of steel, along with 300kg of metallurgical coal. So for these 900 million virgin tonnes of steel, 1,440 million tonnes of iron ore was required, as was 270 million tonnes of coking coal. For recycled steel, 400 million tonnes of steel scrap was required. For 1.42 billion tonnes of crude steel to be produced this year, over 2.1 billion tonnes of raw materials are required. Steel is a big industry – 15 times larger than every other major metals industry put together.

Unsurprisingly, with China leading the charge of economic development among the BRIC nations, its production of steel has grown explosively, expanding five-fold between 2000 and 2011, from 128 million tonnes in 2000, to 707 million tonnes (projected) in 2011. It is the pre-eminent producer of steel globally, producing almost eight times as much as the US. Unfortunately, China does not have a large quantity of economically retrievable iron ore, or metallurgical coal, or scrap, yet.

China’s demand for ferrous raw materials has contributed to Australia’s growth rate being 0.9% above the OECD average over the last 15 years. It has also contributed to the Brazilian export success story. Around 900 million tonnes of iron ore are traded on the seaborne market annually (mostly originating from Australia, Brazil, India and, to a lesser extent, South Africa).

A Changing Picture

This huge industry has been going through massive changes in the last decade. Production has moved emphatically eastwards. Put one way, Asia’s global proportion of production rose from 22.8% in 2000, to 63.4% in 2011. Put another way, in terms of relative ‘importance’ – EU27 production (by far the largest of the ‘developed world’) fell from 22.8% in 2000 to only 12.1% in 2011.

Figure 2: Global Crude Steel Production by Region

Source WSA, Steel Business Briefing (SBB) Research


Industry ownership changed hands dramatically between 1999-2008, going from a situation where ‘developed world’ firms numbered nine out of 10 of the top producers, to one where only a single western firm was in the top tier.

Figure 3: Changing Picture: Industry Ownership

Source: WSA


For decades, steel prices followed macroeconomic cycles and oscillated in minor, seasonally induced variations. Steel price volatility today has been well and truly unshackled. Hot rolled coil steel prices in the US between 1960-2000 never rose above US$400/short tonne. Over the following decade, they tested US$1,100/short tonne, and doubled and halved within the space of one year.

Explosive growth and the shift eastwards has shattered the old ways of doing business. For 40 years, iron ore was priced by means of an annual fixed price ‘benchmark’, i.e. a price would be set between the major consumers and producers, which would be used industry-wide for year at a time. This approach was torn up in 2010, with a move to index-linked pricing that referenced the spot market price into China. It is a similar story for metallurgical coal markets, which also moved from annual pricing to quarterly pricing arrangements. This poses a problem for western steel producers, who now find their input costs dictated not by their own demand levels, but the demand levels in China and Asia.

From Fixed to Floating Prices

It is this withdrawal from long-term fixed pricing arrangements that forms the basis of the most fundamental changes affecting the steel industry today. With floating raw material prices, steel producers have been unable to continue offering ‘fixed’ pricing to their primary consumers. Offering fixed pricing was not indicative of ‘cosy relationships’ between steel mills and, say, automobile producers. It was more indicative of historically minor finished steel price variations during 12-month periods (so a flat fee gave away little upside or downside potential to either party). This is no longer true today.

It was also indicative of the fact that raw material input costs were highly predictable – set once a year – which meant steel prices could also be set annually. This is no longer the case. Iron ore contract prices are changing quarterly, monthly or even weekly, while metallurgical coal prices are negotiated quarterly. Scrap prices have always been are a true ‘spot’ market (Alan Greenspan used to watch the price of HMS#1 every week as a ‘pure’ industrial indicator).

In this new environment, steel producers are unable to absorb downside margin risk exposure when raw material input costs move against them. Their customers are thus exposed to price risk they have not had to face before. Think ‘manufacturing’ and people often think ‘high volumes, low margins’. This may or may not be a fair assessment of the sector, yet steel price volatility only adds to the pressure of margin erosion, where it did not in the past. Amplitudes of steel price variation today are too great to absorb.

Figure 4: Northern Europe Hot Rolled Coiled (HRC) Price 1998-2011 (ex-works)

Source: SBB (pre-April 2008); The Steel Index (after April 2008)


An Evolving Industry

The steel industry is a great survivor. Each year between 1960 and 1990, ‘real’ (inflation adjusted) prices of steel fell. Steel firms are veterans of price competition. The industry has also been a success at constantly reinventing itself – both in terms of technology and production processes, as well as differentiating its products to different users.

What will be the story moving forward? For a long time, steel firms have worked closely with their primary customers to provide the steel and the tonnages they need. The balance of production made it onto the ‘spot’ market. With today’s volatile raw material markets, they have had to constantly ‘feed through’ price increases or decreases to their unwilling customers. Does the steel industry continue to attempt to offer flat prices, or does it accept a move to a spot environment? Do steel consumers accept this move, or look to find ways in which to continue to get predictable prices?

There are precedents – the aluminium industry in the 80’s and the oil industry in the 70’s witnessed significant changes to the way in which their products were priced. There seems little doubt that the financial community believes there is a need in ferrous markets for price risk management. In the past four years, the London Metal Exchange (LME), Chicago Mercantile Exchange (CME), LCH.Clearnet, Singapore Exchange (SGX), NOS Clearing, Intercontinental Exchange (ICE), Indian Commodities Exchange (ICEX), Shanghai Futures Exchange (SHFE), DGCX, Dalian Exchange and a host of other clearers/exchanges have listed ferrous futures products or clearing facilities for over-the-counter (OTC) derivatives.

These derivatives cover iron ore, ferrous scrap, semi-finished steel, as well as finished steel. Liquidity is now building in some of these markets. In iron ore, over US$6bn has been cleared since launch…with the current run-rate at over 3.5 million tonnes of iron ore clearing per month. This compares extremely favourably with the take-up of the aluminium market, which didn’t really trade at all for the first five years after it was available in 1978. The volume of aluminium financial trades now outnumbers physical trades by over 30 to one.

Figure 5: Iron Ore Financial Contracts – Cumulative Value Cleared

Source: The Steel Index


The question is whether the steel sector will embrace the derivatives markets as a way in which to deal with price volatility.

It seems inevitable that it will. Producers wish to keep some control over input costs. Raw material producers will wish to hedge their production. This is evident in the rapid take-off in iron ore paper trading and the huge interest surrounding the new ferrous scrap contract.

While many things have changed in the ferrous landscape, industry concentration – or the lack of it – at a global level has remained relatively stable. Only one firm, ArcelorMittal, stands out as a global force, producing twice the quantities of its peers. Sooner or later, one firm from this fragmented market will decide that they will differentiate themselves by offering long-term pricing. Hedging offers a viable way to achieve this.

End-user markets will demand it – some, such as automotive producers have already asked publically for this. Construction firms are increasingly unwilling to accept an unknown steel purchase price when they draft quotations.

Where, in the past, steel producers found the ability to predict input costs for 12-month periods helpful, forward markets will provide firms with the ability to hedge two, three or, in time, five years forward; offering them the opportunity to provide far longer term fixed pricing than previously.


The means of price discovery for settlement is likely to be indices, rather than physical delivery. Raw materials are too inexpensive and bulky for viable delivery-based contracts (e.g. iron ore prices typically range between US$100-200/tonne). Finished steel products degrade (rust), as well as having low weight/value, again making storage inefficient and costly. This means that index-based settlement is the most practical and efficient manner of price discovery.

This is no bar to liquidity. Many contracts, such as oil, are priced in this way. Iron ore, with prices compiled by The Steel Index (TSI), is already the most liquid ferrous derivatives space. However, it is just at the beginning of its growth path. Financial trades (in relation to physical trade volumes) for iron ore are currently around x0.05. Obviously this is some way off x30+ in aluminium – but this is still a young market. Nevertheless, liquidity is growing at a good rate and there is no reason not to expect a mature iron ore market to trade between five or 10 times the physical market size. Other commodities financial trading scale, such as oil, trade seven to 10 times the physical market. Other steel futures markets show the growth potential available – on the Shanghai Futures Exchange (SHFE), their rebar contract trades more than 40 times the physical market.

Asia has clearly become the centre of gravity for the physical ferrous industry. Perhaps the same will be said for the ferrous derivatives and futures markets. The most liquid OTC markets currently are in China and Singapore.

As an increasing number of steel derivatives and futures contracts are launched over the next few months, alongside the established iron ore contracts, so the pace of growth in ferrous derivatives will increase exponentially. Add to this scrap and, in time, coking coal contracts, and the ‘snowball effect’ becomes enormous. The ‘paper steel mill’ will soon become a reality, with all the trading opportunities this offers.

At whichever venues liquidity pools, the ferrous industry is set to see the greatest growth in derivatives and futures trading of any sector over the next few years.


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