Regional steel futures mark industry evolution

The growth in trade of the London Metal Exchange's (LME) fob China hot-rolled coil (HRC) contract has been a key step in the evolution of ferrous markets amid the rise of regionalised steel markets and the need for product-specific risk management.

The contract, launched in March last year, has seen firm open interest and traded volumes, providing participants with the ability to use the tool to not just hedge their exposure to steel but also take a view of China's macroeconomic situation, the LME's head of financial sales Joe Vu said during a webinar this week.

June volumes for the LME fob China HRC contract rose by 187pc from a year earlier and by 36pc from May, with 6,149 lots traded, equivalent to a little over 61,000t of steel. This represents a nominal value of over $26.7mn for June and more than $425mn traded since its launch.

With Chinese steel demand driven primarily by infrastructure and manufacturing sectors, the steel sector's performance are a good indication of Chinese economic growth and policy support. The Covid-19 outbreak in China this year dented downstream demand sentiment, resulting in a build-up of stocks. Steel prices have managed to avoid a freefall amid government stimulus measures and with Covid-19-related shutdowns restricted to the early part of the year.

"Auto manufacturing data shows that production has bounced back from just 300,000 units in February to over 2mn units, underlining consumer sentiment. Anyone with a view on whether China has sufficient appetite to consume the domestically produced steel and the imported cargoes can use the HRC derivative to express it," said Avatar Commodities founder Andrew Glass.

The Argus fob China HRC index has fallen by 8.9pc to $440/t since the start of the year. Volatility fell in June with prices up by $14/t during the month compared with a $26/t rise in May.

Access to different contracts and derivatives allows the market to manage risks associated with different aspects of the ferrous supply chain, not just iron ore, marked an important evolution for the ferrous industry, Glass said. He also stressed on the development of a forward curve to provide transparency on supply-demand dynamics.

The LME forward curve shows a backwardation at the moment, with September contract at $432/t compared with $438 for the July contract.

The LME also has three other steel futures contracts for the US and European markets. "You do not have to trade equities to play the regional divergence or convergence of different markets because of the different steel contracts," said Drakewood Funds product manager for iron ore Joel Parsons. "This is an interesting aspect that was not available to the market earlier."

An ecosystem of contracts on LME and elsewhere allows participants to trade the arbitrage, and in the future, liquidity in the steel contracts may trickle down to the ferrous scrap contracts, Parsons said.

The LME earlier this month announced the launch of the Taiwanese ferrous scrap contract, settled on a basis of the Argus containerised ferrous scrap cfr Taiwan price. The LME already has a cfr Turkey ferrous scrap contract that was launched in 2015.

Market participants agreed that having a mix of physical and financial participants trading the derivative would be beneficial for its growth.

"Correlation of the derivative with the underlying asset is important and that is where having derivatives based on indices that closely track the physical market is important," Glass said.

For financial participants cash-settled contracts work better because of the typically higher liquidity that they are able to attract, Vu said.

As a fund manager, Parsons said his company would hope to see the involvement of physical participants in this market. The LME provided easy access to a large pool of participants, he said, unlike the Chinese domestic futures contracts that attract higher liquidity but continue to have a substantial barrier to entry for those looking to trade such ferrous derivatives.

By Deepali Sharma