Do Steel Futures Have a Future?

Do steel futures really have a future?

We're about to find out, as the London Metal Exchange begins open-outcry trading in steel contracts this week. The New York Mercantile Exchange promises to follow at a yet-undetermined date later this year. It could go down as a momentous moment in the history of both the steel industry and the commodities trading world.

Steel is the world's heaviest-traded commodity by value after oil. It's a gigantic - but complex - market that has financial investors salivating at the chance to participate.

That has producers particularly worried. Now speculators will be able to place their bets on the direction of steel prices. And the more transparent marketplace could threaten to burst open the closed-door negotiations that have for so long largely established the pricing terms between producer and consumer.

While the LME is trading physically delivered contracts in Asian and Middle Eastern steel billet, the New York Mercantile Exchange is expected to introduce a financially settled hot-rolled band contract. The Dubai Gold & Commodities Exchange launched a steel futures contract for rebar last year; volumes have been pretty thin so far. Each product will serve a different part of the steel supply chain, and the hope is that eventually the contracts will serve as a benchmark for other steel products.

The LME and other exchanges maintain that futures will give the steel industry the chance to hedge against volatility in prices. The LME goes as far as stating there is no evidence to suggest futures contracts have any effect on price volatility, but rather, provide reliable tools to manage market gyrations. It argues the involvement of funds and speculators may even dampen cycles by allowing investors to take the opposite side to industrial clients.

Those are points certainly up for debate, and many producers - most notably industry leader ArcelorMittal - and other opponents to futures trading say the opposite is true. They believe that bringing speculators into the market will mean more volatility and even higher prices during bull runs. Funds, after all, are known for trading technically - using the guidance of charts and graphs - and that trading style can frequently overextend rallies and declines.

New futures products can take years before finding the liquidity required to be considered a reliable pricing mechanism. The LME aluminum contract, for instance, took almost 10 years after being introduced in 1978 before being fully accepted by the industry.

Will steel make it? And will it help smooth out rallies, or just push the metal to higher highs?

Let's look at a few examples.

Is Nickel A Harbinger For Steel?

Opponents of steel futures like to bring up the fact that nickel, traded at the LME since 1979, has been one volatile beast as of late. The LME price surged to more than $50,000 a tonne a year ago before collapsing to half those levels in just a few months. They suggest that was in large part the work of speculators and investors like hedge funds rather than the commercial players directly involved in the industry.

Others, most notably the exchanges, insist it was just the market reacting to the fundamentals of supply and demand.

When nickel prices started rallying in 2006, production of stainless steel - a big consumer of nickel - was up by more than 15%, fueled in part by the rapid ascent of the Chinese economy. Simultaneously, supplies were hit with several delays to new mines, leading to a supply-demand deficit. Since then, though, the stainless market has come off its boil with producers announcing cutbacks.

So, fundamentals certainly suggested a strong move upward in prices, followed by some cooling. But it's also probable that speculators played off these market conditions and took large positions that could have exaggerated the price movements. Financial speculators account for a sizable portion of investing in metals. For instance, in 2005, index funds alone held about 33% of open interest in nickel on the LME. And index funds generally only have long positions.

Still, most agree that short-term turbulence aside, futures prices over the long haul tend to return to the underlying value of the asset they are supposed to represent. In the case of the LME, this is aided by the exchange's use of stored warehouses of steel that are mostly brandished as a threat of physical delivery. If the LME price appears too high or too low, market players will see favorable pricing opportunities and make use of the delivery mechanism. This risk of delivery helps to ensure the LME price is in line with the physical market price.

Resistance To Change Never Goes Away

It's interesting to note that when aluminum was being introduced at the LME a generation ago, producers were just as adamantly against it. There was even a rumor, never confirmed, that Alcoa had circulated a memo threatening to fire anyone who did business with the LME. How times have changed. Today, aluminum is the most heavily traded commodity on the LME, and Alcoa does nearly all its product pricing based on the contract.

But steel is a particularly tough commodity to bring to the futures ring. It has production qualities, chemical compositions and types of fabrication too numerous to mention.

The aluminum contract also gained respect because it allowed participants to not only hedge the pricing of the final product, but also the raw materials that went into their production.

Aluminum producers' costs move in lockstep with electricity, as power accounts for as much as 40% of their expenses. That makes it fairly easy for them to use futures markets to share the risk of fluctuating raw material prices.

Steel producers are in a tougher bind, given their costs are spread amongst many variables, such as prices for iron ore, coking coal, limestone, natural gas and electricity. These are all separate components that will make it more difficult to create an effective hedge.

Consumers Will Need To Show Their Support

For the steel contracts to gain sufficient traction, what may be needed is a key consumer to step up to the plate and link its purchases to the contract. During its early days, the LME aluminum contract received this much-needed shot in the arm when Coca-Cola Co. publicly declared it was using it as a hedge against aluminum can costs.

Many consumers have voiced support for steel futures but haven't taken this extra step yet. Tony Brown, senior purchasing vice president at Ford Motor Co., sent letters to his counterparts at other major automakers in 2006 requesting their support for steel futures. Two years later, the company still hasn't swayed in its hope that the contracts will succeed. "This is a positive step toward a more liquid market for steel derivatives," Ford spokesperson Todd Nissen tells HardAssetsInvestor.com

General Motors sounds more noncommittal, but is definitely eyeing the contract closely. "We're exploring hedging and various other strategic alternatives to reduce costs over the long term," GM purchasing department spokesperson Deb Silverman tells us.

German automaker BMW is already using the over-the-counter market to hedge its exposure to steel prices and has stated it will be monitoring progress in the contract closely. (Koch Metals Trading Ltd. offers OTC swaps for hot- and cold-rolled coil in U.S. and European markets.)

Most investors get their exposure to the steel market from holding shares in the publicly traded steel companies. Steel futures may eventually pave the way for new financial products that allow for direct investing in steel itself. Will liquidity need to be established first before this happens, or will index funds and other financial participants do the heavy-lifting job of boosting volumes? It's the old chicken-and-egg scenario. Regardless, given the size of the steel market and the money that is at stake, there's a good chance exchange-traded steel will be a permanent fixture of the future.