Just as US regulators are moving to stamp out speculative price runs in the energy sector, volatility has taken off in metals and mining - a market historically less liquid and less volatile than the energy world. Iron ore has led the charge, with the cash price tripling in the past year, from a low of $60 per ton to $170 to $190 per ton.
Much of the volatility has been sparked by China's insatiable appetite for steel to fuel its rapid infrastructure growth. Strategists say the sector's volatility also reflects concern that the price surge may not last, due to a jump in new production and questions about China's ability to continue its turbo-charged growth. Prices of other products used to make steel have also shot up as companies restock supplies after dumping inventory during the credit crisis. For example, Molybdenum, a by-product of copper that goes into stainless steel, has soared to $18 a pound from $8 at the peak of the crisis.
Now, as prices roar back and the traditional system for pricing contracts on an annual benchmark basis is replaced by a market-sensitive spot-price system, steelmakers are waking up to the need to manage these new price risks and hedge exposure. For many, it is a new world.
"A lot of steel producers have never used hedging techniques, so there's a huge amount of education that's needed," says Ray Key, global head of metals trading at Deutsche Bank in London. Opportunities are also opening for investors. Michael Widmer, metals strategist at Bank of America Merrill Lynch, says that until now, iron ore has been largely closed to investors. "You could get exposure through equities, but it was impossible to get direct exposure. So the opening of the market, with the move away from a benchmark system, gives investors exposure to price movements," says Mr Widmer. "This is true also for other raw materials, such as the exotic metals, which have largely been closed markets."
As hedging opportunities in the metal sector increase, banks are gearing up. "It's clearly an area of growth for a lot of banks," says Andrew Awad, a consultant with US financial services research and consultancy company Greenwich Associates. "From a competitive perspective, my sense is that the over-the-counter metals business is more concentrated than energy, with fewer meaningful dealers. More banks are starting to build up and extend their franchise, so they're several years behind energy in investing in this business."
Kamal Naqvi, global head of institutional commodity investor sales at Credit Suisse in London, says his group is already looking beyond swaps - a hedging tool that he expects will explode in growth over the next three years. Mr Naqvi, who launched iron ore swaps with Deutsche Bank in 2008, sees swaps volume surging from nearly 30 million tonnes in 2009 to 60 million tonnes this year, with potential to grow to 700 million tonnes by 2013, based on the experience of the thermal coal market.
Hedging toolbox
Mr Nagvi says there are three hedging tools his bank is developing that he thinks others will eventually offer too: longer-term price contracts than the annual benchmark to fix prices, synthetic free-on-board (FOB) iron ore products, and options.
Credit Suisse has already tailored a couple of longer-term contracts aimed at higher-value-added steel producers that want to help eliminate the price risk of iron ore. For example, steelmakers producing a higher value-added product, where their margins are not purely a reflection of their raw materials costs, may want to lock in three years or five years of fixed pricing and then concentrate on the main drivers of their business - something they could not do under the annual benchmark system. "We've experienced strong increase in interest in this type of longer-term price risk management in recent weeks," says Mr Nagvi.
Credit Suisse is also starting to offer synthetic FOB iron ore, in response to concerns that the iron ore swap market is based only on material delivered to China. FOB is a shipping term that indicates that the supplier pays the shipping costs - and often the insurance costs - from the point of manufacture to a specific destination, at which point the buyer takes responsibility. "We now offer to remove the freight component and offer markets that are more applicable to European or Japanese steelmakers, for iron ore from Brazil and Australia," says Mr Nagvi.
Lastly, Credit Suisse has carried out a couple of option trades in iron ore, although Mr Nagvi says this product is "at an earlier stage". Those who purchase the options can lose no more than the premium paid, which can be appealing to those nervous about tip-toeing into a new, volatile market. For instance, a steel mill might buy a call option on the potential for iron ore to shoot to $200, while a producer might purchase a put option at $100, in case iron ore spot suddenly corrects lower.
Kamal Naqvi, global head of institutional commodity investor sales at Credit Suisse in London
Growth and innovation
Deutsche Bank's Mr Key acknowledges there are plenty of opportunities opening up, but says his group remains, for now, firmly focused on developing the swaps market - which is still in its infancy. "You're talking about one of the biggest commodities markets in the world and it's the largest market without financial tools," he says. "We're talking about a 1 billion-ton seaborne market, and we're currently running at an annual rate of 36 million tonnes in the financial market, which isn't small, but is minimal relative to the size of this market."
He recalls that when his group helped launch the swaps market two years ago, the monthly volume was 500,000 tonnes a month. "We are now exploding in volume. This has the potential to become a 1 billion-tonnes-per- year financial market."
Others are looking at launching new contracts to trade on exchanges, aimed at helping steelmakers manage risk and lock in profit margins. For example, The McCloskey Group, a UK group that produces news and indices on the international coal industry, has been talking to Singapore Mercantile Exchange about introducing a metallurgical coal contract for Asia. According to one senior commodities official: "The thought is that this can give steel mills the ability to lock in their margin on making steel so they can hedge the raw materials, such as iron ore and metallurgical coal, then go and hedge the finished product which is steel."
Traders say this is the kind of hedging activity common in the oil market, where oil refiners hedge the crack spread, or the difference between crude oil and the refined products that are produced. According to them, this kind of tool would allow steel mills to lock in the capacity value or profit margin.
Limits to the upside?
As volatility in the metals sector continues - especially in iron ore - some suggest it will be the smaller producers that have the greatest need to hedge. "Similar to the oil and gas industry, producer hedging flows will likely come from the smaller independent producers that are required to hedge in order to support any form of debt in their capital structures," says Stu Staley, head of global commodities at Citigroup.
But he questions the scope for overall growth in swaps. "One of the challenges facing the iron ore market is that such a significant proportion of total production capacity is controlled by three companies [Vale, Rio Tinto and BHP Billiton]. Is this a sustainable structure for a deep and liquid market? You'd be hard-pressed to find another liquid market that resembles it," says Mr Staley. "So, while it is in the interest of the large producers to support development of a financial market, I question whether liquidity will be deep enough to support significant hedging transactions."
Martyn Whitehead, managing director, metals sales at Barclays Capital, agrees that the market will need to see a lot more liquidity to achieve greater viability. "The problem with the market is that one half of it is completely missing, and that's the consumer side. The producers, brokers, exchanges and banks are there. But until the world's biggest consumer, which is China, starts to consent to exposed pricing in its iron ore contracts, liquidity will only continue to build very slowly."
He believes that eventually China will accept index-based pricing in its iron ore contracts. But that will take time. And contrary to the breathless run-up in prices - which has excited extraordinary growth expectations - in reality, progress will likely be a lot slower as new financial hedging tools follow a slow build-up in liquidity. As Mr Whitehead puts it: "There's a process at work and the market just needs to be a bit patient."
