To hedge against fluctuations in raw material prices, so-called hedging has established itself as a generic term for hedging transactions. In contrast to non-ferrous metals, where hedging has been playing a bigger role for some time, it must be taken into account for steel that it is not a homogeneous raw material, but a material that is in demand with different properties, alloys, shapes and dimensions. So is hedging in the steel business only for specialists?
So far, hedging is only known for listed non-ferrous metals, such as aluminum, copper or nickel, which is used as an alloy metal. For steel, on the other hand, there are currently no accepted hedging offers on the market. But that now seems to be changing forever. The call for hedging in the steel industry has grown louder. Hedging is used to hedge someone else when commodity prices fluctuate significantly. Such transactions can then also be commodity contracts, for example. The fact that many people associate “hedging” with an increased risk the other way around is certainly wrong in the original sense. But what does hedging mean in steel procurement?
Challenge in the supply of raw materials
First, however, a look at the market development, from which the current and increasingly tightening framework conditions result. After the sharp decline in the crisis year 2020, the steel volume economy recovered in the first months of 2021. Crude steel production increased by 3 percent to 10.2 million tons in the first quarter. In March, at around 45 million tonnes - extrapolated for the year as a whole - the highest level in four years was achieved. The capacities are therefore likely to have been almost fully utilized.
The economic recovery in the past few months is largely due to special factors: As a result of the restrictions caused by the pandemic, inventories were reduced to a very low level along the industrial value chain in the previous year. In the course of the replenishment, there are currently strong impulses for demand. As a result, incoming orders in the steel industry in Germany have risen again.
Despite the recent countermovements, nothing has changed in terms of the structural challenges for the industry: The global overcapacity situation has worsened in the wake of the pandemic, and with a view to the USA, the steel tariffs are expected to continue under the Biden administration, so that the risk of trade diversions remains. Ultimately, seen over the year as a whole, the recovery in demand is likely to be moderate. Both in Germany and in the EU as a whole, according to Worldsteel and Eurofer, steel demand will remain well below the pre-crisis level in 2018 both in 2021 and in the coming year.
The concept of hedging
First of all, the principle: the underlying transaction and the hedge transaction are coupled with one another in such a way that losses from one transaction are offset by income from the other. The costs of hedging are the fees charged by service providers in the financial market. A stock exchange listing for the asset to be hedged or at least a functioning derivatives market is required for successful hedging. Hedging using non-standardized derivatives is also offered over-the-counter. There are also options to secure yourself through medium and long-term supply contracts or internal netting (offsetting of positions).
In Germany, however, hedging is by far not as widespread as in the Anglo-Saxon countries, where it is very normal for farmers to use the futures markets to secure their harvests such as wheat, corn or soybeans in order to ensure that their company figures can be planned and calculated bring. Too often, especially medium-sized companies, which make up the majority of German companies, shy away from insurance. The main reason for this is that hedging is still a relatively unknown tool. Often an expert is required and thus additional costs, which arise on the one hand for the protection and also for the advice, must be included in the overall assessment.
However, it turns out that this investment is often more than exceeded. Price risks can thus be minimized and a company is less dependent on fluctuations in the raw material, currency or interest markets.
Due to changing times, which are becoming ever faster, companies have to adapt to this new environment. Many futures exchanges trade almost around the clock, five days a week. Currencies are traded continuously from Sunday 11:00 p.m. to Friday 11:00 p.m., similar to many interest rate products. There are next to no free trading days per year, except for less than a handful. The calculation basis for many buyers is constantly changing.
Constant recalculation, especially with the currently volatile raw material and currency rates, can entail enormous effort and commitment of resources. It therefore makes perfect sense to think about hedging strategies that fix a price for a certain time from the outset and thereby give you planning security.
Alternatives to hedging
There are alternatives to hedging, because the phenomenon of sharply fluctuating steel prices has been known for a long time. Price fluctuations are also always an existential problem for companies in the steel and metal processing industry, as the proportion of primary material for products in this industry can be 70 percent and more. Mechanisms to cope with the risk of price fluctuations are currently z. B. Congruent contract terms in purchasing and sales, price escalation clauses, scrap price or alloy surcharges, re-sale programs by the customer, reimbursement systems, renegotiations and an infinite number of mixed forms of all of this.
These alternatives should be reconsidered and incorporated into the contracts even more efficiently. There are some challenges to be mastered here as well. Antitrust law stands in the way of agreeing a general index value that could be an industry-wide basis for a contractual raw material fluctuation clause. But individual agreements on a standard are allowed - and over time an index standard may emerge as common in the industry.
Is it worth hedging?
Hedging is neither a blessing nor a curse, neither a panacea, nor entirely useless. Hedging is a well-established instrument of the financial market that is suitable for absorbing the risks of price fluctuations. Companies at all stages of the value chain have to decide for themselves whether they want to use hedging as an instrument. However, important prerequisites for successful hedging are not met with steel.
There is no sufficiently secure standard for steel derivatives on the stock exchanges. Furthermore, the product differences between different types of steel are so great that hedging can easily become a risky business where it is actually supposed to take risks. There is also justified concern that the fluctuations in the steel price will increase and thus the remaining risks of hedging steel will increase even further. Finally, there are insufficient comparisons of costs for hedging products. The WSM Wirtschaftsverband Stahl- und Metallverarbeitung considers it premature to discuss hedging, which the smaller companies in the industry in particular may not be able to cope with. Important prerequisites for effective hedging still have to be developed for the steel market.
As a matter of priority, however, companies should improve existing contractual alternatives.
Which solution is suitable for you, we can evaluate individually for your company. With this basis we can give you a good impression for further decisions!