Steel trading has traditionally been based on fixed spot prices, with no long-term contracts between buyers and sellers to ensure stability of supply. And traders either do back-to-back cargoes or bet on price increases or drops by entering into either long or short positions.

However, such trading methods do not defend against volatile prices and leave positions highly exposed to price swings.

Trading margins and mill profits from sales can take a hit any time, even as steel prices climb, and dip on a whim. More often than not, this results in steel shipments being canceled as one party backs out of the sales contract. 

Derivatives and hedging tools are already used in other commodity markets - such as the oil, natural gas, petrochemicals and iron ore industries - and are widely accepted techniques that commodities traders, producers or sellers are happy to use.
 
Hedging against fixed-price volatility
For supplier-buyer pairs who are looking to ensure the stability of offtake deals, it is possible to fix a monthly forward offtake price based on the daily average of Metal Bulletin’s fob China price indices to hedge against the fluctuating prices in Asia. A floating discount or premium, also known as an ‘alpha’, is then applied to the average price as determined by the monthly market situation.

For example, in a tightly supplied market marked by mill turnarounds or shortages in raw materials, the buyer and seller could agree on an alpha commanding a $15 per tonne premium for cargoes shipping in six to eight weeks.

The pricing formula for a 30,000-tonne July-shipment cargo then looks like this:

[(Average of Metal Bulletin 1-31 July fob China index) plus $15 per tonne] x 30,000

Hedging for half months

It is possible for the price risk to be reduced further, especially if the buyer or seller does not want to be exposed to price movements outside of the cargo loading or discharge period.

If a buyer is bearish for the first half of a loading month and expects prices to climb in the second half, the buyer can choose to secure the spot cargo based on a specific loading laycan after negotiating an alpha of a $9 per tonne discount with the supplier.

The pricing formula for a 15,000-tonne July-shipment cargo then looks like this:

[(Average of Metal Bulletin 1-15 July fob China index) minus $9 per tonne] x 15,000

Using both fixed and floating element
Counterparties who do not want to solely use indices can choose to use a mixture of both fixed spot prices and daily average indices in their offtake contracts, especially if they have a fixed price in mind. For example, 50% of a contract can be based on a fixed spot price, while the other 50% can be based on the Metal Bulletin fob China index, including an alpha. Both the fixed spot price and the alpha will be negotiated between the buyer and the seller.

If both counterparties have decided on a fixed price of $550 per tonne and the average of a Metal Bulletin index with a $20 per tonne premium for an alpha, the pricing formula would look like this:

[50% ($550 per tonne cfr)] + [50% (1-31 July fob China index) plus $20 per tonne]

Physical swaps to mitigate fixed price risk
Traders can also use these indices either for cargoes they have entered into long or short positions, or for back-to-back trading. This is done primarily by buying at discounted alphas during opportune times and then selling again at high premiums at a time they deem suitable.

If a trader forecasts a continual price uptrend, he can choose to buy a spot cargo based on 1-31 July fob China index with an alpha. He can then sell the cargo to an end user or offtaker at a fixed price later on in the month.

If he has made the right call, the average of the 1-30 August fob China index at which he bought will be lower than the fixed price at which he sold, even after including the premium.

The opposite can also be done if the trader holds a bearish view.

In this scenario, he would choose to sell a spot cargo based on 1-31 July fob China index with an alpha, before buying another cargo at a fixed price later on in the month.

If he has made the right call, the average of the 1-31 July fob China index at which he sold will be higher than the fixed price at which he bought, even if there was a discount included.

A trader can also trade solely using daily averages of Metal Bulletin fob China indices, which could be especially useful when the price outlook is hazy due to mixed fundamentals from key markets such as China.

For example, a trader can buy spot cargoes on a daily average basis with a discount when market sentiment is bearish, before selling the spot cargoes based on daily average prices with a premium when market sentiment improves. This reduces the risk of dealing with fixed spot prices and limits it further to only the alphas.