Three reasons HDG Premium futures are a game-changer for steel risk management

Let’s start with a brief example. In August, a steel service center receives an order to deliver processed steel to an OEM in October. The service center is not able to purchase galvanized steel in the spot markets today, due to Covid-19 disruptions and limited storage space. It will only be able to buy HDG in the spot market in October and needs to protect the business from an increase in prices in the interim. We assume that it agrees to a 100% fixed price today with the OEM, so it cannot pass through any potential increase in HDG prices.

HRC futures for the October contract month trade at $530, and the current HDG premium is $150. The OEM and service center agree to a fixed price of $710, ostensibly generating a gross margin of $30 for the service center. Let’s first assume the customer uses HRC futures only.

The customer buys October HRC futures for hedging, thereby protecting the firm against an increase in HRC prices. However, the company is not hedged against a higher HDG premium. In the example below, the premium strengthens by $30, putting the entire service center margin at risk.

By including HDG Premium futures in the hedge transaction, the customer can protect their business from an increase in outright prices and from an increase in the galvanized steel premium. The customer locks in October prices for HRC ($530) and the HDG Premium ($150), resulting in a net purchasing price for HDG fixed at $680 today in August for October delivery. Now the service center’s margin is protected.

Prior to the introduction of HDG Premium futures, service centers with HDG price risk had to either: a) pass through the risk of a strengthening premium – meaning that OEMs would have to pay a variable component in addition to their fixed HRC price, or b) run the risk that a strengthening premium negatively impacts their business – as seen in the first scenario. HDG Premium futures present a potential solution to help service centers and other market participants mitigate risks around galvanized steel prices.

Firms active in the ferrous supply chain are able to use derivatives to protect their stock against a decrease in value. Let’s look at an intermediary storing galvanized steel. In April 2018, HRC was trading at $860 and the HDG premium was $155, meaning the galvanized steel price was $1015. Over the span of six months, HRC dropped to $830 – a $30 price move that could have been hedged by shorting HRC futures. At the same time, however, the premium dropped to $100 ‒ a loss in value against which the inventory holder was not protected. In fact, in this case, which uses real-world historical price data, the premium change of $55 was even higher than the $30 drop in HRC outright prices in the above scenario. 

Most HDG steel is made using Cold-Rolled (CR) sheets. The prices for CR and HDG (base) are therefore very similar, historically trading within +/- 10$/s.t. of each other. This means that HDG Premium futures can be a useful tool for firms with exposure to the CR price. They can now use HDG Premium futures to manage CR price risk.

If you would like to speak about steel futures in more detail please contact us at metals@cmegroup.com.