Volatility in flat steel prices has led to higher demand for risk mitigation products. Prices of hot dipped galvanized steel (HDG) and hot rolled Coil steel (HRC) have become significantly more volatile over the past few years. The relationship between the prices of these two commodities is worth exploring.
Market participants who only use HRC futures to hedge their galvanized steel exposure may be exposed to more risk. Any change in the premium of HDG over HRC is a risk factor that may eliminate any benefit from an HRC hedge transaction. To help manage this exposure, CME Group offers the HDG Premium futures contract. This contract settles against the price difference between HDG and HRC using CRU index reference prices.
Let’s review an example using the HDG Premium futures contract for price protection:
First, let’s consider a direct hedge for galvanized steel for service centers. Assume, it’s January and a service center is selling galvanized steel, at a price fixed today, to an original equipment manufacturer (OEM) for delivery in April.
The service center will purchase the steel in the spot markets in April and would like to hedge against an increase in steel prices. Assuming that April HRC futures are trading at $530 and the HDG premium is $150, the implied HDG price is $680 for delivery in April. The service center is able to lock in this price using futures. The OEM and service center agree to a fixed price of $710, which would generate a $30 profit margin for the service center.
In April, the price of HRC has strengthened to $550 and the HDG premium has increased to $180. The service center purchases galvanized steel at a spot price of $730 in the physical markets.
How has the hedge transaction performed? Let’s look at HRC first.
HRC increased from $530 to $550. The service center receives $20, the difference between the initial price in January and the final settlement price in April. At the same time, the HDG galvanized steel premium increased from $150 to $180. Since the service center locked in the price of $150, this hedge generated a gain of $30.
On a net basis, the service center has paid $680 for the steel – that is a $730 purchase price in the physical spot market, adjusted for the payoff of the two hedge transactions – $20 hedge payoff for HRC and $30 hedge payoff for HDG. With a fixed price to the OEM of $710, the gross margin of $30 is secure.
If HDG Premium futures had not been used in the hedge transaction, the increase in the HDG premium from $150 to $180 would have completely erased the $30 profit margin. Customers can use HDG Premium futures and HRC futures to create a comprehensive hedging strategy. This protects them from an increase in HRC prices and from an increase in the galvanized steel premium.
HDG Premium futures are available to trade through your bank, broker, or electronically nearly 24 hours a day through CME Globex. HDG Premium futures contracts offer market participants another instrument to protect themselves from the volatility inherent to the steel market.