This is the year that steel futures and options came of age. Both the London Metal Exchange (LME) and CME Group (Nymex) are expanding their metal operations with respect to steel futures, although progress toward global pricing and trading of steel futures was made first by LME.
Before the initiation of steel futures trading by LME in 2008, a futures market in steel was not without controversy. Many producers would prefer to stay with the traditional negotiated contracts for pricing their products. The fear expressed by some producers and users of steel is that futures trading attracts too much speculation -- more than the amount needed to offset normal hedging risk and enough to cause disruptive price movements.
During the spring and summer of 2010, LME continued to announce increased volume of trading in steel futures contracts. For example, volume for the month of July was 18,906 lots traded of the steel billet contract, covering 1,228,890 metric tons, and this was the fifth consecutive month of record volume. Although the steel futures market is still young, it is developing a sustainable growth rate even in this period of worldwide economic contraction.
Steel futures trading in the United States should expand further as the result of two recent initiatives by LME: the change from trading two contracts, Mediterranean and Far East, to a single global steel futures price that merges the two previous contracts, and the establishment of delivery points at New Orleans, Chicago and Detroit.
Over the past five years, six exchanges have begun trading steel futures based on a variety of products. The following list shows the exchange locations and the steel products covered by futures contracts:
- London (LME): rebar quality square billet, 65 metric tons per contract
- Dubai Gold and Commodities Exchange: rebar, 10 metric tons
- CME Group (Nymex): U.S. Midwest hot rolled coil (HRC), 20 short tons
- Shanghai Futures Exchange: steel wire rod and rebar contracts, each 10 metric tons
- India (National Commodity & Derivatives Exchange): mild steel ingots, mild steel billets, each unit equal to 10 metric tons
- India (Multi Commodity Exchange of India): steel flat, 25 metric tons, and steel long, 15 metric tons
Most steel futures contracts are physically deliverable to one of multiple locations in the various countries in which they are traded; however, CME Group’s steel futures are settled in cash against a reference price for U.S. Midwest hot rolled coil. Convenience for steel buyers and sellers was an important consideration in the recent establishment by LME of a delivery location in New Orleans. In any case, steel for trading or delivery on the exchanges listed above must meet quality standards (for example, steel originating at an exchange-approved producer).
“London steel” (below) shows daily averages between buyer and seller for Mediterranean and Far East contracts. Increased volatility is obvious for both contracts in March and April 2010, with prices declining with a slower economy and falling demand for steel products toward the spring and summer. From January through mid-May, the Mediterranean price changes lead the Far East futures. From later in May through June, the two prices are identical as the market prices anticipate the origination by LME of a single global steel futures price on July 28, 2010.
On “Dueling metals” (below) the three series of daily prices are shown as ratios to their average price over the period Feb. 1 to Aug. 31, 2010. The higher volatility of steel futures (using only the Mediterranean contract) reflects the peak and decline shown in the “London steel” chart. Copper futures exhibit a smaller amount of volatility, although they match the steel price increase and subsequent decline through March and April, in timing if not in absolute gain in the price ratio. LME and New York copper futures stay closely related because of arbitrage between the two futures markets. Potential spread trades between the two markets were analyzed in “The New York -- London Connection” (January 2010).
Crossing the pond
Looking to the future, the potential exists for an active futures market in steel on both sides of the Atlantic, similar to the current daily phasing of London copper futures into those traded in New York -- with predictable opportunities for arbitrage between the two markets. Trading two different steel products -- billet versus hot rolled coil -- should not present a large problem in comparative pricing.
Currently, we can structure a hypothetical simulated call option on LME steel futures. This requires the use of options on Nymex copper for construction of an option price curve and an assumption that the volatilities of the prices of LME steel futures and LME or Nymex copper futures are closely related.
The second requirement -- close relationship between the volatilities of LME steel futures and copper futures -- is supported by their ratios of daily prices to the five-month average price during May and June 2010. Whether increased futures trading in steel will help to eliminate volatility differences is unknown at this time, but for the purpose of the proposed option analysis, it is assumed they are equal.
“Modeling the price of steel” (below) contains two sections. The upper section shows calculation of a call option price curve for September 2010 Nymex copper futures on July 1, 2010. A regression equation based on an original set of 16 futures price-option price pairs resulted in the following equation coefficients:
A = - 2.6102
B = 8.2308
C = - 14.5758
Ln (W/E) = A + (B x Ln(S/E) + C x (Ln(S/E)^2)
W = option’s market price
S = future’s price
E = strike price
The predicted call price at each strike price is computed from the following equation:
Predicted call price = ((2.718281)^Ln(W/E)) x E
The accuracy of the regression equation is indicated by the close relationship between the call option prices and the predicted option prices. The next step uses the regression equation developed for September 2010 copper call options to compute predicted prices for hypothetical call options on three-month LME steel futures on July 1, 2010.
On July 1, the steel futures price was $430 per tonne on a 65-tonne contract. The call prices calculated are charted in “Call options on steel futures” (below). Intrinsic values for each strike price equal the futures price less the strike price and delta is equal to the slope of the option price curve at each strike -- the expected change in the option price for each dollar of change in the underlying futures price.
Upper and lower breakeven prices for copper and steel futures reflect the potential range of the underlying at expiration in approximately three months. While the price range for copper options is tied to actual market prices for the calls on July 1, steel futures have no published option prices and the predicted call prices, as well as breakeven prices depend (as shown in the previous calculations), on similar volatilities of steel futures and copper futures.
In both sets of calculations, the breakeven prices are prices at expiration that will result in zero profit or loss for a delta trade -- selling call options against long futures contracts in a ratio that is the inverse of delta.
One advantage of the option pricing method shown here is that the same technique may be used with any pair of futures for which the underlying price volatilities approach equality. In the present case -- that of steel futures -- call and put options may arise in the near future in addition to the present over-the-counter market in swaps on iron ore and steel. Preparation for potential trades may include simulating options on steel futures based on other related metal options.
Traders in equities of steel producers gain from the expanding market for steel futures because both futures prices and the companies’ expected earnings are affected by the same underlying forces of consumer demand and raw material pricing.
Commodity price and share price relationships are illustrated on “Taking stock of steel” (below). Movements of the U.S. Steel stock price are closer to steel futures prices than those of Nucor. The reasons include differences in product markets between Nucor and U.S. Steel. For investors in steel equities, the futures market provides additional information on current and future earnings and valuation.
Over the next few years, we may observe the growth of this relatively new futures market and learn to take advantage of the opportunities it presents for trading and hedging for buyers and sellers of steel products.
Paul Cretien is an investment analyst and financial case writer. His e-mail is PaulDCretien@aol.com.
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