Hedging the Risk of Raw Materials Price Fluctuations - Platts · Hedging the Risk of Raw Materials...

Hedging the Risk of Raw Materials Price Fluctuations 19th-20th November 2012

Presented to: 8th Steel Markets Asia Conference 2012 Presented by: G. S. Slavov | Managing Director – Research (Basic Resources & Dry Bulk Freight)

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ICAP Plc. The world’s largest voice & interdealer broker

• World’s largest voice and electronic

interdealer broker with daily average transactions in excess of US$1.4 trillion

• Covers a very broad range of OTC (over-the-counter) financial products and services in commodities, foreign exchange, interest rates, credit and equity markets, as well as data, commentary and indices

• More than 5,000 staff, with a strong presence in each of the three major financial markets - London, New York and Tokyo

• Operates in more than 32 countries • FTSE 100 company

© ICAP Shipping International Limited 2012

8%

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18%

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13%

9%

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39%

2010 2011

Rates

FX

Commodities

Emergingmarkets

Credit

Equities

Revenue by asset class

£1605m £1741m Market Coverage London New York Singapore Hong Kong Rio de Janeiro Sydney

Interest Rates ● ● ● ● ● ●Credit ● ● ● ●Commodities ● ● ● ●Foreign Exchange ● ● ● ● ● ●Equities ● ● ● ●Shipping ● ● ●

Our offices – a non-franchised truly global operation

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London USA China Singapore Delhi Germany Gibraltar

Dry Chartering ■ ■ ■ ■ ■Tanker Chartering ■ ■ ■ ■Projects ■ ■ ■Sale & Purchse ■ ■ ■ ■ ■ ■FFA (Dry bulk) ■ ■FFA (Tanker) ■ ■Research ■ ■ ■

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ICAP Shipping: Over one century of shipbroking expertise

• Headquartered in the heart of London’s financial district with over 230 staff worldwide in Hamburg, Gibraltar, Singapore, Beijing, Shanghai, Copenhagen, New Delhi & Stamford CT, ICAP Shipping delivers shipbroking solutions covering wet and dry cargo chartering, sale and purchase, FFAs, research and operations.

• The company’s proficiency in this area is recognised by its seat on the Baltic Exchange Panel.

• ICAP Shipping is a Member of the Baltic Exchange

• ICAP Shipping shares its roots in the proud history of over a century of tanker and dry cargo shipbroking

• Following a successful JV in freight derivatives with J.E. Hyde, ICAP went on to secure their physical shipbroking business acquiring the company in 2007

• Tanker market presence was significantly enhanced by the integration of Capital Shipbrokers in 2008

• Global market coverage has been fully achieved through organic growth, and through further the acquisition of Skaarup Shipbrokers in the USA, Island Shipbrokers in Singapore & JV with CTI Shipbrokers in India



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ICAP Energy: Largest global commodities franchise


PRODUCT / OFFICE London Amsterdam Bergen Copenhagen Geneva M adrid New York Calgary Houston SingaporeElectricity ■ ■ ■ ■ ■ ■

Natural gas ■ ■ ■

Oil derivatives ■ ■ ■ ■

Weather derivatives ■

Fuel oil ■ ■

Renewables ■ ■ ■

FertilizersCoal ■ ■

Nuclear fuel ■Residual oils ■Emissions ■ ■Cross commodity opt ■ ■ ■

• Ranked #1 European coal broker

2011 by Energy RISK Magazine • Industry expertise in sourcing,

marketing, and facilitating transactions on any energy market

• Range of clients including banks, hedge funds, utilities and producers

• Offices in London, Houston, New York and Louisville covering North American, European, and Australian swaps and options markets

• Only broker to provide 24hr global coverage in the international energy market

• ICAP Energy provides price discovery

and execution services in a wide range of OTC products – coal – crude oil and products – electricity – natural gas – metals – carbon emissions – weather products

• Largest global commodities franchise with over 400 brokers and comprehensive coverage across markets

• Named “Broker of the Year” in a poll of 1,500 market participants conducted by Energy RISK Magazine


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1. Why do we need to hedge?

- Macroeconomic conditions unstable

- Production costs keep rising

- Seasonality & re/de-stocking cycles

- Changing trading environment on the underlying physical markets

- Trade patterns constantly shifting (FOB/CIF arbitrage)

- Raw material prices volatility

- Changing correlation between the asset classes

6 6 6 6 6

• Macroeconomic conditions remain challenging with Capacity Utilization flattening and PMI below 2011 levels

• We remain long-term positive but at the same time we cannot ignore some warning signals:

- Industry capacity utilization still below pre-crisis levels - Debt and de-leveraging driven slowdown worldwide - USD strengthening – not US government policy but rather “flight to

quality” - Stagnant manufacturing and sluggish lending - EU27 demand is weak, not expected to pick up this year

Global manufacturing sentiment Industrial capacity utilization

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Jan 08 Jan 09 Jan 10 Jan 11 Jan 12

Index

USA EU JAPAN CHINA


Global Risk Aversion

-4

-3

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-1

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4

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Percent points

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120Index points

USA China World EU Japan (Index)

Short term macroeconomic conditions: Global overview

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per tonne

Steel production cost structure (BF)

Blast margins – imports from Brazil

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per tonne 0.5t Coke (domestic) 1.5t Brazil FOB 1.5t C3 Steelprice basket

US steel production cost structure (EAF)

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per tonne 1.15t scrap 0.44 MWh/MT Rail VA - IN margin Steelprice basket

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per tonne

Blast margins – US production

Short term market outlook: Profitability of steel industry is the key

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Domestic iron ore production seasonality

• Domestic production of iron ore subject to strong seasonal fluctuations • But prices well supported on the back of higher production costs

• The import trend when seasonally adjusted suggests that imports should rise towards Q4

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Mt

Iron ore imports seasonality

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Mt

2010 2009 2008 20072006 2005 2004 2003

2011 Average 2012


Short term market outlook: Seasonality in play

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Sep-11 Dec-11 Mar-12 Jun-12 Sep-12

$/tonne

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70Mln Tonne

China IO Imports Price Diff

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China’s iron ore imports & price differential • The iron ore production costs in China are generally 2-3 times higher than that in Australia / Brazil.

• The price differential between domestic ore and international ore will affect China’s import appetite. A falling international iron ore prices will eventually push China to rely more on the international market.

• The current port stocks are available for around 32 days of consumption, whereas this level was 21 days in average during 2006-07, and 28 days in average during 2009-10.

• The average level of iron ore stocks at China’s large and medium-sized steel plants is around 21 days, the current level is only 13 days.

• The poor profit margin explains why steel plants postponed their restocking activities.

Short term market outlook: China’s iron ore re/de-stocking cycles


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Days

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-1%

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5%Large and medium-sized steel mills

Monthly profit margin (rhs)

Iron ore stocks at plants & plants’ profit margin Iron ore stocks at China’s major ports

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Days

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120Mln TDays of production IO stocks (rhs)

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Market volatility & uncertainty: Price formation & Capacity utilization

FOB-CIF Arbitrage

Source: ICAP, Steelhome, The Baltic Exchange

•Chinese steel production capacity is the most volatile amongst the top 5 producers

•Bearing in mind that China is also the biggest producer in the world, this introduces significant volatility to the market

•Different approach to cope with that is needed…

•The breakdown of the annual contract system created many opportunities

•It also introduced high volatility to a market which was traditionally extremely stable

•Many still struggle to adapt…

China’s iron ore imports & price differential

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Sep-11 Nov-11 Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12

$/tonne

Chinese domestic 62% adjustedIndia CIF 62% adjustedAus CIF 62% adjustedBrazil CIF 62% adjusted

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China IO Imports Price Diff

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2. Forward markets overview

- Paper iron ore trading volumes

- Correlation between spot & forward for steel, iron ore and coking coal

- Market volatility

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Iron ore swaps market: Trading activity

Monthly trading volume (Mln tones)

•The trading volume has increased significantly over the past years

•Q2 2012 registered the highest so far trading volume on record (23mln tonnes). Q3 is expected to far exceed that record…

•Around 8mln tonnes are traded each month as cleared swaps

•We understand that the share of the bilateral transactions keeps falling gradually and it is currently at around 15-20% of total

•We estimate that in 2012 the annual US$ value of the market will exceed $20bn with volume in metric tonnes reaching nearly 140mln tonnes

•This represents around 20% of the underlying physical market (seaborne import flow into China)

Quarterly trading volume vs. Annual US$ value

048

121620242832364044485256

Q2 2009 Q4 2009 Q2 2010 Q4 2010 Q2 2011 Q4 2011 Q2 2012 Q4 2012

Mln mt

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$22Bn us$Market volume (mt) Annual market volume (us$, rhs)

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Annual trading volume vs. Annual US$ value

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Apr-09 Oct-09 Apr-10 Oct-10 Apr-11 Oct-11 Apr-12 Oct-12

Mln tones cleared bilateral


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Steel: Correlations & Volatility Dynamics

Correlation between Spot & Forward

•Correlation between the cash and forward market can vary enormously from -80% to +95%... •Due to number of factors discussed above, over time the correlation have weakened and stabilized around +50% (fairly weak)

Market volatility

•Steel market volatility declined over the last couple of years but pockets of nervousness remain •The average cash market volatility is only marginally lower than the forward market (9.95% vs. 9.98%)

Source: ICAP, Bloomberg © ICAP Shipping International Limited 2011

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Cash 3M

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Iron ore swaps market: Correlations & Volatility Dynamics

Correlation between Spot & Forward

•Correlation between the cash and forward market can vary enormously from -35% to +99%... •Over time the correlation has been steadily weakening (linear regression line in red)

Market volatility

•Iron ore market volatility declined over the last couple of years but pockets of nervousness remain •The average cash market volatility is marginally lower than the forward market (3.8% vs. 3.93??)

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%Cash +1Q

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Coal swaps market correlation

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Spot vs +1M Spot vs +1Q Spot vs. +1Cal

•Correlation between spot physical and the front month contract is strongest •The periods of high correlation appear to be diminishing in terms of duration, as illustrated here by the steadily reducing size of the grey areas •This suggests that we are entering higher risk environment and therefore there will be stronger need for risk management

Coal swaps market volatility

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API4+1M API4+1Q API4+1Cal API4-Spot physical

•Several pockets of high volatility have been identified over the recent years •Their duration has been fairly steady over time, varying between 6 and 12 weeks each •Understanding the structure and duration of volatility is vital for both successful hedging and proprietary trading


Coal: Correlations & Volatility Dynamics

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3. Statistical arbitrage between the spot & paper steel production margins

- What are the cost elements for producing 1 tonne of steel?

- Which production cost centers can be hedged against future adverse price movements?

- Trading scenarios

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Arbitrage: Steel producers cost structure


Iron ore23%

Margin22%

Coal13%

Scrap9%

Fluxes3%

Ferroalloys3%

Emissions2%

Other costs2% Refractories

1%Oxygen

1%

Coal freight1%Electricity

2%IO freight

2%Labour

2%

Scrap freight0%

Depreciation6%

Interest7%

•The major five production cost centers are: iron ore, coal, scrap, interest on existing loans and asset depreciation •These are however not the most volatile one… •Volatility of 10-15% is normal for cost elements such as alloys, emissions, electricity or freight… •The diagram above shows in dark blue the costs which can and should be hedged •We also include these in our statistical arbitrage model

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Iron ore

•Iron ore can be hedged through the available swaps market •The average daily swaps volume is 450-500,000 metric tonnes which gives sufficient liquidity for a small/medium size steel mill to hedge its exposure out

Coal

•Coal can be hedged through the nascent coking coal swaps market •The liquidity is poor with many bilateral transactions typical for the early stages of any market development • Using thermal coal swaps as a proxy should not be excluded as an option on this stage

Freight

•Freight can be hedged through the available swaps market •The average daily swaps volume is 4-4.5mln tonnes which gives sufficient liquidity for any hedging operation

Scrap

•Scrap can be hedged through the available swaps market •The liquidity is poor with many bilateral transactions typical for the early stages of any market development

Ferroalloys

•Ferroalloys can be hedged through the available futures markets for base metals •Two of the most important alloys in the steel making process are ferroaluminum (FeAl) and ferrochrome (FeCr). •The spot market price for FeCr is >+95% correlated to aluminum future price therefore we choose aluminum to hedge also the ferroalloy exposure

Electricity & Emissions

•Electricity can be hedged through the available futures European power markets •Emissions can be hedged through the available futures EUA markets •These are very liquid markets which give sufficient liquidity for any steel mill to hedge

Arbitrage: The alchemy of hedging the steel price

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Arbitrage: Spot (cash) vs. Forward (paper) margin


Both the spread between the margins and the ability to trade in/out each of the components create attractive opportunities

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usd/t

FORWARD MARGINSPOT MARGIN

Scenario 1: Both steel price and raw material costs likely to increase •Buy the raw material components in the forward margin •Leave your steel price exposure open Scenario 2: Both steel price and raw material costs likely to fall •Buy steel futures •Leave your raw material exposure open Scenario 3: Paper margins > Cash margins •Buy raw material components •Sell steel futures

Scenario 4: Paper margins < Cash margins •Sell raw material components •Buy steel futures

Trading scenarios Cash vs. Paper production margins

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4. Reasons to trade the paper margins:

- Challenging macroeconomic conditions

- Mitigating the underlying physical market uncertainty / volatility

- The forward curve provides market transparency

- Improve profitability through locking attractive raw materials price

- Improved liquidity across the asset classes involved in the hedge

Arbitrage: Conclusions

© ICAP Shipping International Limited 2012. This report has been prepared by ICAP Shipping or its affiliates ("ICAP Shipping") and is addressed to ICAP Shipping customers only and is for distribution only under such circumstances as may be permitted by applicable law. This information has no regard to specific investment objectives, financial situation or particular needs of any specific recipient. It is published solely for informational purposes and this information is not, and should not be construed as, an offer or solicitation to sell or buy any product, investment, security or any other financial instrument. ICAP Shipping does not make any representation or warranty, express or implied, as to the accuracy, completeness or correctness of the information contained herein, nor is it intended to be a complete statement or summary of the securities, markets or developments referred to in the report. Neither ICAP Shipping, nor any of its directors, employees or agents, accepts any liability for any loss or damage, howsoever caused, arising from any reliance on any information or views contained in this report. While this report, and any opinions expressed in it, have been derived from sources believed to be reliable and in good faith they are not to be relied upon as authoritative or taken in substitution for the exercise of your own commercial judgment. Any opinions expressed in this report are subject to change without notice and may differ from opinions expressed by other areas of the ICAP group. ICAP Shipping is under no obligation to update or keep current the information contained herein. This report may not be reproduced or redistributed, in whole or in part, without the written permission of ICAP Shipping and ICAP Shipping accepts no liability whatsoever for the action of third parties in the respect. Certain companies in the ICAP Shipping group are authorised and regulated by the Financial Services Authority. This information is the intellectual property of ICAP Shipping. ICAP Shipping and the ICAP Shipping logo are trademarks of the ICAP group. All rights reserved.

Produced by ICAP Shipping Research Chief Knowledge Officer, Global Head of Research, Consultancy and Information Strategy – James Leake Managing Director of Research (Dry Freight & Basic Materials) – Georgi Slavov, FICS

Dry Freight & Basic Materials Analysts - Rui Guo, Stefan Ljubisavljevic

Head of Oil & Tanker Research – Simon Newman Senior Tanker Analyst - Stavroula Betsakou Tanker Analysts – Oliver Burdick, Lichun Zhang

ICAP Shipping International Limited, 2 Broadgate, London EC2M 7UR United Kingdom +44 20 7459 2000 [email protected] www.icapshipping.com ICAP Shipping Derivatives Limited and ICAP Shipping Tanker Derivatives Limited are authorised and regulated by the Financial Services Authority

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