The futures, the physical, and the steel and iron ore prices

The winds of change are blowing in the global steel market, as heightened volatility and macroeconomic factors increasingly affect the supply chain. Nowhere is this change more clear than in the growing importance of futures — which many carbon steelmakers have viewed with suspicion for many years.

The question is: to what extent do futures markets actually impact the physical?

In March-April this year there was an explosion in Chinese steel pricing, which had gigantic ripple effects on the global supply chain. The more stellar first-half results of European steelmakers can, in part, be attributed to that huge run-up — rocketing Chinese domestic prices made its export offers much more expensive, giving mills in Europe a more captive market and the ability to export into wider geographies than just a few weeks/months previously.

At the start of this rise, on March 7, the price of square billet in Tangshan ballooned from Yuan 1,780/mt to Yuan 2,130/mt (an increase of around $55/mt at today’s foreign exchange rate). Many attributed the shock move to climbing futures prices — on the same day, the third forward month rebar contract on the Shanghai Futures Exchange firmed from Yuan 1,987/mt to Yuan 2,073/mt (that’s less than $15/mt as of August 1’s forex).

The SHFE rebar contract is often deemed a speculator’s haven; a place for day-traders and punters with no physical exposure to gamble hot money — a viewpoint that has been cemented since the frenzy that engulfed Shanghai equities last year, after which Beijing intervened to stabilize the market and bundles of investors fled in search of better alpha.

However, there’s a correlation between SHFE and the physical market, at 91% since the start of 2015, according to S&P Global Platts data. SHFE undoubtedly drives sentiment to an extent in China, and everyone knows China’s steel market is heavily influenced by sentiment on a day-to-day basis.


“China futures to physical market [link] appears to be strongest at the moment and informing physical as opposed to the other way round,” one trader focused on China said.

“We take risk on the SHFE rebar; we haven’t used it to cover physical risk,” one derivatives trader said, suggesting the basis risk is too high. He did suggest, however, that Dalian ore and SHFE rebar are affecting the physical. “Apart from sentiment, if the physical guys are using them as a hedge it impacts what price they are willing to sell the physical [at].”

Some see physical leading paper

In a research note back in May, Morgan Stanley reiterated its view that restocking and macroeconomic policy changes were the main drivers of actual trade, and the link between paper and physical had been severed by short-term speculators seeking quick returns in China; the average duration of ore/rebar futures contracts in Dalian and Shanghai are a matter of hours.

Only when these speculators on SHFE’s rebar and the Dalian Commodity Exchange’s iron ore exit stage right would “conventional risk management strategies” reestablish that linkage, the note said.

March’s move upwards was driven by a hot billet market, according to one iron ore trader. “In the background [there was] steel stockpiles run down to the floor and then a turn in demand/house prices, run on stocks,” he said. Physical billet gave SHFE and DCE their cue, and they ran with the gains as money poured in — daily volumes in Dalian and Shanghai “were stunning” and bigger than the S&P 500 some days, the trader continued.

The graph below evidences the improvement in physical market fundamentals that actually drove the March/April movement. Steel output fell in February and stocks were approaching roughly their lowest level of the year, so there was clearly more tightness in consumption/demand — apparent demand was also accounting for output to a large extent as buyers took more material than some had expected post-Lunar New Year.


Dalian, a ‘broken contract’

Focusing on iron ore futures, the Dalian Commodity Exchange’s contract is clearly a hotbed of liquidity, far outstripping the volumes done anywhere else. And there is, again, strong correlation with the physical indices. But it is not a contract that people look to hedge seaborne trade via, although some traders are backing out quayside trade with Dalian.

The majority of participants on Dalian are retail investors trading months far forward in fear of physical delivery (because who wants tons of iron ore turning up on their doorstep?); Chinese commodity exchanges often encourage retail investors with small lot sizes.

The lack of physical delivery prevents Dalian from moving in line with the physical indices and reference prices — if you buy a September contract, you should expect delivery in September, and that ensures the contract converges with spot value.
But on Dalian, open interest just shifts to the next most liquid month and never gets to settlement, so there is no convergence.

The graph encapsulates the issues with Dalian — open interest is a tiny portion of trade, at a mere 4% last month, showing the amount of churn and short-term positions being held and liquidated day-to-day.

Still, Chinese buyers of iron ore and steel certainly look to Dalian – as well as SHFE — before deciding whether to enter the market or not.


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