HardAssetsInvestor

Do Steel Futures Have A Future?

It's launch week on the LME for steel futures. Will they succeed?

• The history of nickel and aluminum
• Will futures push prices higher or dampen volatility?
• Customers hedging on use

Do steel futures really have a future?

We're about to find out, as the London Metal Exchange begins open-outcry trading in steel contracts this week. The New York Mercantile Exchange promises to follow at a yet-undetermined date later this year. It could go down as a momentous moment in the history of both the steel industry and the commodities trading world.

Steel is the world's heaviest-traded commodity by value after oil. It's a gigantic - but complex - market that has financial investors salivating at the chance to participate.

That has producers particularly worried. Now speculators will be able to place their bets on the direction of steel prices. And the more transparent marketplace could threaten to burst open the closed-door negotiations that have for so long largely established the pricing terms between producer and consumer.

While the LME is trading physically delivered contracts in Asian and Middle Eastern steel billet, the New York Mercantile Exchange is expected to introduce a financially settled hot-rolled band contract. The Dubai Gold & Commodities Exchange launched a steel futures contract for rebar last year; volumes have been pretty thin so far. Each product will serve a different part of the steel supply chain, and the hope is that eventually the contracts will serve as a benchmark for other steel products.

The LME and other exchanges maintain that futures will give the steel industry the chance to hedge against volatility in prices. The LME goes as far as stating there is no evidence to suggest futures contracts have any effect on price volatility, but rather, provide reliable tools to manage market gyrations. It argues the involvement of funds and speculators may even dampen cycles by allowing investors to take the opposite side to industrial clients.

Those are points certainly up for debate, and many producers - most notably industry leader ArcelorMittal - and other opponents to futures trading say the opposite is true. They believe that bringing speculators into the market will mean more volatility and even higher prices during bull runs. Funds, after all, are known for trading technically - using the guidance of charts and graphs - and that trading style can frequently overextend rallies and declines.

New futures products can take years before finding the liquidity required to be considered a reliable pricing mechanism. The LME aluminum contract, for instance, took almost 10 years after being introduced in 1978 before being fully accepted by the industry.

Will steel make it? And will it help smooth out rallies, or just push the metal to higher highs?

Let's look at a few examples.

Is Nickel A Harbinger For Steel?

Opponents of steel futures like to bring up the fact that nickel, traded at the LME since 1979, has been one volatile beast as of late. The LME price surged to more than $50,000 a tonne a year ago before collapsing to half those levels in just a few months. They suggest that was in large part the work of speculators and investors like hedge funds rather than the commercial players directly involved in the industry.

Others, most notably the exchanges, insist it was just the market reacting to the fundamentals of supply and demand.

When nickel prices started rallying in 2006, production of stainless steel - a big consumer of nickel - was up by more than 15%, fueled in part by the rapid ascent of the Chinese economy. Simultaneously, supplies were hit with several delays to new mines, leading to a supply-demand deficit. Since then, though, the stainless market has come off its boil with producers announcing cutbacks.

So, fundamentals certainly suggested a strong move upward in prices, followed by some cooling. But it's also probable that speculators played off these market conditions and took large positions that could have exaggerated the price movements. Financial speculators account for a sizable portion of investing in metals. For instance, in 2005, index funds alone held about 33% of open interest in nickel on the LME. And index funds generally only have long positions.

Still, most agree that short-term turbulence aside, futures prices over the long haul tend to return to the underlying value of the asset they are supposed to represent. In the case of the LME, this is aided by the exchange's use of stored warehouses of steel that are mostly brandished as a threat of physical delivery. If the LME price appears too high or too low, market players will see favorable pricing opportunities and make use of the delivery mechanism. This risk of delivery helps to ensure the LME price is in line with the physical market price.