Scrap Futures for Demolition Firms
Prepared by Daniel Uslander, High Ridge Futures LLC
Although ferrous scrap futures came onto the scene a few years ago, it's only in the last year that they are getting a serious look. Calendar 2016 saw a concerted effort by the London Metals Exchange to recruit customers and market makers, and they met with some success. According to a market newsletter circulated by LME staff, about 500,000 MT of scrap futures and 100,000 MT of rebar futures traded on the LME in 2016. In 2016 approximately 30 different companies participated in the LME scrap trade and about 20 firms were involved in rebar futures.
Now that we are out of the gate, we can start to look at some of the ways futures and hedging strategies can be used along the scrap supply chain. If the development of other successful futures markets is a guide, strategies that may seem very “cutting edge” at this moment will be routine in only a few years. With that in mind, consider the challenges faced by demolition firms. Depending on market conditions, they are paid to demolish or they they may demolish for no charge in order to retain and sell the scrap. Jobs may be bid weeks in advance or many months in advance. Start dates and completion dates can be affected by weather, permitting issues or other considerations. In short, there are a myriad of uncertainties that demolition firms struggle with as they sit down to cost and bid a job. Monies received through scrap sales is a moving target that affects their ability to make winning bids since scrap prices are in a steady state of flux.
Ferrous recyclers are uniquely positioned to provide a solution that can help demolition firms manage one of their major uncertainties--revenues generated through scrap sales. As an illustration, consider a hypothetical firm, XYZ Wrecking. It’s January and they are bidding a demo job scheduled to start on or about March 1st; material to be delivered to our imaginary recycling firm, ABC Recycling, by the end of March. XYZ estimates that the job can yield 1000 gross tons of scrap. With the export price at about $300 per MT, assume that ABC and its competitors are currently indicating that if the material were delivered today, the bid price would be around $200 per GT. That’s $200,000 in revenue to XYZ if the metal was available today. Of course, the material won’t show up until the second half of March, in about 60 days. Who knows what the price will be at that time.
This is where ABC Recycling can step in with the following alternative way of quoting: say that ABC told XYZ Wrecking that instead of a flat price, ABC will pay them $100 under the final settlement of the March LME scrap futures contract. To keep the numbers simple, say the current price for March futures is also $300. XYZ could contact their broker, assess the futures market, and determine that they could sell 100 contracts (each contract is for 10 MT) at $300. So provided the estimated yield from the job of 1000 tons is reasonable, XYZ could use a futures hedge to preserve net total revenue of approximately $200,000 even if overall market conditions weaken, resulting in ABC’s offers to XYZ at the end of March being lower.
Let’s fast forward to April 1st. The 1000 tons is now in ABC’s yard and prices are $30 lower. The futures contract for March expired with a final settlement price of $270, meaning that ABC’s price paid to XYZ will be $170 per GT. (That is, ABC is paying $100 under the settlement price.) XYZ earns $170,000 from the sale, $30,000 less than the original January “snapshot” of the market would have suggested. However, in their hedge account held by their futures broker, they sold contracts for $300 that were then marked to market for final settlement at $270. That’s a $30 profit on 100 contracts or $30,000. Net revenue from the scrap remains about ($170,000 + $30,000), or $200,000.
Let’s flip the script. On April 1st, prices are $30 higher; the final settlement price is $330. This time, the formula of “selling 100 under” means that ABC pays XYZ $230 per GT. Now, come final settlement, instead of a profit in the futures account, there is a loss of about $30 per ton, or $30,000. The $30,000 loss in the hedge account is netted against the $230,000 XYZ received from ABC, resulting in realized net revenues of about $200,000.
In the second case the market went up--does that mean XYZ did something “dumb” or ill advised? Not at all. XYZ wanted to quote a job in a competitive environment where there might be incremental differences among the competing bids. Perhaps through hedging, XYZ had a less pressing need to build a larger “cushion” into their bid to protect against the uncertainty of future scrap prices. By being able to prepare the bid with a “sharper pencil”, they won the business. Sure, hedges can be put on because experience and market acumen may suggest that an adverse change in price may be imminent. However, in my experience, hedges are also placed because they help with a company’s normal planning process.
A few caveats: total commission expenses for the futures transactions would be about $25 per contract or $2500 for the hedge to go on and to come off. There is also an exchange fee levied by of LME of .30 per contract; this will result in total exchange fees of $60 for the hedge to be put on and taken off. Next, the illustration has XYZ holding the hedge until settlement. This is a financially settled contract, meaning at final settlement the contracts literally disappear from the account, leaving behind the mark to market gain or loss. These are not contracts that ever trigger a delivery obligation for buyer or seller; they are a financial tool only, not a procurement tool. Holders of these futures positions are always free to liquidate them (subject to market conditions) at any time. There is no obligation to hold until final settlement.
Note that the scenario described does not require our hypothetical recycler to necessarily do anything in the futures market. ABC Recycling is merely offering a novel, alternative pricing policy that may attract and retain business from demolition firms that normally make spur of the moment decisions regarding where to sell their scrap. The hedges you may elect to use in your own business will depend on the overall nature of how material enters and leaves your system.
BE ADVISED THAT TRADING FUTURES AND OPTIONS INVOLVES SUBSTANTIAL RISK OF LOSS AND IS NOT SUITABLE FOR ALL INVESTORS OR PRODUCERS.