20120516 tsi market watch us producers reach for reset button

© The Steel Index 2013. The Steel Index is owned by Platts, part of McGraw-Hill Financial Inc. www.thesteelindex.com

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TSI Market Watch

May 16, 2013

US Sheet Producers Reach for the “Reset Button”

Unwinding the years

The turn of the century saw US hot rolled coil consumers and producers struggling to take the teeth out

of unexpected market price volatility, recently unshackled by a new level of Chinese competition for raw

materials and a globally-uplifted demand for finished products. American steel buyers and vendors led

the ferrous industry in the adoption of indices as a way of managing the effects of suddenly-

unpredictable prices.

Prior to this adoption, bilateral mill-customer negotiations had often become bitter and acrimonious as

the new cost dynamics represented such a discontinuity from the long march of recent history. It is easy

to understand why: the highest upward month-on-month (m-o-m) push between the Januarys of 1994-

2002 had been US$17.50/short ton. 2002 onwards saw not just a plethora of price increases, but many

more of over US$20, US$30, US$40/s.ton, and even the previously unthinkable US$100/s.ton increase

happened twice in 2004!

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1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Instances of +US$10/s.ton upward move

Average Price Movement US$/s.ton (RHS)

Steel purchasing became a white-knuckle ride from 2002

The number of upward moves in prices took off, while the absolute size of the individual price rises became eye-popping: a complete departure from previous experience

Millennium: ENTER the BULL


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Putting this in perspective, the sum of the upward moves in 2004 was only US$71/s.ton less than all of

the US sheet market’s gains between January 1994 and December 2003.

With that backdrop, it is natural that there was a pressing need to avoid a price focus and find

mechanisms which allowed the flow of material from mill to customer without continuous renegotiation.

While the cost of steel is important, manufacturers also know full well that what is more expensive is idle

machinery and workforces standing by without material to process.

So, from 2004, index-linked pricing crept into the US sheet market and rapidly gained traction. This

(quiet) revolution had a number of far-reaching knock-on effects that, at the time, went largely

unnoticed. It surprised even index creators themselves, who first noticed that companies were

embedding indices into their sales and puchasing arrangements sometime around 2006!

Over time, the proportion of the US market using indexing rose to the point where more than 50% of the

market are using indices to price steel today. In the process, US sheet markets ‘commoditised’ HRC - all

HRC rollings became equal in the eyes of indexed sales agreements.

Trouble at the mill

So…what has gone wrong in the birthplace of finished steel index-linked pricing?

Well, not much from a

buyer’s perspective, but the

solution has certainly soured

for producers. Indexing has

been successful in other

industries, notably the

ferrous raw materials

markets …but why not steel?

Firstly, the widespread

introduction of index-linked pricing in US HRC inadvertently led to a sweeping ‘homogenisation’ of the

market. Indexation ‘flattened’ product differentiation. Gauge, width, chemistry tolerances, surface finish

and defect rates all too often got ignored. Whether the product was auto-grade, welded pipe feedstock,

destined for use in grain silos, mill-trim/edge-dressed, etc., they were frequently all subjected to the

same index-linked pricing treatment.


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Secondly, North American consumers were extremely successful in persuading mills to give a discount to

the index, in exchange for getting ‘guaranteed tons’ each month. Other parts of the ferrous supply chain

have not given discounts, other than for quality differentials from the index specification.

Worse than that (from a mill’s perspective), the US marketplace for steel has been extremely

competitive for many years, with some producers offering deeper and deeper discounts. The -7%

example above is far from an extreme example of the margin erosion and value destruction that mills

have suffered. This has eroded negotiating positions at even more-disciplined mills which have found

themselves faced with customers ever more confident they can achieve better deals.

A consequence of this was that mill order books became a poor combination of spot and discount-to-

spot, with the vast majority at a seemingly ever-increasing discount. In fact the very best that mills could

contemplate was achieving the spot price!

With the exit of some producers from the marketplace, those still standing are taking stock and drawing

a line in the sand. ArcelorMittal went on record recently to say they would not be entering into any more

CRU index-minus deals and other producers such as Severstal and Nucor have been communicating

similar messages to their clients.

In short, the status quo had become unsustainable for mills. It was only a matter of time before they

either went out of business or demanded a change in pricing practices. And that time has arrived. The

harder question to answer is… what to introduce instead?

With little access to upside, mills have been slowly ex-sanguinated by anemic margins

“Index-minus” a bad sales plan

US$/short ton Index Price “Index -minus” 7% Value Foregone

January 2012 729 678 -51

February 2012 729 678 -51

March 2012 689 641 -48

April 2012 685 637 -48

May 2012 660 614 -46

June 2012 620 577 -43

July 2012 606 564 -42

August 2012 649 604 -45

September 2012 645 600 -45

October 2012 592 550 -42

November 2012 621 577 -44

December 2012 640 595 -45


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An increasingly homogenous environment seeks variety

It is an often-repeated mantra that there is strength in diversity. There is truth to this and the US sheet

market has suffered from an increasing uniformity of pricing.

Certainly, a lack of differences in pricing mechanisms meant that there was little ‘shielding’ for mill

margins when prices moved south. Discounting spot index-lined arrangements simply added “gearing” to

downside pain.

The impact was less acute when there was a portfolio of pricing arrangements in a mill’s order book -

spot, monthly, quarterly and annual deals were all part of the fabric. Fluctuating margins for steel

producers are inevitable, but a portfolio approach to selling can dampen margin volatiliy.

Indexing, however, is not about to exit the stage. Indices are powerful tools, for both buyers and sellers.

It is hard to find better tools for handling pricing in volatile markets and other sectors have shown

indexing can work successfully. Moreover, the advantages are compelling for both parties, and often

symmetrical.

So, if indexing is too useful to throw away, what then?

All options remain on the table

In conversations with the market, it seems that three fundamental options are on the table:

Advantages for Steel Buyers

Smooth intra-month pricing volatility

Get supplier to focus on improving non-price factors (JIT/credit/quality/service)

Avoid buying in short-term price peaks

Avoid being “the buyer that paid the most” (indexing’s averaging effect)

Guarantee supply of material for processing

Costs known one month in advance

Avoid repeat negotiations/negotiation breakdowns

Advantages for Steel Sellers

Smooth intra-month pricing volatility

Index customers become stickier (barrier to switching). Focus on value-added.

Avoid selling into short-term price troughs

Avoid being the cheapest seller

Know minimum booked tons per month for production

Prices known one month in advance

Avoid repeat negotiations/negotiation breakdowns

Indexing too useful to throw away:

benefits often symmetrical


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1) Move wholesale to guaranteed prices, using the forward (derivatives) market to lock-in prices for

customers

2) Return to bilateral negotiations

3) Call a reset on the index or the type of indexing being used.

Moving forward, there may be a little of the first option, as well as a little of the second, though these

are unlikely to be attractive or feasible for buyers and mills for the majority of their business. This leaves

option 3 as the key area for further consideration: various resets of index-linked pricing approaches.

Index Reset Options

Something Old

Continuing with the status quo seems not to be an option. It is rare to see US mills agreed on anything,

but this appears to be a singular example of unified opposition to carrying on as is.

Is it likely that they will get their way? Nothing is guaranteed – but recent history from raw materials

(iron ore, coking coal) suggests that determined changes in sales mechanisms from producers tend to be

achieved. That said, these industries are more consolidated on the supply side than the US hot rolled

coil industry, which prevented fragmentation of unity or dissolution of discipline in adhering to a line.

In addition, in these raw material sectors, there was a clear shift from one structure to a new structure.

Annual fixed to quarterly index-linked, or quarterly to monthly indexing, and so on.

And yet the balance of power is shifting, as some US mills at the top end of the cost curve have been

idled (competition eased), demand post the global financial crisis slowly returns and previously-

effervescent raw material costs abate.

In the case of HRC, the simplest proposal is to abolish discounting. In effect, simply move to something

less attractive to buyers. But why would buyers accept ‘CRU index, minus’ simply becoming…’CRU

index’? A sweeping change affecting all buyers negatively is unlikely to be achievable: treating steel end-

consumers as a single bloc will simply pit the buy and sell sides directly against each other. A choice is

better received than an edict, so it is more likely that a variety of approaches will be pursued.

Something New

Some alternative index-linked arrangements are also being mooted, aiming to differentiate from the

previous approach.

Raw Material Basket adjustments

One alternative strategy is to use a starting price for HRC, followed by adjustments made via a weighted

basket of raw materials. Each month, changes in the feedstock of prices for mills can be applied to that

starting price, to prevent any untenanble drift away from that initial starting price. Raw materials can be


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weighted in terms of how much each contributes to a mill’s cost structure i.e. iron ore 35%, met coal,

33%, scrap 23%.

This allows for a price mutually agreeable to both sides to be buffeted up and down, fairly, by the

prevailing cost movements in these individual markets. Like the existing direct HRC indexing, this

approach prevents mills and buyers having to negotiate frequent changes to final hot rolled coil prices.

One additional positive from this is the potential for self-cancellation in price movements, limiting price

movements and hence volatility in the HRC price. Scrap prices could be flat, iron ore down and coking

coal up: the net result could very conceivably be a net ‘zero’ adjustment factor to HRC prices for that

month.

On the downside, this approach is more complicated than using a straight HRC index. The formula in

each contract for determining the price would itself be complex - incorporating all of the agreed raw

material components in appropriate proportions - and, as each mill has a different cost structure, the

formula itself would likely differ by mill.

Bushelling scrap + fixed conversion margin

This option is being discussed and considered by some US sheet market participants, although it is

something which has been heavily resisted elsewhere in the steel world. In this scenario, a steel mill and

the customer agree to fix to an index of bushelling scrap + a conversion margin. Sometimes referred to

as ‘tolling’ – as the mill becomes a convertor that the customer ‘hires’ to convert scrap to sheet.

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Tolled premia/discount to spot (RHS)

Tolled HRC FOB

Open Market HRC FOB

Tolling arrangement…

US$/s.ton US$/s.ton

A tolling arrangement pays a flat fee for converting raw materials: so prices behave differently from those on the ‘open market’ which reflect supply and demand, not a fixed margin

Example: Tolling Margin = $235/s.ton

US$/short tonBusheling #1

N.AmTolling Margin

(example)Tolled HRC

Ex-millOpen MarketHRC Ex-mill

Jan 12 531.5 235 766.5 730.5

Feb 12 470 235 705 719

Mar 12 465 235 700 687

Apr 12 455 235 690 682

May 12 444.5 235 680.5 654

Jun 12 380 235 615 611.5

Jul 12 344.5 235 597.5 608

Aug 12 407.5 235 642.5 665

Sep 12 397.5 235 632.5 642

Oct 12 346.5 235 581.5 597.5

Nov 12 372.5 235 607.5 644.5

Dec 12 387 235 622 639


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Selling this way will certainly give a different earnings profile. The question is whether a mutually-

acceptable margin can be arranged and whether a producer can tolerate foregoing upside in the open

market, when competitors would enjoy healthy returns, in exchange for avoiding the squeeze in a

downturn?

Something…Blue

Here are 3 options that TSI offers as viable alternatives.

1. Differentiated Indexing

All customer needs are not homogenous, nor is coil quality.

By sector: e.g. Auto = TSI HRC index plus; Construction = TSI HRC index minus; Vessels = TSI parity

By tolerance, width, gauge, coil weight… extras/discounts

By surface finish, crown, edge… extras/discounts

By service level, delivery lead-time… extras/discounts.

2. New Index, new rules/Blended Index

In announcing an index “reset”, US mills are seeking a change of behavior in the market. As any

psychologist will tell you, behavioral change is hard to achieve if the environment and the tools remain

the same. Although the encumbent index may not be the cause of the problem, changing the index – to

another or to a blend of indices - can help achieve that discontinuity so crucial for a new approach to be

accepted in the market.

A full index reset, along with actual guaranteed (stipulated) tons, can be attractive to both mills and

buyers. To be sustainable, it is essential that discounts to index levels do not become embedded and

systemic in pricing arrangements and that the index (or indices) chosen accurately reflect the spot

market average and buyers’/sellers’ own experiences on a robust and timely basis.

3. A Baseline with index adjustments – e.g. June 2013 = ‘100’

There is the opportunity to introduce heterogeneity back into the marketplace, simply by bilaterally

negotiating a new start price for HRC and then making a monthly adjustment to that, using the change in

an index to inflate or deflate that by a certain percentage. This gets away from the martketplace seeing

the index as the headline price (ripe for negotiation) and enables mills to achieve different prices with

different customers.

Whichever way is chosen, and a few may well be, buyers and sellers should think long and hard about

the index they use. Who produces it? Is it sustainable? Is it worth using a ‘basket’ as other ferrous

industries do? Is it worth using a few? Does assessment frequency matter?

Change is coming…


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Summary

To conclude, the US sheet market is a diversely-populated pyramid industry. One reason for the current

malaise has been the adoption of an inappropriate ‘one-size-fits-all’ approach to sheet pricing.

A portfolio of selling/buying approaches is likely to emerge: making the outcomes for buyers and sellers

more diffuse and, overall, resilient. ‘Choice’ and diversity are key components for success moving

forward.

This varied market cannot be straitjacketed into a single pricing approach. If “indexing v1.0” was helpful,

but flawed, expect a far more sophisticated approach in “indexing v2.0”.

Expect term contracts (hedged, on exchange), limited tolling, raw material basket driven indices,

bilaterally negotiated starting points adjusted incrementally by index-change moves and selling on a

variety of indices.

It is likely that mills will come forward with a new toolbox of pricing mechanisms during the next few

months, with indexing still the central theme, but with different tools designed for different products,

different pricing terms and different types of customer.

If you would like to explore these issues further with TSI, or examine how TSI’s pricing data could be used

in your business, please do not hesitate to contact us.

Pittsburgh: Kurt Fowler Tel: +1 412 431 0584 [email protected]

London: Steven Randall Tel: +44 20 7176 7667 [email protected]

Singapore: Tim Hard Tel: +65 6532 2800 [email protected]

TSI compiles a daily US Midwest HRC price, using its renowned and respected methodology. Like all TSI’s

steel, scrap and iron ore indices, it is an ‘open-access’ index: any reputable company involved in spot

trade can participate as a data provider to TSI, having passed our screening and signed our engagement

agreement. Partiicpation is not restricted by invitation. Price history, derived from submitted transaction

prices, is available from 2006.

mailto:[email protected]



https://www.thesteelindex.com/en/procedures-methodology/


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About The Steel Index (TSI)

The Steel Index (TSI) is a leading specialist provider of impartial iron ore, steel and scrap price information based on spot market

transactions worldwide. TSI will also shortly launch coking coal reference prices.

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and steel products. TSI’s index reference prices are then calculated using transparent and verifiable procedures.

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their physical pricing arrangements. TSI’s indices are also used as the industry standard in the settlement of ferrous financ ial

contracts.

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20120516 tsi market watch us producers reach for reset button