Futures Daily: Nanjing Iron & Steel Co., Ltd: Grow with Screw Thread Steel Futures

Updated on: August 23, 2017

Reported by Chen Donglin, Journalist from Futures Daily

Establishing hedging systems and sharing futures market development benefits

Introduction

It has been nearly eight years since the screw thread steel futures were traded in SHFE in 2009. From the limited transaction scale at the beginning to the current high degree of fitting between forward and spot prices as well as the participation of customers from various industries, many corporate customers have gained profits from it. Nanjing Iron & Steel Co., Ltd (hereinafter referred to as “NISCO”) is one of such corporate customers. During the process, they have not only gained benefits brought by the futures market but also accumulated abundant experience of utilizing futures.

Rich hedging experience and increasingly mature strategies

According to relevant information, at the beginning of participating in the futures market, NISCO had always been prudent and eager to learn something from futures trading due to the lack of relevant knowledge and experience and the worry about the risks caused by price fluctuations in financial market.

“We have kept studying these years due to the emphasis and supports from the management. With the help and guidance from SHFE and relevant futures companies, NISCO has lowered all relevant risks during production and marketing through comprehensive hedging and basis trading and enhanced enterprise revenues. In addition, it has established sophisticated internal coordination system and risk control system based on its idea that finance can serve business operation.” Cai Yongzheng, from the Securities Department of NISCO, told the Futures Daily during the interview. During the process, they have not only got the profits of the futures market, but also gained abundant experience that can be shared to the market.

Established in 1958, NISCO specializes in ferrous metal smelting and rolling and sales of rolled steel, billet and other metal materials. With complete production lines for iron ore selection, coking, sintering, pelletizing, iron smelting, steel making (including refining) and steel rolling (including thermal treatment) and the comprehensive productive capacity of producing 10 million tons of steel, 9 million tons of iron and 9.4 million tons of rolled steel annually, NISCO is a large-scale iron and steel complex with medium plate and excellent long steel products as its leading products. According to Cai Yongzheng, the enormous output and various product lines of NISCO have made it have increasingly strong demands of utilizing modern financial instruments such as futures to manage risks and enhance profits.

“In terms of futures operation mode and strategy, NISCO has gradually explored some suitable and mature systems combining futures and spot trading and it has adhered to the principle of advancing with the times and keeping flexible. Currently, the futures operation of NISCO is performed at three levels.” Cai Yongzheng said. The first layer is basic hedging. It is mainly specific to the risks caused by the fluctuations in the purchase prices of raw materials and sales prices of rolled steel. For the procurement of raw materials, the products such as iron ores, coke and coking coal can be combined to purchase hedging so as to fix about 60% of production cost for long-term orders.

For example, NISCO signed a fixed-price long-term order in April 2016, and the gross margin of the order was RMB 208/ton. When the order was signed, the costs of materials for spot goods were RMB 433/ton (USD 53/ton) for iron ore and RMB 900/ton for coke. On May 10^th, 2016, NISCO opened a position on Contract 1701 for hedging. At that time, the futures price of Contract 1701 for iron ores was RMB 354/ton (USD 42/ton) and that for coke was RMB 903/ton. Later the prices of such raw materials rose dramatically. On August 22^nd, in terms of spot goods, the Platts Index for iron ores was RMB 61/ton monthly, the purchase price of coke in July was RMB 1,165/ton. As a result, the profit of NISCO was RMB 290/ton short if calculated as per spot goods, and the gross margin of the order was RMB -82/ton. However, calculated after closing the position of futures, the price of iron ores for Contract 1701 on August 22^nd was RMB 445/ton (USD 53/ton) and that of coke for Contract 1701 was RMB 1,259/ton. As a result, the profit of NISCO for futures was RMB 378/ton. Finally, after hedging the futures and spot goods, NISCO not only retained the original gross margin of RMB 208/ton but also gained an increase of RMB 88/ton for the order.

The basic hedging of NISCO also includes the hedging of selling rolled steel inventory, namely retaining the gross margin of pre-sold rolled steel, billets and open billet inventory and maintaining the value of relevant inventory by selling rolled steel futures to prevent losses on inventory valuation due to price dropping.

For example, in June 2015, considering that The Youth Olympic Games would be held in Nanjing in August, many construction sites had stopped working successively. The demands of rolled steel were affected as a result. And the inventory of NISCO rose dramatically. During the period that the futures price and spot price of screw thread steel were basically the same, NISCO found opportunities to sell the futures of screw thread steel for hedging. The facts prove that the price of rolled steel dropped substantially in East China after the decline of the demands of many construction sites. In June and July of 2015, the drop of spot price made the inventory loss at RMB 150/ton. However, due to the hedging of position liquidation price of RMB 2,363/ton for Contract RB1510, it declined to RMB 2,285/ton during the period that the futures price and spot price of screw thread steel were basically the same, NISCO earned RMB 78/ton for futures as a result. Finally, the loss was reduced to RMB 72/ton from RMB 150/ton.

According to Cai Yongzheng, the second layer of futures hedging is strategic hedging. Strategic hedging includes two aspects as well: One is the strategic hedging for crude fuels and the other is that for rolled steel inventory. The strategic hedging for crude fuels is to perform strategic position opening by using the non-rational trends of coke ore prices in futures market. Properly increase monthly or quarterly crude fuel futures to relieve the “negative price scissors” dramatically. In principle, the amount of hedging shall not exceed that of purchased open crude fuels. The strategic hedging for rolled steel inventory focuses on the basis between futures price and spot price. Compared with futures and spot prices, screw thread steel futures can be sold when there is abnormal trend of screw thread price in the futures market to hedge the risks of drop in price of rolled steel in later period. In order to prevent the risks of drop in price of inventory caused by interim price drop, presale hedging can be conducted for monthly or quarterly rolled steel inventory, and the amount of hedging shall not exceed the monthly output of rolled steel.

“Due to recent fluctuations of steel prices at high levels and the profits of steel plants return to normal levels, we have attached great importance to the arbitrage strategy of virtual steel plants with each passing day.” said Cai Yongzheng. The third layer of NISCO’s futures hedging is arbitrage of virtual steel plant. A virtual steel plant can fix the positive gross margin convergence arbitrage opportunity on the market by performing hedging transactions of screw thread steel products on the futures market and iron ores and coke as raw materials. Likewise, the arbitrage of a virtual steel plant includes two aspects: one is short selling of the profits of a steel plant and the other is going long of its profit, both containing industry supply operation logic.

Performing virtual steel plant arbitrage is to solve the problem that any steel plant cannot fix or continue profits during high gross margin periods. In such high gross margin periods, steel plants usually cannot fix or continue high gross margins of current stage due to the restrictions of output, capital or inventory management. However, the forward trading and margin requirement of futures contracts have made it possible. A steel plant may purchase the contracts of iron ore and coke at the same time by selling the futures contract of screw thread steel to make going-long of the steel plant, vice versa, it may sell the contracts of iron ore, coking coal and coke by purchasing the futures contract of screw thread steel to make short-selling of the steel plant. By performing either of the above two, closing position can be made to get profits after the profit level of the futures market returns to a normal range.

According to Cai Yongzheng, it is worth noting that price discovery is a major function of the futures as well. The future price is expectation on the future and the futures market has the function of price discovery. As a result, NISCO has analyzed the inventory, turnover and price changes of futures products on a regular basis. Relevant information can be used for providing bases for enterprise procurement and marketing decisions to a certain degree by combining spot market conditions. Currently, the purchasing department of NISCO compares the prices of the futures and spot markets.

According to the introduction, futures have been an indispensable part of NISCO for its routine operation. The futures department participates in weekly operation analysis meetings, analyzes relevant futures and spot market conditions and provides relevant strategies to cope with the risks caused by rises in prices and cost rises of iron ore, coking coal and coke and loss from falling prices of rolled steel.

Using basis trading to assist enterprise operation

During the interview, the journalist learned that basis is an important factor for consideration in NISCO’s combination of futures and spot markets. In order to learn and practice basis trading, the Futures Investment Department of NISCO has contacted and exchanged ideas with institutional investors such as Shanghai ICO Steel, Hangzhou CIEC and Whiterock Asset to learn and research the basis arbitrage trading in the futures and spot markets. Cai Yongzheng introduced that after making the exchanges and learning, NISCO realized that it is necessary to shift its objective to seek stable processing profits and fix such processing profits from previous seeking production scale by using the measures such as basis arbitrage on the futures and spot markets.

Basis trading is undoubtedly a good measure for the stable operation of an enterprise. However, during specific practices, the enterprise still needs to solve some issues, such as discontinuous contracts of iron ore, coking coal and coke and large basis between futures and spots of coke. Because steel plants use monthly and 10-day pricing models for the spot goods of coke, the prices are discontinuous and the ranges of price fluctuations are not as large as futures. Futures contracts are continuous transactions, and delivered underlying assets are closer to imported coking coal. As a result, the basis between the two is large. Steel plants will face large basis risks by using it for futures hedging.

Cai Yongzheng said that, based on NISCO’s experience, if it’s difficult to control the spot arbitrage level of basis trading, the spot goods department is required to make rational calculations, in particular under the circumstances of coke risk exposures. The price fluctuations of the spot market are large and the prices of different areas have certain variations as well. As a result, it is difficult to select fair prices recognized by both parties. In addition, it should be noted that the signing of spot contracts is complicated, involving two departments, namely raw materials procurement and sales of rolled steel.

The involvement of futures in the production and sales of spot goods has dramatically enhanced the company’s competitiveness and built up its capital barrier. The journalist learned that many steel plants were inactive in receiving orders after calculating that the gross margin was meager at the second half of 2015 for the cost slightly rose. For some orders, the loss might be RMB 50/ton. On the contrary, NISCO made calculations by combining futures and spot goods. And the loss of RMB 50/ton was charged off basically due to the discounts of forward futures contracts. The gross margin of some orders was as low as less than RMB 1. There would be no orders if NISCO didn’t take them. After taking these orders, the gross margin was increased by using the discounts of futures contracts. As a result, the production and operation were stabilized and favorable hedging effects were achieved. According to Cai Yongzheng, NISCO has enhanced its degree of taking orders by using the discounts of futures. It has not only got many valuable orders but also alleviated the working pressure of spot business personnel.

Cooperation of various parties and comprehensive evaluation of futures and spot goods

“For enterprises using futures instruments, the relationship between futures business and spot business and the two departments are independent or consolidated act as key factors for successful futures business.” Cai Yongzheng introduced.

NISCO’s futures business and spot business supplement each other. Although the futures department is independent compared with other spot departments, it has used modular operation in actual operation. The futures department cooperates with the hedging requirements of all spot divisions to establish plans, submit documents for approvals and conduct specific work, and the personnel of the department is few as well. Relevant personnel hold weekly operation analysis meetings and conduct exchanges and meetings on an unscheduled basis and make rapid and sufficient communication based on some information groups.

In terms of hedging range, NISCO has only dealt with the current futures products produced and operated by it as per the Management System of Steel Industry Futures Hedging, including but not limited to rolled steel, iron ore, coking coal, coke, iron alloy, and nickel plates.

As for hedging position, the amounts of relevant fuel products required for long-term price-fixing orders are not generally exceeded in actual operations. According to Cai’s introduction, generally speaking, the amount of rolled steel sold by NISCO for hedging does not exceed its monthly output of rolled steel. In addition, its actual amount for hedging will be controlled as per market trends. The Financial Department is responsible for allocating after relevant plans are approved.

“In terms of accounting, futures are recorded in ‘trading financial assets’ or ‘trading financial liabilities’, the price fluctuations of futures are listed in ‘changes in fair value recognized in profits or losses. Currently the futures and spot are calculated separately.” Cai Yongzheng said. As for specific transaction procedures, the spot division initiates a declaration as per orders and inventory hedging requirements; the securities department establishes a plan after receiving the above declaration and reports it to the decision-making group for approval. After the approval is finished, the securities department is responsible for execution. Later on, production schedules are made for spot goods or finished products are sold or delivered. In principle, the futures shall have equal position liquidation, and hedging results will be evaluated after futures and spot hedging is finished. The hedging of NISCO is not profit-oriented but considering profits and loss by combining futures and spot markets. After relevant plans are approved, NISCO will mainly focus on position-opening opportunities and proper prices.

Cai Yongzheng also said that the hedging of futures is professional. In order to enhance the coordination and efficiency of the futures and spot departments, NISCO will conduct in-house trainings on futures hedging on an irregular basis so as to enhance relevant efficiency and effects.

Improving risk control measures and seeking stable profits

As for risk control, Cai Yongzheng said: “In case of any emergency, first of all, we will promptly report. We have been adhering to the daily report system. We will contact our customers by phone calls to inform them about such emergencies and provide opinions for execution. Secondly, all hedging plans are reserved with 100% of risk deposit; in addition, the futures department has the right to allocate the funds in each account to prevent market fluctuation risks; thirdly, the financial department uses the cash deposit monitoring center account for backstage supervision from the perspective of fund supervision.”

After a plan is approved by the decision-making group, the securities department will open a position as per the price and quantity specified in the plan. Upon the completion of transactions on each day, the social media tools such as WeChat and DingTalk will be used to inform the decision-making group and the spot division about latest news so as to let them make relevant hedging arrangements.

According to introduction, relevant departments of NISCO will make predictions when making plans and reserve sufficient risk deposit. They will promptly report and allocate funds in case of any market fluctuation; the futures deposit will be monitored daily after it is transferred to the financial department; in principle, loss stop is not considered for long-term price-fixing orders.

According to Cai, in case of unrealized losses caused by abnormal price fluctuations during trading of futures, relevant personnel mainly find out the causes for abnormal price fluctuations, in particular judging they are short-term disturbances or long-term tendencies. If they are short-term disturbances, proper purchases will be made if allowed by funds. If they are medium and long-term tendencies, loss stop will be performed correspondingly.

Cai Yongzheng also expressed that NISCO emphasizes basis changes for futures operation. It regards basis as the foundation for hedging instead of conducting transactions based on feelings. It will not make hedging immediately in case any basis is unfavorable.

Based on Cai’s introduction, for next stage prospects, the objective of NISCO is to stabilize basis hedging, grasp opportunities for strategic hedging and make achievements for arbitrage of futures and spot markets.

Firstly, NISCO will explore the channels of listing the utilization of financial derivative instruments into NISCO’s strategic level. NISCO will shift its objective to seek stable processing profits and fix such processing profits from previous seeking production scale by using the measures such as basis arbitrage on the futures and spot markets.

Secondly, NISCO will improve its system of utilizing financial derivative instruments. Cai Yongzheng introduced that, on one hand, NISCO will keep building up its R & D team. Besides using external help, it will mainly integrate its in-house resources, use the networked ways made by Fosun, and adopt modules to deal with corresponding futures products. On the other hand, NISCO will keep improving its risk control system and asking financial and legal affairs departments to appoint special persons to control relevant risks.