China Metallurgical News: Mismatches between Supply and Demand Have Driven Steel Prices to Rise, Risk Management will be an Arduous Task for Steel Companies

Updated on: April 28, 2016

Reported by Wu Yong: Journalist from China Metallurgical News

Steel spot and futures prices have been rising since the beginning of the year, which is unexpected for the market. What has supported and driven it? How to interpret the huge trading volume of futures market? What measures has the futures market taken in terms of risk management of steel companies?

Weak supply is the main reason for the rise in steel prices

In accordance with Galaxy Futures data, from the beginning of this year to late April, Shanghai rebar (HRB400, 20mm) spot price rose by 53% from RMB1,920/ton to RMB2,940/ton, and hot rolled steel spot price rose by 50% from RMB2,200/ton to RMB3,290/ton. As of April 22, the steel composite price index released by China Iron and Steel Association (CISA) was 81.13, rising by 43.9% compared with the beginning of the year.

For this round of price hikes, the market generally believes that it is a need of asset allocation under weak stagnation from the perspective of long term; from the perspective of medium term, it is the result of mismatches between supply and demand against the background of low stock and low capacity utilization rate, coupled with seasonal demand for stock replenishment in the busy season; from the perspective of short term, it is a quick fix for pessimistic expectations.

As for the supply side of steel, China's steel companies have suffered greater losses and a significant reduction in crude steel production since the end of last year, and China's steel production fell by 3.2% on year-on-year basis in the first quarter. As of April 22, the social steel stock was 9.3795 million tons, dropping by 33.3% over the same period last year. Steel supply is at a relatively low level compared with recent years.

Cai Yongzheng, Director of Securities Investment Department of Nanjing Iron & Steel Co., Ltd., told the journalist that the unbalanced flow of credit resources and credit easing was the fundamental reason for this round of steel price hike. Most credit resources have flowed into real estate, automobile, capital construction and other downstream consumer industries of steel, leading to the start of demand on a massive scale. However, credit funds for the steel industry are not loose. Without this indispensable resource, it is difficult for steel plants to achieve large output, so they can only continue to raise steel prices to get high gross profit and then expand production to increase output, and exportable products are sold in the domestic market.

CISA data show that the bank loans of steel companies with CISA membership declined in 2015, especially short-term loans with a decline of 2%; there was a slight increase in bank loans at the end of this March, but there was almost no increase in short-term loans.

Someone from a large state-owned bank told the journalist that currently the bank still adopted a tough stance on credit for the steel industry, and basically it would not increase the line of credit. Most credit resources have flowed into real estate and other industries.

In accordance with data of the National Bureau of Statistics, China invested RMB1767.7 billion in real estate development from January to March 2016, up 6.2% year on year. Actually, RMB3199.2 billion was allocated to real estate developers, up 14.7% year on year (with a decline of 1% from January to February).

The data released by the central bank show that China's broad money (M2) grew at the rate of 13.4% at the end of March, and medium and long-term loans of companies increased by RMB507.8 billion, but such loans of industries with excess capacity fell by 0.2% year on year, among which the steel industry suffered a decline of 7.5%.

Based on the market data, the three futures exchanges have introduced relevant measures, and Shanghai Futures Exchange also adjusted the continuous trading hours of rebar and hot rolled steel to facilitate risk management of the industrial chain. As of the close of the 27th trading day, the prices of both steel products declined to a certain degree.

A thorough examination of the huge trading volume reveals that frequent dealers didn't participate in trading

Futures market follows closely the pace of the cash market and strikes new highs over and over again. Its trading volume hit a historical high on April 21, and the WeChat moments of was quickly flooded with the news that the volume of rebar transactions has exceeded the total volume of the Shanghai and Shenzhen stock markets.

In this regard, Galaxy Futures released a report, saying that it should be understood from two aspects. On the one hand, the trading volume of rebar has really hit a historical high, but the main reason is that companies have great hedging enthusiasm and demand for the current hedging profits in the context of real economy; on the other hand, futures implement the futures margin system, so its trading volume is the nominal value after leverage rather than the actual amount of money invested.

For example, on April 21, the total trading volume of rebar futures was 23.972 million lots (bilateral), and the nominal turnover was RMB323.982 billion (unilateral) if daily settlement price calculated at RMB2,703/ton. The margin ratio of the day was 7%, so the maximum amount of funds actually available was RMB22.678 billion (323.982 billion × 7%). However, the total daily turnover of the Shanghai and Shenzhen stock markets that implement full trading was RMB356.898 billion.

"Based on the actual funds that have been traded, funds used by rebar trading of the day account for only 6.35% of the funds of the Shanghai and Shenzhen stock markets. Taking into account the T+0 trading system of futures market, which prescribes that the same funds can be used repeatedly on the same day, the funds that have actually participated in trading will be less," Galaxy Futures stated in the report.

The analysis of Yongan Futures shows that the surplus budgetary funds of commodity futures are still maintained at about RMB 80 billion of the beginning of the year. Although there is a slight increase in the ferrous metal sector, it is moved from the futures varieties of other sectors, for example, non-ferrous metal futures that have moderate performance recently, so it is impossible to put a lot of money into stock markets to trade futures.

On the other hand, with the rise in both the volume and price of futures, news such as "People line up before futures companies to open accounts" and "frequent dealers participate in trading" was widely spread in the Wechat moments. However, this proved not to be the case.

The survey of Galaxy Futures shows that compared with the previous two months, the total number of new accounts opened by futures companies from March to April increased by about 30%, and margins increased by 10% to 15%; compared with last March to April, the total number of new accounts decreased by 19.84%, and margins decreased by 9.76%.

Yongan Futures also believed that lining up to open accounts and craze for account opening did not exist based on the customer situation of futures companies, but some dormant accounts resumed futures trading due to the impact of market sentiment, which was normal.

There is an urgent need for risk management due to the grim industry situation

Although steel prices have been rising since the end of last year, the overall situation in the steel industry is still grim, and companies are faced with increasing risks. On the one hand, substantial progress has not been made in addressing overcapacity, and low industry concentration (CR5 was only 22% and CR10 was 34% in 2015) and disorderly competition has not been improved. On the other hand, the overall loss of the industry continues. In accordance with CISA data, the total product sales revenue of CISA members in the first quarter of this year decreased by 20.5% year on year; the total profit was RMB-8.748 billion with an increase of RMB7.597 billion in losses; profit margin on sales was -1.48%, dropping by 1.33% year on year.

In this context, steel companies can effectively prevent market risks if making timely and prudent use of futures instrument. At the first Futures Conference of China Steel Industry held on the 22nd day, General Manager Liu Jian of HBIS Group Beijing International Trade Co., Ltd. said that steel companies should understand the relevant rules through continuous learning, and make full use of derivatives to carry out hedging and other business based on their own advantages to help companies achieve better development.

Cai Yongzheng believed that the hedging model with futures price as agreed price is of positive significance for finished steel products to stabilize the production and operation of companies and support the benefits of the main business. Futures hedging can change the original short-term sales order model of companies, and can make the sales platform become active when receiving orders with low profit or orders that it dare not or cannot accept before on the basis of full consideration of the premiums and discounts of futures contracts. He stressed that there should be one-to-one correspondence for orders with futures price as agreed price, and positions should be opened below the costs involved in determining prices of agreements to lock gross margins of orders and prevent the risk of rising costs during delivery.

At the same time, Cai Yongzheng told the journalist that in the current market environment, steel plants with cost advantage could participate in delivery at the appropriate time and in a proper manner. Galaxy Futures also believed that considering that steel companies lost RMB200 to RMB300 per ton last year, but earned more than RMB500 per ton this year, futures, as an instrument to hedge spot risk and lock operating profit, is bound to attract the hedging demand of steel companies.

It is reported that the physical delivery of steel futures went smoothly since the listing. By March 2016, a total of 1.6543 million tons of rebar futures amounting to RMB5.771 billion had been delivered; a total of 105,700 tons of hot rolled coil futures amounting to RMB256 million had been delivered.