Steel Success Strategies — Europe V

Paris, France, December 4, 2007

Steel Futures Panel IV Presentations

Steel Futures: Customers are ready; how about the mills?

Biographies

Patrick A. McCormick is Managing Partner of World Steel Dynamics. Prior to joining WSD, he was with Emerson Electric Co. and led Emerson’s global steel team. During his 28-year career at Emerson, he held various engineering and procurement management positions. Mr. McCormick, a member of the Institute for Supply Management, holds a master’s degree in business administration from Washington University and a degree in electrical engineering.

Martin Abbott was appointed Chief Executive Officer of the London Metal Exchange on October 2, 2006. He has over 22 years experience in the metals industry and was formerly President and Publisher, AMM LLC and Publisher and Editor-in-Chief, Metals, Minerals and Mining Division of Metal Bulletin PLC. He also worked for LME Ring-dealing members AMT and Sogemin and spent three years with the LME from 1990-93.

Nasser Alaghband is CEO of Balli Steel, plc. He started the Steel trading operations of Balli Group in 1981, after graduating from Boston University and has expanded the business globally during the last 25 years.

James Oliver is Marketing Manager at the New York Mercantile Exchange. Prior to joining the NYMEX in 2004, he worked for the LME and Merrill Lynch Investment. He has a BA in business studies from Sheffield Hallam University and a diploma in marketing from the Chartered Institute of Marketing IMC.

Ralph Oppenheimer joined Stemcor in 1965 having previously worked as a government economist. He was appointed a director of Stemcor Holdings Limited in 1972 and Chairman and Chief Executive in 1982. In 2000, following the appointment as the Group Managing Director, his role was changed to that of Executive Chairman. Mr. Oppenheimer attended the London School of Economics, MsC-Economics and Oxford University, BA-Politics, Philosophy and Economics.

Presentations

Patrick A. McCormick
Managing Partner
World Steel Dynamics
(Transcribed Remarks)

It's my pleasure to be talking about such an important subject as steel futures. Before I begin, I just want to talk about our new business segment called “World Steel Dynamics Steel Stratagems” where we work with a select group of clients to improve either their buying or selling performance. Certainly the use of price risk management tools is a big part of our service. We’d like to present some of the opportunities that better tools, such as steel futures, can provide the global steel industry along with an understanding of how these tools work to develop good solutions for more robust trading.

I would add that producers will eventually use these tools. Already you can see with DGCX, the Dubai Gold Commodity Exchange, on rebar, producers are signed up. People on billets are signing with the LME. So, producers will play.

I believe producers want to embrace futures development in raw materials — scrap and iron ore, especially if iron ore becomes more variable in pricing to the mills. Going forward, we'll touch on some of the benefits these tools offer to the various market constituents, whether seller, buyer, or trader; talk about what an exchange entry means versus what's already being done. Even last year, when we were debating whether these tools were going to happen, they were already in place. A limited exchange has been going on in Shanghai since 2004.

The OTC has been active in flat rolled products in both the US and Europe since 2004. The first issue I hear from the mills commonly is, "I don't like giving long term agreements to customers, because I don't believe they will honor them. ” Or, “The customer may use it as a call option and renegotiate the agreement". When you do a futures contract, it's a guaranteed price. There is no renegotiation. There seems to be a misunderstanding. Why wouldn't somebody want to embrace that concept, if, indeed, they're concerned about the honoring of agreements.

It ties to the middleman's benefit in that these contracts will allow middlemen to hedge their inventory. A major source of price volatility is the collection and then purging of inventory that happens in the different regions of the world. This has been the case especially in the US market in 2007, where the service center industry probably liquidated about three million tons over the past 12 months. The ability of middlemen to hedge their inventory value would protect it from price declines in the general market, would mean that they need not physically purge their inventory for cash flow purposes and would lead to more stability to the markets if practiced on a broader basis. It's obvious what end users are looking for — the ability to guarantee a price to their customer and look to a profit. Peter calls it "locking in a spread". Basically, you're trying to lock in a margin, so you know what your returns are.

Here is my example of a six-month strip modeled pretty much after how a financial swap works in euros per metric ton. I use fictional market numbers to set the high and the low based on what the high and low was over the past 12 months versus the dollar. I simply took the exchange rate and worked it backwards.

If you're the mill in this case, you'll sell at 451 euros for this six-month period. Now the OTC will charge a markup of seven euros per ton. The buyer of this swap is going to see a fixed price of 458 euros. The assumption is that the physical market was already at 458. In other words the assumption is to sell, or discount, at seven euros to get the forward fixed price. I could've re-engineered the figures in favor of the seller, and the buyer will basically pay a seven Euro premium. It may be split.

The issue is, as time progresses and you see the market price change, the buy side variance equals what's happening on the exchange, or in this case, the OTC. It's always in balance, whether the market is going up or down. The buyer here gets a fixed price. The seller gets a fixed price, less the seven euros that's in the middle. These tools allow people to manage price volatility.

Still, here's the bad news. Yesterday, we heard a lot about who has raw materials, who has low energy, who has capacity, and who has high demand. There are a lot of discontinuities in the world, by region, by what's in balance and what is not. The balance today is the linkage of freight and currency. Those are also variables. Throw in a further compounding of inventory management.

Frankly, in my opinion, consolidation alone does not get you stability. The fact is we have globalization but we do not have uniform capabilities in each of these regions. Until we get to some common global currency, or a steady state of global freight cost, volatility is not likely to be reduced. In fact, we believe it will increase. Having better tools is really what this new world is all about.

What's so exciting is the 12-month snapshot from the last time I was here. How much progress has been made. Various things have been going on. The OTC has been active since '04, in Europe and in the US. I believe the Shanghai futures exchange that's coming will give you a longer time horizon because what is available in China today isn't electronic exchange. You will be able to trade hot rolled sheet, wire rod, and rebar on a forward four-month basis and you can basically convert that to cash or physical. In essence, it is a limited exchange. Certainly, we're expecting the NYMEX to be up early in '08, as well as the LME.

What will happen when an exchange is involved versus where we've been in OTC? It's like going from a horse and buggy to an automobile or maybe even to jet plane transportation. An exchange will facilitate a much greater growth in these tools. Over time, as we said earlier, you'll see more liquidity, which means it’s going to be so much easier to trade and be effective in trading. The number one point is the daily forward settlement price curve. People will start to look at that forward price and say, "Is that a price I should hedge at? Is that a price I should start to trade at? Frankly, should I wait?"

Today, you have people's opinion of what the market may, or may not, do with no confirmation of what you can physically do, until you actually make a deal. Now there’ll be an exchange that is calibrating what is possible everyday. In a volatile world, that is tremendous. It is a giant step forward helping people see what is required in the future to make trades. Efficient communication helps pricing transparency as well as additional sources of liquidity. I hear such steel industry concerns as, "I'll be inviting in financial speculators. ” “I'm going to lose the ability to control the price in my markets." I think that's yet to be proven. It can be argued, in many different ways, whether this is true or not.

Look at an indexed product. The financial speculator, or in this case the financial investor, doesn't get a vote in the index that's used as the final settlement tool. In that regard, we believe the product is more insulated. I think when Martin's products trade, we'll see over time whether the physical world believes the futures price is, indeed, where the physical world is. Ideally, the two should be viewed as acceptable.

The challenge is we have tools with different solutions on how they come about. The answer to any of these tools being successful is how they're accepted in the marketplace. Let me explain: Three different types of products have been introduced over time. WTI was basically a crude index product, natural gas and aluminum. All those index products, as well as physical inventory products, have shown the ability to gain acceptance in the trade over time.

Aluminum is particularly noteworthy, in that the producers were very much against it from the beginning. Now there’re up to trading a hundred thousand contracts a day. Acceptance, even with producer resistance, occurred.

If we look at the NYMEX specification, what's basically been advertised by the NYMEX, what drives the settlement of the NYMEX is the SteelBenchmarker. A number of you are participants in the SteelBenchmarker already. Frankly, if you're not a participant, I would ask that you go to the website (http://www.steelbenchmarker.com) and take a hard look at it. Because it gives you a voice in what you believe the price of steel is doing in your physical world. It is easy to use. There's no fee to have access to it. Here's the SteelBenchmarker result, as of November 26th for hot rolled band, the European and China prices are without VAT. The USA price is without income taxes. This gives you the world comparison of what domestic prices are in those regions. Then you have a world export reference price. Look at what's happened. One source of volatility is the wide spread between regions.

There is some debate about solutions. To use an American story: If it looks like a duck, quacks like a duck, it must be a duck. What that simply means is when people say an index should only be transactional prices, and the SteelBenchmarker is saying, "We collect opinions", it's still a duck. Frankly, if you were to plot the data, you would see the results are the same. The real scrutiny should be, "How is the index going to be repetitive in the future? How robust is it? Will it meet the scrutiny of anti-trust, etc?"

Karlis has engineered one heck of an index. If you really look at the operation manual (again, on the website), you will find that great attention to detail has been done on this index. Therefore, when it is used in steel trading, I think it will meet the regulatory scrutiny and be a very robust solution.

To summarize: First, there will be more physical indexing done in contracts. Everyday that number is growing. Why? With more volatility, it's hard to reach agreement on what the forward market is going to be between buyer and seller. The answer? Let the index determine it. What we do in negotiation is to make sure our negotiated adders, or deducts, to the index are sufficient to meet what level we've been at historically and what we believe we should be at in the future.

Price management tools. The dynamics of this world require better tools. The good news is you've got a whole group of people working on providing you better tools. I believe the ones that will be successful are the ones, shown over time, that are the easiest to use. When you want to make a trade, you make a trade. It happens because there's liquidity. You'll have many choices, but this is not something to be afraid of. It's something to embrace. It works. I can tell you it works.

I would just summarize that there're a lot of examples where index contracts have been used. Natural gas energy is a great example. Whether it's a physical approach, such as Martin described, and or an index approach, which you'll be seeing more of, the tools are there and they will help you. With that, I look forward to your questions. Thank you very much.

For Mr. McCormick’s PowerPoint presentation, please click here.

Martin Abbott
CEO
LME
(Transcribed Remarks)

In the last couple of years, the LME has given a number of presentations about the prospect of steel futures trading. We've spent a great deal of time talking about why the LME is going to trade steel futures and why we believe that the LME is the natural home for steel futures. We believe things have moved on considerably, and now the message should change a little. It is highly important to note that we're no longer talking about why we're doing steel futures. We're no longer talking about where steel futures are going to trade. We're now talking that steel futures will be trading on the London Metal Exchange in less than three months.

There is no longer any possibility to pretend that it's not going to happen, and there's no need to find out how it works. Today, I want to take a slightly more practical approach than we have done previously.

After a quick introduction to the LME to remind you about our credentials, I want to talk you through the contract specifications. As we now ramp up preparations for that launch, we're making announcements on a regular basis about additions to specifications and detail plans as to how the contract will actually come up. Then I want to conclude with what is actually a hedging scenario. In the past, we’ve avoided the great detail of exactly how one trades as a customer with the exchange.

I think it will be instructive for two reasons. First: I want to show you how the physical world continues life, uninterrupted, with the addition of a parallel tool provided by the futures world. We'll look at how you can use the contract scenario as well.

First of all, The London Metal Exchange is the world's leading non-ferrous exchange. We trade more than 95 percent of all of the non-ferrous metals futures trading in the world. Our cleared turnover last year amounted to eight point one trillion dollars. Broken down to the kind of numbers that we mere mortals can understand, it’s only 34 billion dollars per day.

We say that 95 percent of our turnover derives from outside the UK. The reality is significantly more than that derives from outside the UK. We are, after 130 years, a truly global business.

The primary roles of the exchange: There's hedging. We're going to take a look at a hedging example. There's pricing, absolutely critical for two reasons. Initially it is the price discovery on the metal exchange. Price is discovered as a result of the interaction of people like you trading through your brokers. Price discovery sets our benchmark price allowing you to index your physical contracts, and hedge. But it's also a service. There are many people in the world who use LME prices, who don't actually hedge.

Now, we actually prefer them to be hedging. Nonetheless, we don't mind that people take our prices, because we believe that it adds to our credibility and helps to embed our prices into industry. Why do people take our prices, even if they're not going to hedge?

Primarily because we provide an independent assessment through the actions of the industry as to where the price actually is. Meaning that annual negotiations, quarterly negotiations, even spot transaction negotiations become a much more constructive affair. One is no longer attempting to hammer out the details of a base price. One actually has a base price provided by an independent authority. One is able to concentrate, instead, on the value added and the individual details of each contract. We also have our delivery. Physical delivery for us is critical to everything we do.

We believe our warehouse system, with its long-term storage potential, provides an entrée into the marketplace for the financing business. We think that financing helps to make the whole of the industry more efficient. We also believe the provision of delivery is what keeps our prices fully converged with the underlying cash markets.

Anyone who thinks that the price on the LME is too high can deliver an LME registered brand into warehouse and receive cash within two days. Anyone who thinks the LME price is too low can buy, and take, delivery from an LME warehouse. There is no more efficient way of ensuring that the prices that are being discovered and traded are accurate.

Enough of the general pitch. Let's move on to what we're actually doing. We will, on February 25th of next year, begin a partial trading of two regional billet contracts. One will be focused on the Mediterranean and Middle East, the other one on the Far East.

Our current proposed delivery locations in Turkey and Dubai are not in all cases the same as for our existing non-ferrous contracts. We’ll be in South Korea and Malaysia for the Far Eastern contract. These locations have been chosen after a detailed analysis of billet trade figures, coupled with a pragmatic look at the legal and customs jurisdictions in various countries. LME warehouses must be sited in jurisdictions that allow for the free movement of warrants, and for the unencumbered title of metal, not necessarily possible in every location we would like to be in.

We announced last week we had enlarged current specifications for delivery. The specifications of steel that can be delivered into the contracts are the same for each contract. We have six specifications listed.

For billet to be deliverable to the LME, it must conform to one of these specifications, and it must be from an approved producer, a listed brand. Brand listing is taking place as we speak. You'll be pleased to know, though not quite as pleased as I am, that we're not having to coerce anybody into listing.

People are stepping forward. We have, so far, nine brands listed. We expect there to be many more. Those nine brands are derived from producers in Belarus, Russia, Ukraine, Turkey, and Greece. We're working, obviously, with some Asian producers, and we expect to list more in both contracts on a rolling basis between now and the February launch. And, indeed, thereafter.

People will list brands because, if one looks at the non-ferrous experience, a listed brand carried a natural premium over an unlisted brand, be it copper, aluminum, zinc, lead, nickel. The reason that an LME listed brand carries a premium is the flexibility involved in owning that particular material. The reason is that one can put it into a LME warehouse. One can collateralize it. One can simply monetize it by selling it for immediate delivery. There is, therefore, an advantage to receiving an LME listed brand over a nonlisted brand.

Now let's get into the nitty-gritty. We've attempted to explain the interaction between the LME, its members, their clients, and the physical world. It's very important to note that the LME and its brokers are not trying to insert themselves into the physical trade and billet. The physical trade and billet will continue, much as it has before, in terms of producer, merchant, customer relationships, and physical delivery.

What will change, however, is that producers and consumers will have the ability to hedge their transactions. That's also very important, because the producer and the consumer may well have a contract together. Either, or both of them, may also have a hedge in place; but neither of them actually needs to know the other has a hedge. The hedge is done independently, done between an individual company and a brokerage house. In order for you to take part in LME hedging and price risk management, the first thing you need to do is to establish a broker, or several broker relationships.

I'm pleased to say part of the momentum building in preparation for this contract is that we now have a number of brokers who attend these meetings of their own free will. They will be happy to introduce themselves to you over coffee after this session, and talk to you in detail about how one goes about opening a trading account. That constitutes direct principal-to-principal relationships. We then have LCH. Clearnet. I don't propose to go into any enormous amount of detail, but LCH. Clearnet is a massively capitalized clearinghouse that guarantees trades between LME brokers. You are, therefore, assured your broker is protected from exposure to other brokers in the market.

The only credit relationship that you need to have any concern about is that between yourself and your broker. I'm pleased to say that we have not, in living memory, had a default from a broker. We do require, as does the Clearinghouse, very strong capitalization and financial management from the brokerage community. I recommend that you discuss with our brokers the setting up of an account very quickly.

Let's move into a hedging scenario. For those of you familiar with hedging, I apologize if this is a little simple. For those of you who are not, I apologize if this seems a little complex. Hedging is a subject that is utterly and totally logical. Up until the moment when the penny drops, it may seem to be a series of numbers. But once the penny drops, it becomes the easiest thing in the world to understand. Somebody once said that hedging is not complicated, but it is potentially complex.

Let's assume you have a customer, we’ll say a producer, but it could also be a merchant hedge, making an inquiry to buy billet at a fixed price on a monthly basis. Your customer wants to buy five thousand tons a month for a six-month forward period at a fixed and single price. The freight to deliver on this contract is going to be $50 a ton. Now here's something interesting: your premium. Why do we talk about your premium? Well, in those metals that trade basis on the London Metal Exchange, the LME represents a basis price. Nobody delivers metal to a customer at the LME price.

The LME price becomes the benchmark from which a contract is negotiated. For those of you listing your billet brands on the LME will charge a little higher premium than those who do not, because your customer, your intermediates, will have the flexibility of taking delivery of an LME brand. They can, if they need to, deliver to an LME warehouse.

So, your premium will be $15 per ton. We can actually call it whatever we want, because we don't know what it will be. At the moment, neither do you, because we're not yet trading based the LME benchmark. The premium represents the added value of your billet above the LME futures price. In order to put all these various factors together and quote your customer, you need to get the LME price for the six months period as well. You telephone your broker who tells you the LME price for the period is $505 per metric ton. That's a single price. Your broker has taken the six months of your delivery period, averaged out the prices, and says, "Yes, we can give you a single price for the period".

Translating that into the quote to your customer, you take the LME basis price, $505. You take your premium, $15. You take your freight. You add them up, and tell your customer that the price for delivery, five thousand tons a month for the next six months, is $570 per ton. Your customer is happy with the price. In fact, your customer is delirious. Nobody has offered them a six month fixed price before. Your customer is happy but you now need to protect yourself against any volatility in the billet market. You need to hedge.

You are going to take a mirror of what you've just done in the physical world, which is you've just sold five thousand tons per month, going forward for six months. You now need to buy five thousand tons per month of LME futures. What you're buying, of course, is a price.

You are not actually buying billet from the LME. You're buying the billet price from the LME. You ask your broker for a two-way market. Of course, you've just asked your broker how you can buy five thousand tons a month for the next six months. Hopefully you will have such a constructive relationship it won't be necessary for you to make your broker second-guess you. You always have the option of asking for a two-way market, in other words, where will you buy and sell. Then you can declare your hand. It's another part of the flexibility of dealing with the exchange: You can always keep your cards very close to your chest.

Your broker quotes a price of $495 at $505. You say you're going to buy the five thousand tons per month, at the offer price of $505. To be able to look at the financial outcome, we now need to move forward in time. Let's say to January. You own five thousand tons of LME futures for January at $505. You need to sell this position, because you're delivering physical in January. You telephone your broker and ask, again, for a market for January. The billet price has gone up. The price now is $525 at $530. You tell your broker you're selling five thousand tons for January at the bid of $525.

Let's take a look at how this all unwinds. You have the fixed contract price, the physical transaction in which you sold five thousand tons of billet to a customer for $570 per ton for delivery in January, against the new January price that transpired since you negotiated the contract. You bought five thousand metric tons of billet futures for January delivery, at $505 per ton on the other side of the ledger. Now you sell back the five thousand on the LME at $525. Meanwhile, you've delivered your five thousand metric tons of billet to your customer, who's paying you $570 per ton. On the LME, you have a profit of $20 per ton. What you bought at $505, you've sold back at $525. But on the physical market, the price is also up 20 dollars.

Therefore, had you not sold LME futures and had you not made a fixed price, you would've been selling at a higher price in the physical market. You’d be showing a notional physical loss of $20 per ton. The $20 that you've achieved on the LME has compensated for the loss of $20 on the physical market. The loss you took facilitated your customer’s requirement for a fixed price. You'll also notice that your $15 per metric ton premium is protected by this transaction.

In another scenario, let's assume the price dropped. We'll take June just to show you how the math works on these hedges. Whether the price is up or down, we don't have to show an LME profit all the time. In the original scenario you bought five thousand tons of LME, because you had a sale of five thousand tons physical. You've sold back your LME. But this time, you've sold back your LME at a loss. You've delivered to your customer at $570. Your customer is now as happy as could be because they've paid just a single price throughout though there's been all sorts of volatility in the billet market. You now have an LME loss of $22 per ton.

When you go through the numbers, you will see, hey! The loss on the LME is, indeed, matched by a profit in the physical market, which means that you have come out even. You have put yourself back to market. You've come out even, and protected your premium. I don't propose to go into any more detail than that today. A copy of this presentation, made available to you through the WSD/MB Conference website, will give you a chance to study this further.

As I said, hedging is not complicated. It can be complex. Obviously physical scenarios can become much more involved than the simple one we just looked at. But the mathematical principles are very, very straightforward. Going up on our website, and available, very shortly, on disk, we have hedge training software that will allow you to sit in the privacy of your own study and work through scenarios, put together some numbers, and actually see exactly how a hedge might work for you.

I urge you to engage now with our brokerage community, perhaps spend a little longer reading those pages of the AMM and the MB that talk about the LME steel billet contracts. As I said, we are less than three months away. In fact, I would say we're 20 minutes closer than we were when I stood up. And it just can't be ignored any longer. Thank you very much.

For Mr. Abbott’s PowerPoint presentation, please click here.

Nasser Alaghband
CEO
Balli
(Transcribed Remarks)

I've been asked to speak about the steel futures as a product. Martin gave a very good insight from LME's point of view. I'll try to discuss some other angles of this exciting development in the steel industry.

To start, let me give you a quick profile of what we do as Balli. We are in different industries and activities. We are multi-metal traders. We trade in steel and aluminum products. We also have fixed assets on the production side, primarily in aluminum and packaging. And we are project developers on the construction site. It gives us different angles to look at steel futures and see how they could affect one's business.

Before we get involved in the steel futures discussion, I'd like to maybe take a step back and talk about forward contracts, and what they are, and what shapes them. A forward contract is simply a contract that allows pricing, at one point in time, to be protected in the future. You like the price of something today. But you don't have the physical means of securing that price.

LME would provide you with an option to fix that price, as would NYMEX, in the future, or DGCX. As to forward contracts: Their pricing depends on a number of factors — a forward date, interest rates, risk assessment, market sentiment, and liquidity will all have something to do with how a forward price is formed and shaped. A forward price is not identical to the price that you see today.

The steel industry is a large, $800 billion a year industry. Steel prices have gone up quite dramatically in recent years. A lot of the metals have price risk management tools available to them, as does steel at the moment. Until now, steel stood as a commodity that didn't have price risk management available. What does price risk management do for consumers and the steel producers?

Let's have a look at the consumer end of this first. You're a developer and you're building a project that requires 15 thousand tons of steel. You started your project in June 2006 when rebar prices would have been $475 a ton. By the time you get to the practicalities of building your dream project, prices have moved up. You could end up with rebar prices in the region of $625 a ton. This price variation, for which, until now, there has been no real mechanism to hedge, would have cost your project two point two million dollars. Now, the steel futures do provide a means for you to protect your cost increases against your budget prices.

You could ask, "Why would you not do this through your contractors? Would you just not end up having turnkey fixed contracts?" It's not an efficient way to hedge yourself. You could, but the risk premium attached is quite high. Risk premium today is probably around 15%, in some cases 20%, depending on who your contractor is.

And the futures market (the financial market) is a much more efficient way for you to manage your risk, then paying premiums. The producers are enjoying the steel price boom. At the moment, they are not seeing the concerns about price volatility and price depreciation. But producers also can protect their cash flow by hedging part of their production with steel futures. They could end up in a stable cash flow. If the hedge goes against them, they have the physical market to balance that out. And if the physical market goes against them, the hedge comes into place to maintain a stable cash flow for them.

On the steel futures road map, we now have DGCX, which launched in 2007. We've just heard from Martin that LME is launching in 2008, and I believe the NYMEX and Shanghai futures exchanges will also be coming on stream soon.

Steel futures are going to develop traction. At the end of the day, there is always anxiety whenever there is a new product launch. People will ask themselves, "Is this going to take off, or not?" I'm optimistic, but there are concerns that have been raised. I would like to address them today.

Some people have said steel is not a commodity. Others have said steel futures will lead to volatility. Finally, there have been concerns about market liquidity. If you look at steel products chosen for futures markets — billets, rebars, and hot rolled — and the portion of world steel exports that are involved in these three product sections, sixty percent or more of the products traded internationally are in these three product categories.

They may not all look the same. While they may not all be the same size, you can draw the example of oil futures. Oil is not the same as a product, but it has had a very successful futures market. It's a good hedging tool being used day in and day out.

The next concern is price volatility. Price for steel products has generally been volatile. I don't really think steel futures will lead to more or less price volatility. Prices are volatile because of supply and demand nature. Prices for hot rolled in Europe have been as low as $200 per ton in January '02, and as high as $700 a ton. They drifted up and down during this period.

Some people say that consolidation is the answer to volatility. According to IISI, the steel industry is very fragmented at the moment. So, we cannot really look at consolidation as a solution as to why the industry remains fragmented. Even if you take that argument forward, at the moment producers have no mechanism to offer risk mitigation to most customers. There may be risk mitigation in packaging or automotive industries with longer-term contracts, but that's it. For the rest of the industry, there’re really no price and risk management opportunities.

Should market liquidity be a concern? Nobody expects we would start running from day one, but everyone's expectation in the industry is that there would be a gradual liquidity increase in the initial years. When you look at DGCX's start, it has been quite promising. They have started to trade, and there has been a slow but steady liquidity buildup. One of the main factors, which will direct the speed of liquidity generation, is how readily the financial community accepts this as a proper risk management tool. Will they treat it the same way they accept it for other non-ferrous products or other commodities?

I talked before about risk management preparation for steel futures. I believe this is one of the most fundamental things from a steel company's perspective, because steel companies, except for very large ones, are not used to derivative markets in their day-to-day business. No two companies are alike. I think each company needs to define its own unique strategies on how to use and shape risk management tools for itself. That's, I think, fundamental and unique to your own companies.

Once you do that, you have to have robust IT systems to manage your hedging operations. Hedges move all the time. You need to be able to keep yourself up to date with your mark to market positions. And having an IT system, which is robust enough, is fundamental for that.

You must also bear in mind that the market in the startup phase will not always be liquid. So, if you are involved in large hedges, you may not be able to just look at the screen and get the prices you want. Market liquidity will be a factor, at least in the initial phases.

Margin calls are a factor new to people who have not involved themselves in derivative products. You have to have different forms of margin cash available. Depending on your credit with your broker, you may need to have initial cash for the initial margin to be placed for doing a hedge transaction. Markets move up and down all the time. You need to have cash flow available for variation margins. One thing important to know is that margin calls must be settled promptly. You cannot delay on settlement of margin calls.

To take you through a quick example of what a margin call would mean. Say you have hedged yourself with the futures market at $640 per ton and prices move up in the market, if you have sold at $640 per ton you are exposed to a million dollars of margin. If

you had put a two thousand dollar initial cash margin with your broker, when the prices move up, you could end up having a margin call of eight thousand dollars on ten thousand tons of rebar.

Finally, just some observations on how the futures industry has performed till now. I think that industry interaction has been high. The information that has been provided to users has been quite good. The product development is good, because it covers quite a large degree of the market. And when you look at the trends of the futures market that are already available, you could actually see a good linkage to market trends. So, all in all, I would say a good start so far. Thank you very much, gentlemen and ladies.

For Mr. Alaghband’s PowerPoint presentation, please click here.

James Oliver
Marketing Manager
NYMEX
(Transcribed Remarks)

By way of background, NYMEX is the largest currency exchange in the world for physically based futures and options. We provide a forum for the trading and clearing of futures and traded option contracts on energy contracts, such as crude oil, as well as metal contracts for bullion and also base metals. I will try to answer the subject: "Customers are Ready; How about the Mills?" by covering three topics: Examining risk management tools available to sellers, buyers, and traders; exchange traders versus OTC; will exchanges find traction from the industry through the following five areas.

Whilst everyone has an intuitive definition of "risk", it is important to be precise when trying to manage risk. We need to be able to manage the degree of riskiness, and, of course, what constitutes risk. Using futures contracts is a very efficient method of managing a firm's risk, and as a company coming into changing circumstances. Few companies can make profits without taking some risks. But actively managing their risks allows companies to concentrate on their risk capacity in areas where it can be most beneficial. Risk is probable. The future is most definitely uncertain. From that uncertainty, one may experience a positive, or negative, outcome or change, i.e. profits or losses. Through the use of futures, it is possible to mitigate this risk and counterpart your credit risk.

Over a period of time, the price of steel like that of any other commodity, or financial instrument for that matter, will change in an unpredictable fashion, due to the fundamental forces of supply and demand, or other influences, such as speculators and investors, or natural disasters. Futures contracts can work for you wherever you are in the supply chain dynamic. If you are buying products in, then the company's risk is that of price increases, especially if you are selling at a pre-arranged fixed price.

The opposite is true as a seller of a product. As a company, you need to be able to assess how much of this risk, the price increase or decrease, you can afford or are willing to take and thereby, take action in engaging in the futures markets. I've spoken with many in the steel industry about hedging. At least a proportion of their inputs or their production costs are in materials, or even their energy inputs. But how many actually go out and try to hedge some of that proportion of their steel outputs?

We provide two ways for transactions to be submitted to the exchange — through a trading platform, and through a clearing platform. To the uninitiated the trading platform allows direct entry into the marketplace. Trades are executed on the basis of price and time, with total anonymity. The first order is always executed at the best price. All trades are then submitted to the exchange clearinghouse for clearing.

For the cleared only transactions, these are individually negotiated transactions executed off exchange, and can be submitted to the exchange clearinghouse for clearing. Currently, on the NYMEX market, participants can negotiate their own transactions off the exchange from a slate of over 330 energy futures contracts, and then submit them for clearing by the exchange clearinghouse. These transactions can be submitted by either OTC brokers, or can be submitted directly to the exchange staff.

When an off exchange trade is submitted, each side of the trade will be subjected to a credit check by the carrying clearing member. An important part of any market gaining acceptance of any contract or concept, and therefore encouraging new participants to enter, is that of price discovery and transparency. With on exchange trading, the posting of bids and offers, that is to say the fair market value on the trading venue, can be seen by anyone in the world, via a trading screen, or via a quote or news reporting vendor as can all trades that have occurred. This enables participants to see the real time structure of the market, and give comfort in entering into any transaction.

In addition, those traders who recognized the opportunities will arbitrage any prices they deem to be out of line therefore keeping the price of the commodity around its fair market value. Off-exchange transactions have a much lower degree of transparency, as by their very nature they are off-exchange OTC. Therefore, only the counter parties, and of course their broker, if one was used, are privy to the transaction size and price at which it was executed. It's clear port clearing that allows for these off-exchange transactions to be submitted to the exchange clearinghouse.

So, what does clearing mean, and why is it so important? The key component to the financial stability and integrity of any marketplace is the credit worthiness of your counter party. In futures markets, there's always a central counter part, typically one with a strong credit rating, and it's usually, in the case of future markets, the actual clearinghouse. Having conducted an on exchange trade with a counter party, the trade then goes through a process called clearing, whereby novation, the trade is given up to the central counter party who will then take the opposite side against your trade, so that clearinghouse, in effect, becomes the buyer to the seller and the seller to the buyer.

The financial strength of the exchange, and its clearing systems, is based upon a series of financial safeguards. Through clearinghouse, we are able to offer a guarantee of financial performance for the transaction, which provides the market with additional integrity and confidence. The NYMEX Clearinghouse has a double "A" plus long-term counter party credit rating from Standard & Poors. The clearinghouse also has a guarantee fund of $135 million, and a further default insurance policy of $115 million. All positions must be properly margined with the clearinghouse. The clearinghouse personally holds more than $17 billion dollars in margin funds, and currently deals with over one point four million lots per day.

Acting as a fiscal transfer agent, the clearinghouse transfers money from the margin funds of traders who have a position in the market, whose value has decreased. Then on any day they do the same to the margin funds of traders who have a position in the market, whose value has increased.

NYMEX's regulatory oversight comes from the CFTC, the Commodities Futures Trading Commission. The primary function of the CFTC is to encourage competitiveness and efficiency, and ensure market and trade practice integrity and fairness. Proposed contracts can be submitted by the exchange to the CFTC, and the CFTC oversees registration of firms and individuals, who either handle customer funds or give trading advice. It also conducts and monitors rule enforcements at US exchanges. The Commodities Futures Modernization Act of 2000 gave the exchange the flexibility to self-certify new contracts without prior CFTC approval.

NYMEX rules and procedures have been carefully honed as a result of nearly 135 years of experience in building a safe and liquid futures and options markets, therefore ensuring market performance, financial performance, and operational performance, even under severe circumstances. A major indicator of the recognition of any exchange listed futures contract is that the contract is used and quoted as being the reference point by the market. I've already covered our specs, such as clearing transparency, and financial performance, and regulation, essential ingredients for any contract.

However, I've also mentioned there needs to be a reliable price relationship with the futures market to the physical market, and that the futures price converges to that of the physical market price. There are two main ways to ultimately settle a commodity contract — either through physical delivery, or via cash settlement in referencing a price index.

As to the key aspects, I think it's quite important to note that in mature futures markets, less than one percent of all transactions actually go through to physical delivery. In fact, last month, in the NYMEX WTI contract, which is one of the most liquid commodity futures around in the world, not one single barrel of oil went through to delivery, and that all positions were either closed out or rolled forward to a future month. At NYMEX, the steel industry has opted for our first contract to go along the path of the cash settlement mechanism, referencing World Steel Dynamics’ SteelBenchmarker index. At NYMEX, we already have over 300 contracts, which are cash settled basis indices. This is no new departure for us. The contract will be for a Midwest hot rolled band.

We feel that this provides a very reliable price reference to the physical market price, as the SteelBenchmarker currently has approximately 65 active data providers who submit their prices. This is published bi-monthly, on the second and fourth Wednesdays of the month. I think you will admit this is an enviable number of participants, and can give a fair reflection on the state of the market.

These providers are screened by World Steel Dynamics, and only industry participants are invited to submit prices. There are no financial players involved in this price discovery mechanism. These prices come from across the spectrum, and importantly from both the buy side and the sell side. The index now has a good history, and you're welcome to use the data for your own purposes. I'm sure that, should you also wish to be a data provider, World Steel Dynamics will welcome your approach at http://www.steelbenchmarker.com.

In answering what risk managements tools are available to sellers, buyers, and traders, NYMEX is, for the first time, offering the steel industry the choice to use tools which will enable you to have some certainty of the future. We'll allow you to lock in material input costs, unlocking forward sales revenues. This means that you are able to set budgets and make plans for the future, the degree of which will depend upon how much you wish to hedge.

NYMEX is also offering you the ability to mitigate counter party risk with your counter party ultimately being the double "A" plus NYMEX clearinghouse. Trading via the exchange will enable you to buy and sell these risk management contracts with multiple counter parties. Looking at an exchange versus over the counter, NYMEX is offering a choice of venue, trading on a traditional on-exchange trading platform of posting bids and offers, a relatively new way for the steel industry to trade. Or via a cleared only platform, so that pre-negotiated trades can be given up to the exchange for clearing. The huge advantage is that, as an exchange, we're able to offer both. It will enable the market to decide which way they wish to trade steel futures. Through the OTC option, you are able to deal with many of your counter parties.

The only requirement is that you have a NYMEX clearing account, which has to be permissioned for a steel contract. It alleviates the need for costly and time-consuming index and credit lines to be set up, and gives you instant access to the OTC marketplace. In addition, should you wish to close out your position, you are no longer tied into that particular counter party. So, you can always trade out with another.

Finally, will exchanges find traction from industry? Many companies are already engaged in the hedging program for their energy requirements. This will, we hope, become a natural progression for them.

Such an exchange allows unknowns to become known. It facilitates the ability to make projections and set budgets. A key point which I feel should be made is that if you engage in a hedging program for your steel entity, you could find that your cost of financing, if you have any, should be reduced as forward prices can be locked in, and therefore, the perceived risk premium that you are currently paying for your finance will be reduced. We commodity exchanges are through our expertise, and experiences, and dialogue with industry participants, developing the tools which we think to be the most useful and the most relevant to you. We all urge you to embrace them, as it will, in the long term be to your benefit. Ultimately, the choice is yours. Thank you for your attention.

For Mr. Oliver’s PowerPoint presentation, please click here.

Ralph Oppenheimer
Chairman
Stemcor
(Transcribed Remarks)

Some brief words about Stemcor, which has been in existence since 1951. During that period, we've had two chief executives, first my father, and now myself. We're still a private company. One-third is owned by the staff, the employees and two-thirds is owned by my own extended family. We are steel traders, and we operate in a very risky, dangerous environment. Many steel traders have gone bust. I can give you a long list of famous names, if you're interested.

The risks we face are various. Some of them are listed. Contractual defaulting is a curse of our industry, when prices go up, suppliers don't want to deliver what they've contracted. When prices fall, customers try and cancel. We have counter party risk, if our suppliers, or customers, go bust. We have quality problems, if the steelmaker does not stand behind his steel and walks away. We have logistical risk.

In the last few months, we've suffered greatly. We've pre-calculated freight rates. Comes the time to actually book the freight and we have to pay very much more. But the risks for a steel trader that I'm going to concentrate on this morning are volatile prices. You've already heard about them this morning. I just want to draw your attention to the volatility of some steel products, in relation to various non-ferrous metals, copper, or aluminum and also in relation to foreign exchange. You will see that steel, historically, has been more volatile than these two non-ferrous products, even more than exchange rates. The non-ferrous products and exchange rates can be hedged with financial futures. Steel can't. So, we start off with greater volatility, not less volatility.

What is the effect of this volatility on the steel industry? If you're a steelmaker, it means that you don't know what price you're going to be selling at in the future. You're speculating, as a steelmaker, on future prices. If prices fall, you won't meet your budgets or forecasts. If prices rise, it can also cause problems. In the UK, a steelmaker called ASW (Allied Steel and Wire), with too many mills, went bust because they sold their output forwards for three to four months. Then the scrap price shot up, and they hadn't covered the new price. Their production costs were higher than their sales price, and they went bust. Steelmakers suffer from price volatility. Traders suffer when they have long positions, or sometimes short positions.

Steel stockholders hold enormous quantities of stock. Klockner recently had to announce that its profits were going to be reduced, because the stainless steel they held in stock had fallen substantially. Fabricators who take long-term contracts, like the one that Nasser indicated for the building in Dubai, have to commit to fixed prices. They can't get prices for rebar, for more than a month at a time, and they have to commit for two or three years. Structural steel fabricators are in the same boat.

Of course, all the components suppliers to the automotive industry like one year, two year, three year fixed prices, so they can plan their production, their sales. Shipbuilding likewise takes some time and you'll be buying the plate and other components during construction. On new investment projects you can produce the most beautiful forward plans for a new steel works, take it to a bank and they say, "How do you know that the prices you're planning for are going to be achieved?" There's no way of knowing, because you can't hedge those prices. So, effectively, all of us in the steel industry are speculating. We don't know what the future will bring. We're forced to speculate.

Now, you say that everyone takes risk. That's part of every business, but every business has to learn to manage its risks. It wasn't so long ago, some 30 years or so, that Goldman Sachs nearly went bust. They hadn't learned to manage risk. Since then, they've become very successful at managing risk and they've gone from strength to strength. But they operate largely in markets where it is possible to hedge. In the steel industry, it has not been possible to hedge.

We've had to rely on the crystal ball. As the man says in the picture, "Nobody knows how the crystal ball works". At least, that was the case in the past.

Now, we do have a way of making the crystal ball work. We've all been speculating in the past, and that's like climbing just with your bare hands. If you climb with ropes and spikes, that's hedging. Hedging gives you protection. Some people won't want to hedge. They'll want to go on speculating. Most of us in the steel industry will be happy to take some risk out of our business, to manage the risk in the future.

Who's going to benefit from hedging? In my view, the whole of the steel supply chain. The people who want to invest in capital plant or new steel works can hedge their future revenue and make their cash flows more predictable. That will help them raise finance. The fabricators and transformers of steel can protect themselves against price movements. Stockholders, traders are all going to be able to control and manage risk more effectively in the future. This is going to be a tremendous benefit to the steel industry.

It's all very complicated, listening to the specialists from the LME and NYMEX. It's all a bit too complicated for our simple steel traders. But I have no doubt at all. Steel futures will happen. It's going to come. You'd better believe it, and get used to it. It'll help us to be more efficient. It's going to offer new challenges to steel traders. We are going to be able to sell forward, linked to a LME price or a SteelBenchmarker NYMEX price. That's going to get acceptance. We're also going to be able to advise our customers and our suppliers on how they can best hedge. It may be that traders like Balli and like my own company, may move into brokering.

This is still a new world. We don't quite know how it's going to develop, but there is a natural role for steel traders to become brokers in the future. We'll never completely get rid of risk, but we can manage that risk and hedge that risk. That's what steel futures is all about.

I believe that steel traders have a major role and function in this new world of steel futures. That's why we've set up a separate unit within Stemcor, Stemcor Risk Management. I have some colleagues here in the audience who would be happy to talk to you about it further. Thank you very much for listening to me.

For Mr. Oppenheimer’s PowerPoint presentation, please click here.

QUESTIONS & ANSWERS

Q: The first question is for Martin Abbott. Going down the road a number of years, what is your high-end expectation as to how much billet can be trading per annum?

A: MARTIN ABBOTT: This is a very difficult question for me to answer, because if I go low, the press will say that I'm being pessimistic. I think it will be a hundred million tons per year. Then I think we could say we'll be trading a lot. Because I can do 30 times 500 but the reason I'm not doing 30 times 500 is because if you take a look at the aluminum and the copper, you would have to include those raw materials that get indexed as well and the downstream. So it's 30 times 500 plus 30 times the scrap input. I think we'll certainly get scrap linkage and it's 30 times the rebar or the merchant bar, et cetera. So I would imagine that it could make quite a difference to the LME’s life.

Q: I have a few questions for Martin. First, what mechanisms do you have in place to stop people who are going to use the system for their own profit gains? Most of us in the industry have an idea as to what the prices are going to be at least one or two months down the road. What stops people from abusing the system in order to make short-term gains for their own profits?

Second, why have you chosen to buy for delivery because there's not a single producer of billets in that area. Most producers consume their own production. At the same time, I would like to commend you for the progress that you've made because I clearly remember two years ago when Ralph called the futures "Weapons of mass destruction." So I commend you on that.

A: MARTIN ABBOTT: First of all, speculators. You say that most people in the industry have an idea of what the price may be. With all due respect to the Benchmarker and it's opinion based survey, I had the pleasure of being involved somewhat with Peter in the early days. The price of anything is not actually down to a democratic poll. It's down to what someone is prepared to buy and sell at.

Having an idea is not the same as the reality. We all have an idea of what the weather should be like in August when we book our holidays. It doesn't actually matter what we think the weather's going to be like in August until we get there. I would say is we actually welcome the specs in.

We have no safeguards to stop the speculators from coming into the market. We welcome them. When you put on your trade, when you do your fixed priced deal with a customer and you then come to the market to hedge, you need someone. What you're doing is unloading your risk and you need to unload that risk to someone who is looking to take on risk. That's where the specs and the funds come in. As I said, the price is discovered because people are prepared to put real money behind their trades. There's no purer way of discovering what a price actually is.

In terms of Dubai, you make a very good point or you allow me to make a very good point, so thank you for that, about there are no producers in Dubai. Why have we delivered Dubai, We list our delivery points in areas of net consumption, not areas of net production. The reason we do it in areas of net consumption is that we do not want to interfere with the trade flows of the physical market. If we were to list all of our warehouses next to producers, if we put them all in Ukraine and Russia, Turkey obviously has production and consumption, but if we put them all in China, then actually the metal, the steel would never move.

It would just go straight into the warehouse. Why would you bother to ship it to a consumer when you can put it straight into a LME warehouse and get payment in two days? We actually put the warehouses in areas of net consumption so that if one has surplus steel to drop into the warehouse, there is at least some effort involved to get it near to the consumers. What it means is the LME warehouse price generally contains an element of safety, simply backed into the fact that it's sitting in an area of consumption.

Q: For my question let's assume that you have a six months fixed contract. The element of risk, of course, is the ocean freight. So how do you unload that risk? The second thing. If you put it in Dubai, in a free zone, let's say, you have freight going in and when you sell it you have freight going out. Double freight.

A: MARTIN ABBOTT: Okay, there are two issues here. As far as the freight is concerned, there is not yet an on-exchange freight derivative contract. I apologize for that. We're a tad busy with the steel at the moment. You know, I think freight will be the next steel, to be honest. I'm not talking purely about the LME either.

In terms of having the steel move in and out of Dubai, you're quite right. But that's not linked to your six-month contract because the six-month contract you make is between a producer or a merchant and a consumer. It's for direct shipment. The LME element of that transaction is a paper hedge that does not depend upon the movement of steel through LME warehouses.

The LME warehouses act as infantry of last resort. The only reason someone would take material out of a Dubai or a Turkey or a Jihora interim warehouse, is if they cannot get it from anywhere else. In which case, you're right. There will be a double freight involved.

Somewhere along the line, the price will reflect a double freight. That's one of the things that we like about the LME system. We do not make it easy to use the warehouses. They're your last resort. So if the inventories are going down, you can be pretty sure that that reflects a stress in the marketplace and a shortage of steel.

Q: I got a question for Pat McCormick. In your role at World Steel Dynamics, you engage in discussions with decision-making levels at all major steel producers. Some of these have come out quite negatively, explicitly negatively, on the topic of steel futures as a hedging tool.

This has puzzled me and, I guess, a lot of other people in the financial services industries a bit because in our opinion, it's basically free option has been delivered to this industry. There's no need, there's no obligation to use it. If they don't want to use it, then I would say that's fine. Why do you think that people come out so negatively?

A: PATRICK A. McCORMICK: I appreciate the question because it seems we're all asking that. If you look at prior history, futures has been a win for producers. I chalk it up to human nature. Fear of change. Fear of the unknown.

These are clearly tools you have to experience to build confidence. But when you do use them, you're going to find that you want better tools. Tools that have more liquidity. Tools that cover more products.

I think it’s, "Try it, you'll like it." It's just a matter of experience. I can tell you in private side discussions, not what's been published, we're hearing much more favorable comments. I don't think it will be all that long before you see producers saying a little more favorable things about futures. That's my prediction.

Q: Can we discuss the difference between a cash settled, physical commodity and a financially transacted commodity where there's no inventory and there's no physical delivery. What are some of the differences and how could this be better or worse?

A: JAMES OLIVER: We at NYMEX have over 300 contracts currently being settled against indices. These are indices that the market already settles their own OTC trades against. So you know, having spoken to the steel industry we feel that the SteelBenchmarker would provide a good reference point for the industry to just have their trades settled against as it provides a fair market value.

A: PETER F. MARCUS: Okay, let me say the difference that I was trying to get at, when you have the cash settled product, each day there's an opportunity for those in the financial industry, sometimes called speculators, to buy and sell. At times perhaps, the price can rise to an extraordinarily high level relative to the production cost of the mills.

When you take the CRU index or the SteelBenchmarker, only those involved in buying and selling are offering their view of the transactions price or the price opinion. So the financial player doesn't have the ability to impact the index price.

A: MARTIN ABBOTT: There is no such thing as a person in the steel industry who is not also a financial player in the steel industry. Every time you invest in a piece of plant, every time you make a contract that goes forward more than one published price reference, you've become a financial player. We've seen enormous banking and speculative involvement in the industry.

We've seen charts this morning showing steel’s volatility, which is actually greater than that in aluminium and copper. We saw similar charts from another source, actually, at a recent conference in Chicago. There is volatility. There is financial involvement.

The consolidation that's taken place in the steel industry, such as it is, has been financed by the banking and the investment fund world. So they're already in the steel industry. They will be playing, in time, in the futures contracts. We will welcome them because of the liquidity they bring.

But the key point for us, what keeps our price fully converged, is the physical delivery aspect. Because if a financial player comes in and starts buying up the LME billet price and it starts to rise and rise, they will have to live with the threat that if they're wrong, and if they're bidding that price up beyond where it should be, then people will deliver. They will wind up having to either take delivery of thousands or millions of tons of billet or they will have to sell out their positions at losses as those rising stocks drive the price down. We refer to the opportunity and the threat of delivery.