COLUMN-Can the London Metal Exchange crack the steel market? Andy Home

(The opinions expressed here are those of the author, a columnist for Reuters.)

By Andy Home

LONDON, Nov 30 (Reuters) - The London Metal Exchange (LME) has just launched two steel contracts, one for steel scrap and one for steel rebar.

It (Other OTC: ITGL - news) 's the second time the LME has tried to expand its dominant franchise in nonferrous metals markets into the ferrous space.

Its steel billet contract has long been moribund. Volumes so far this year have totalled a meagre 28 lots and there has been no trading at all since June. Despite that, the exchange has decided to keep the contract to facilitate potential arbitrage with the two new contracts.

Steel could offer a timely boost to the LME, which is seeing volumes across its core base metals contracts decline for the first time in many years.

But might the LME's latest drive also finally crack open the steel market to derivatives trading? Because this is an industrial sector that has proved curiously resistant to exchange pricing, even while exchange volumes of iron ore rise steadily around the world.

And will the calamitous state of the steel market, characterised by falling output and bombed-out prices, be a hindrance or a help to new pricing ideas?

SHANGHAI SHINES, OTHERS STRUGGLE

The Shanghai Futures Exchange's (SHFE) steel rebar contract is by a considerable margin the most traded ferrous contract in the world.

Volumes in the first 10 months of this year were a staggering 8.77 billion tonnes, up 54 percent on the same period of 2014.

However, such apparently high liquidity flatters to deceive. It's quite evident that much of this turnover is in fact daily churnover fueled by short-term speculative flows.

Total (Swiss: FP.SW - news) market open interest at the end of last month was just 38 million tonnes, a tiny fraction of nominal volumes.

Nor is the SHFE much use to any non-Chinese steel-maker looking for a hedging tool, given China's capital control walls.

But outside of China steel (Taiwan: 2002.TW - news) contracts are struggling to gain traction.

Singapore Exchange (SGX) may dominate non-Chinese iron ore trading but it has so far failed to translate this purchase on the ferrous chain into its steel contracts.

Hot-rolled steel swaps were introduced at the beginning of last year but volumes so far this year have been just 52,500 tonnes, representing a year-on-year decline of 41 percent. SGX's equivalent steel futures contract hasn't traded at all this year after a brief flurry of interest over the middle of 2014.

CME's hot rolled coil contract has fared a bit better with volumes of just over a million tonnes in the first 10 months of this year. Volumes are up 36 percent on last year, when they fell by 10 percent relative to 2013.

However, the U.S (Other OTC: UBGXF - news) . exchange's vision of offering a "virtual steel mill" in terms of ferrous trading remains very much work in progress. Its steel billet contract is untraded this year, while its steel scrap contract has experienced only minimal volumes over four years of trading.

No-one, it seems, has yet found the key to unlocking the steel industry's aversion to exchange pricing.

TARGETING TURKEY

For its part the LME is returning to Turkey and the Black Sea for its entry point into ferrous pricing.

The steel billet contract was supposed to be aimed at the same geographical hub of physical steel flows but quickly fell foul of Turkey's tax code, which stymied physical delivery into LME warehouses in the country.

The two new contracts bypass such problems by not being physically deliverable, something of a first for the LME.

Both are cash settled and referenced against The Steel Index, in the case of scrap, and Platts, in the case of rebar.

And both target the Turkish steel sector, which is the ninth largest in the world and the third largest in Europe after Russia and Germany.

Turkey is a huge buyer of steel scrap from Europe and the U.S. and a huge exporter of rebar into the Middle East and North Africa.

The LME has strong cultural ties with Turkey's nonferrous sector and has this year hooked up with Borsa Istanbul. The Turkish exchange will both disseminate LME data and work with the London exchange "to develop future products and services for the steel market".

There is even Turkish representation on the LME's steel committee in the form of Cihan Akdeniz from the Turkish Steel Exporters' Association.

All of which reinforces the LME's claim that it has worked hard to bring on board the type of industrial player that will give its products pricing legitimacy.

CRISIS

But that's still no guarantee that its latest efforts will be any more successful than its lifeless steel billet contract.

The steel sector at large still seems impervious to any need to switch to exchange pricing, even though strong volumes on both SGX and CME attest to at least a partial embrace of iron ore derivatives trading.

Yet iron ore may itself offer some hope for the LME.

It took the Global Financial Crisis and the resulting collapse in iron ore demand to accelerate a switch from the decades-old annual benchmark prices to something closer to spot trading.

Faced with massive volatility and delivery defaults, even producers such as Vale, previously a staunch supporter of the benchmark pricing model, had to admit it was no longer fit for purpose.

Steel pricing is facing exactly such a crisis as the world faces up to the consequences of Chinese growth slowdown in the form of massive steel exports and the resulting crushing of steel prices both in and outside China.

Steel-making is rapidly becoming a matter of basic survival, an environment which might well encourage fresh ideas about pricing if it helps keep operators afloat.

Consumers, meanwhile, might be expected to embrace a way of forward price-hedging at current depressed price levels.

Auto-makers, for example, have been consistent hedge buyers into falling aluminium prices this year but have no obvious way of replicating such a strategy when it comes to their other core metallic input.

Launching new steel contracts during a time of pricing crisis may seem a bad idea but crisis might yet be what it takes to crack the steel market.

These steel contracts are an important potential growth engine for the LME given falling volumes in its other contracts and its owner Hong Kong Exchanges and Clearing's limited progress in connecting with China's huge metals sector.

But they may prove to be even more important for large parts of the global steel sector that are struggling to stay alive.

(Editing by Susan Thomas)