surcharge mechanism — Tarik Yildirim

Here are some possible explanations of why ArcelorMittal recently decided to offer fixed-price contracts to its customers which previously did not have any choice but to stick to the surcharge mechanism.

The story line: 1,2,3,4

- ArcelorMittal may be trying to resolve a mismatch between its assets and liabilities. Banks prefer financing floating-rate credit with floating-rate debt, and fixed-rate credit with fixed-rate debt. This is a basic risk management philosophy. Perhaps, in a similar fashion, ArcelorMittal desires to finance its fixed-price purchasing contracts with fixed-price supply contracts. This allows ArcelorMittal to lock-in on the difference. (In November ArcelorMittal has unilaterally cancelled most of its purchasing agreements. The contracts I am referring to here are the ones that, I suppose, were recently signed behind closed doors at prices far lower than ones on previous contracts.)

- “When prices are going up everybody is happy but one day they had to go down,” Arcelor's Payet-Gaspard tells MB. “Now people are making tremendous losses, the value of the industry is being destroyed and they want someone to blame.” It seems as if it is in the interest of steel makers to switch to the old fashioned fixed-price system, because under the surcharge mechanism the steel prices collapse immediately along with the ferro-alloys prices. But is this really a valid argument?

It depends. Swapping floating agreements with fixed ones does not necessarily increase Arcelor’s profits. As in every swap transaction, the key point is the swap rate. For example, assume that you have a liability that floats along with LIBOR and you believe that LIBOR will increase in the future. If the market’s beliefs are aligned with yours, then the market will not swap your floating liabilities with a fixed rate that will make you happy. Why? Because, just like you, the market believes that LIBOR will go up and therefore it will demand a fixed-rate that is higher than the floating rate which you are currently paying. The chances are that you will gain from the swap agreement only if LIBOR moves up more than the amount anticipated by the market.

Similarly, ArcelorMittal will gain from the removal of the surcharge mechanism only if the ferro-alloys prices depreciate more than the amount anticipated by the steel buyers. In the supply chain it is closer to the ferro-alloys markets than the steel buyers are. Moreover, due to its sheer size, ArcelorMittal can physically influence the ferro-alloys prices. Hence it probably has a deeper understanding of the ferro-allloys markets and its expectations have higher chances of being in line with the ferro-alloys price developments. However this still does not mean that ArcelorMittal will be able to gain from the removal of the surcharge mechanism. Why? Because the customers of ArcelorMittal already know that ArcelorMittal is more informed about the ferro-alloys markets. Therefore they will be risk-averse and ask for significant price cuts during negotiations.

- In a similar fashion to the above argument, one could claim that customers of ArcelorMittal believe that the ferro-alloys prices will appreciate more than the amount that is anticipated by the steel producers. Therefore it makes sense for them to demand a switch from a floating contractual agreement to a fixed one. Today the steel market is a buyers’ market, and ArcelorMittal desperately needs cash in order to retain a healthy debt-coverage ratio. Buyers have the bargaining power to dictate both the terms and the forms of contractual agreements.

- Buyers will benefit from the increased competition among steel makers: “The surcharge gives stable returns and stable margins and keeps the industry and customer aware of what is going on with the raw material prices,” Arcelor Stainless International CEO Pascal Payet-Gaspard tells MetalBulletin. “The alloy surcharge gives flexibility to the market which we don’t have. The Danish market is very competitive and for this reason stockists will not talk to each other. We are quite stupid because if we communicated, like in Germany, then we could have a margin,” one trader says. In other words, steel producers may be using the surcharge mechanism as a vehicle to collaborate and preserve margins that would otherwise be impossible to maintain in a competitive environment.

- Buyers will benefit from increased pricing transparency from the removal of surcharge mechanism:"The pricing system of stainless is so complicated," one trader tells MetalBulletin. "ThyssenKrupp started it and everybody had to follow. I try to calculate it myself each month but it is a misty area." The rebate system that has emerged in ferro-alloys pricing is nice example of how steel buyers become victim of the lack of transparency. Instead of asking for a direct discount on ferro-alloys prices, the purchasing departments of steel producers ask for a rebate. This keeps the published ferro-alloys prices higher than the actual market levels and pushes up the surcharges.

- Buyers may believe that ArcelorMittal is in a better position to manage the risks involved in the fluctuation of raw materials prices that can not be hedged via financial markets.