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COMMENT: Those damn discounts

April 26, 2013 - 16:34 GMT Location: London

KEYWORDS: hot rolled coil , HRC , discount , CRU , HRC index , US midwest , pricing mechanism

A widely known but little-examined practice broke into the light earlier this month, when ArcelorMittal USA, followed by Severstal North America and Nucor, said they intended to stop selling hot rolled coil (HRC) at a discounted rate to CRU’s HRC index for the US midwest.

The mechanism of offering term business at a discount to published and benchmark prices is not confined to flat steel in the US midwest, of course. Such mechanisms are also widely signed into contracts in the global cobalt market, for example. Quarterly ferro-chrome benchmark pricing in Europe is defined as much by the scale of the discounts as it is by the headline numbers.

It is easy to understand how such agreements come about.

Having settled on a market reference that both sides have reason to believe will be representative, they then contract maximum and minimum tonnages to be delivered over a specified period, with the price settled with regard to a published assessment or index.

The reports that some US steel mills are looking to move away from the CRU-minus-a-discount pricing terms that have become prevalent is a vindication of the index’s success to this point.

The discounts have helped to seal deals...
Producers’ marketing teams introduce the discounts in competition with their peers in both rising and falling markets.

In the former case, securing as much business as possible when prices are rising can make the discounts seem immaterial and, in the latter, the producers’ need to fix tonnage gives buyers a strong hand in negotiations.

(A sceptical observer might question whether the move against the discounted rates has anything to do with the mechanism at all as opposed to the low level of steel prices.)

If company X is offering a 1% discount to the average low price for the second quarter of 2013, company Y’s marketing team reasons, we will offer a 1.5% discount, or match the discount but offer a better option on tonnage.

...but are now eating away at spot prices
Of course, like the introduction of an alien species the discounts tend to take over.

Just as Japanese knotweed strangles other species, so the discounts impede spot business in the first place.

Why would a customer enter the spot market at all, if instead they could push up volumes on contract and take the discount?

A strong and widely used reference combined with the habitual use of discounts in contracts inevitably means that risk-averse and cautious sellers and buyers will frame their spot discussions around both the index — and the discounts to it.

This is not helpful since it can add artificial downward pressure to the spot market.

So: damn the discounts at the best of times, and particularly at the worst of times, as they threaten to erode sales margins beyond a sustainable level.

And praise the producers that brought them into being, if they now have the creativity to come up with an alternative – and the stomach and staying power to wean their customers away from this pernicious form of pricing…

Alex Harrison
Twitter: @alexharrison_mb 

All material subject to strictly enforced copyright laws. © Euromoney Institutional Investor PLC.

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