Some European steel producers are under pressure from customers to provide contracts with steel prices fixed for a year with no index-linked raw material clauses, sources throughout the steel supply chain have told Platts.

As a result, steelmakers could be exposed to short-term raw material contracts and longer fixed prices with customers, meaning they cannot pass on fluctuations in their own costs. Iron ore has recently been the most volatile cost element throughout the steel supply chain, and contracts with index-linked clauses allowed mills to pass on some fluctuations to their customers.

Buyers, particularly in the automotive sector, feel they have more pricing power given the depressed market and are demanding to move away from raw-materials linked steel product contracts.

A source with one large European mill admitted his company is losing some of its pricing power to OEMs, and could be forced to compromise on commercial terms to maintain market share.

He said customers were taking advantage of weak demand to press for prices fixed for a year and threatening to move business to other mills that will agree to their terms.

"The market is so weak that unless we meet their demands they will just take their business to another producer," said the mill source.

A service center supplying the automotive industry said it has a "number of annual agreements" in place, and is looking to get even more. A source at the company said mills are more flexible than in the past.

"People are very much pushing against this [contracts with index-linked raw material clauses], as nobody trusts these indexes anymore, because they do not reflect their reality," a source with a large European trading company added.

A procurement executive with a leading global automotive producer said his company tries to refrain from signing contracts with index-linked clauses.

"We try to avoid index-linked raw material clauses wherever possible as we think they are leading to unreasonable inflation," the executive said.

"We do have some index-linked contracts with small tier-one suppliers for specific raw materials," he added.

In these instances the index-linked clause is related to finished product prices, rather than raw materials.

A Benelux-based agent with one large European mill said index-linked contracts "only work for a short period of time as they create problems whenever prices change sharply."

ONE MILL ENDS RELATIONSHIP WITH LARGER BUYER OVER TERMS

The agent did say, however, that his mill was sticking to quarterly and six-monthly contracts.

They ended their relationship with one large customer that was not accepting shorter contracts, he added.

An executive with a large white goods producer, however, said index-linked clauses provide more visibility over how steel prices will move going forward, given that raw material prices have been so volatile of late.

"If we are back to more stable raw material prices then it will not be a big issue for steel producers to go back to 12 month contracts," he added.

He did not see this as the case at present.

His company in turn has formulas in contracts with its buyers -- which can range from 12 months to three years -- based on its primary raw materials. The executive said they are not so much index-linked, but raw material prices are monitored for their percentage change over a period of time.

MANAGING EXPOSURE A RISK FOR MILLS WITH LONGER CONTRACTS

For mills pressured into selling coil and other products on fixed prices over terms lasting several months through to one year, managing exposure to iron ore and coking coal prices remains a concern.

Meanwhile, the steel industry is showing hesitancy in allowing a move towards a tolling operational model, where it simply captures a margin around short-term moves in raw materials prices passed onto steel prices.

Tolling is seen in simpler industrial processes, such as ore smelting and coke production, which the steel mills may not feel is appropriate based on the value added and diverse customer applications and segments.

The iron ore swaps market has developed liquidity since its inception, but hedging the 10 million dry mt-plus volumes a typical large EU steelmaker is exposed to annually requires substantial cash placed at clearing houses for margining.

In the case of coking coal, liquidity across derivatives markets has not yet emerged, and grades of metallurgical coals and origins required remain far more fragmented. The market risk is less correlated to a single point of liquidity as in iron ore, which has centered on CFR China prices.

Lossmaking mills do not have the free cashflow available to enter into the derivatives market to any such degree.

Possibly this will only change if their main relationship banks agree new terms allowing a sharing of the burden of margining at clearing houses for any paper trades when it comes to refinancing existing loans, suggested one mill source. A London-based banking source welcomed the rise in contracts with index-linked raw material amendments.

He said this kind of pricing mechanism has been good for liquidity in iron ore derivatives, with some steel end-users, particularly in the automotive sector, hedging steel price exposure through iron ore swaps.

He said finished product indexes and reference prices are "bad for liquidity" as they discourage some buyers from using iron ore swaps, where the lion's share of ferrous derivatives action takes place.

He pointed to the airline industry -- where companies buy jet fuel but hedge their jet fuel price exposure through crude oil swaps -- as a model for steel.

Index-linking against finished product reference prices is nowhere near as prevalent as in the US, where physical hot-rolled coil deals have referenced CRU's published weekly prices until recently and US HRC swaps have seen higher trade activity than for other similar contracts.

There is some longer-term project business that references CRU, and of late some business has been done linked to northern and southern European HRC prices published by The Steel Index.

However, this has mainly been small-scale driven by traders, according to sources.

There is a belief among some buyers, however, that hedging the product you buy makes more sense than hedging a raw material that has gone into it. However, the white goods executive said his firm has tried finished product swaps to hedge its exposure, but found it was not "useful."