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Profits for the steel industry have been plagued by the overcapacity issue and the situation is synonymous to the current crisis in the dry bulk industry. However, the shale gas revolution has brought some hope for the steel industry. Nucor (NYSE:NUE), the second-largest steelmaker in the U.S., has solid plans to benefit from cheap natural gas. This article explores different channels through which the steel players can benefit from the shale gas boom.

The Steel Industry

In my previous article on Nucor Corporation , I discussed in detail how the steel industry is being severely damaged by the overcapacity issue. Not only this, the whole industry is facing the problem of the "prisoner's dilemma". A reduction in capacity would benefit all of the market players, but no single player is willing to cooperate and take the first step and therefore all are losing on their ends.

The Shale Gas Boom and the Steel Industry

The potential implications of the shale gas boom seem to be very significant for the steel industry. In terms of demand, steel should play an important part in the development of both oil and gas infrastructure at the shale gas sites. For example, steel pipes can be used in the casings for wells.

However, this article will focus on the supply-side benefits of natural gas. Steel makers would benefit from using natural gas in the steel-making process, with potential material cost savings and margin enhancement. However, this is likely to center on EAF/mini-mill configurations (discussed below).

The various steel production techniques

We all know that steel is merely the reduction of iron using energy. The iron units can come from iron ore or scrap. The energy units are produced using the following four techniques:

  1. Coal in the blast furnace (BF)
  2. Electricity (Electric Arc furnace)
  3. Direct Reduced Iron (DRI) route for Arc furnaces
  4. Injection of gas in the blast furnace, which combined with Pulverized Coal Injection (NYSE:PCI) can make a cheaper substitute for coke (a derivative of coking coal).

Some terms need to be described here.

Electric Arc Furnace (EAF) - A type of furnace used during the steel-making process that shoots electric arcs between electrodes to burn a combination of pig iron and other materials to produce steel.

DRI - This process uses prodigious amount of natural gas to create iron by heating the iron ore at a temperature high enough to burn off its carbon and oxygen content. This process uses the same infrastructure as EAF.

PCI - powdered coal that is used to generate thermal energy to produce electricity. In this context, it is used as a cheap alternative to coking coal to produce steel.

I am interested in discussing the DRI technique. This is because of the fact that the effective input cost of EAF and blast furnace are broadly similar, so a shift in the dynamic of a "new" route could lead to significant savings. The steel makers, by adopting, the DRI technique can make massive cost savings by using cheap natural gas in the steel-making process.

DRI currently accounts for a small part of global steel making process. The important point is that DRI technique is hardly used in the US. Almost 100% of the iron ore production is achieved using the BF method.

Nucor's Plans to Benefit from the Natural Gas

Nucor has already announced that it plans to benefit from the declining natural gas prices. It is one of the largest mini-mill steel producers in the world. Globally, the DRI technique is mostly used by mini steel mills (to melt rich sources of metal such as steel scrap). NUE has been at the forefront of pushing forward on utilizing the cost benefits of natural gas through the construction of a new DRI facility in Louisiana. The company is targeting self-sufficiency of one third of its scrap needs (approximately 6-7 million tons). The company is expected to achieve this target after the completion of first and second phase at the Louisiana site.

No stranger to DRI, NUE currently has the most exposure to DRI among the US steel producers, with its recently expanded two million ton DRI facility in Trinidad, and its multi-phase DRI project in Louisiana. Louisiana DRI project is expected to be a game changer: NUE is currently in the middle of the construction of its new DRI facility in Louisiana. The first phase is expected to produce 2.5 million short tons of iron per year at a capital cost of $750 million. The company has also got the license to carry out the second phase, allowing for the construction of a second DRI plant on the site taking the total capacity to 5.0 million short tons. The first phase of Louisiana DRI plant is expected to be completed by mid-2013, with the second phase likely to be completed by 2014-15 if the company proceeds soon after the completion of the first phase.

Also, NUE has entered a joint venture agreement with Encana Oil & Gas (NYSE:ECA), one of the largest natural gas producers in North America, which essentially hedges the cost of natural gas needs. The partnership allows the company to:

(1) buy the natural gas at cost

(2) There are no upfront investments needed and

(3) the drilling can be terminated if gas prices go lower (i.e., a "pay as you go" capital investment).

The capacity will generate sufficient low-cost natural gas to hedge the gas usage of Phase One (at Louisiana plant) for 20 years. DRI is a lower cost substitute if the scrap prices are above $300/ton - $350/ton. According to an estimate, with the iron ore price at $100/ton and the natural gas price at $3/MMBtu, the savings are expected to be $110/short ton.

Conclusion

A 2.5 million ton DRI facility would cost $750 million to NUE. However, Credit Suisse (NYSE:CS) believes that it would save an annual $380 million thereby giving a phenomenal payback period of two years. The important aspect to understand is that Nucor is an EAF producer of steel. The EAF infrastructure (as mentioned above) can be used to employ the DRI technique. Therefore, for NUE, the switch to the DRI technique makes sense. But an existing BF producer or a new entrant will have to fund the additional capital cost of a new EAF/DRI plant also.

This is why I believe that NUE enjoys a competitive advantage by using natural gas to produce steel. US Steel (NYSE:X) also announced in its earnings call that it plans to benefit from cheap natural gas. However, X has not yet approved any specific projects or timelines to benefit from higher natural gas usage.

Key risks: Nucor will lose its competitive advantage once other US steel makers start investing in the DRI technique.

Source: The Shale Gas Boom Brings Hope For Nucor