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By Elizabeth Collins

World steel prices have recovered some ground since their nadir last spring, but they're still a far cry from the levels that prevailed during the heady days of summer 2008. With demand ultimately resting on activity in construction, automotive and machinery markets, a full recovery will likely be drawn out and fraught with uncertainty. Exacerbating this still-weak global demand outlook is surging steel production in China--which places the burden of discipline on other steelmakers' shoulders--and increasing costs for key raw materials.

Background: Steel Production and Uses
China is by far the top steel-producing country, followed by Japan, Russia, the United States and India. ArcelorMittal (NYSE:MT) is the world's largest steelmaker, with 2008 output more than double its closest peer, Nippon Steel (OTC:NISTY). Major end markets for steel include construction, machinery and autos.

Demand Still Weak
While demand for steel in China has remained quite strong and developed nations' demand has begun to improve, a full recovery in global demand for steel will likely be drawn out and uncertain. Indeed, ArcelorMittal expects that the developed world's demand for steel in 2010 will still fall 23% short of the 2008 level. The company's tempered outlook is informed by lingering unemployment and growing government budget deficits.

Production Discipline Necessary
Given the outlook for still-weak global demand, production discipline is necessary to ensure favorable pricing and the health of the overall industry. With China producing steel flat-out--output was up 13% in 2009 according to the World Steel Association--the burden of discipline is falling on the rest of the world (where output was down 21% in 2009). Since steel producers have a high degree of operating leverage, this production discipline has come at a steep cost. Witness ArcelorMittal's profitability versus utilization rates during 2009: The company swung to a profit only after capacity utilization rates rose above 60% in the third quarter.

Raw Material Costs Increasing
Exacerbating the still-weak demand from developed nations is the outlook for cost inflation, as the prices for many key inputs (iron ore, metallurgical coal, scrap and natural gas) are either already on the rise or contracts are expected to reset at higher levels. In particular, seaborne iron ore benchmark prices seem ripe for an increase. Amid last year's massive economic uncertainty for the global economy, the Japanese steel producers (the Chinese failed to reach an accord) and the Big Three iron ore exporters -- Vale (NYSE:VALE), BHP Billiton (NYSE:BHP) and Rio Tinto (RTP) -- struck an accord for a 33% reduction from 2008 prices. This year, with nightmares of economic Armageddon having largely abated, base metal spot prices up across the board, and Chinese steel output at record levels, iron ore producers are back in the driver's seat. Indeed, China's continued appetite for seaborne ore will be the biggest demand-side driver of benchmark price negotiations.

Daniel Rohr contributed to this article.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Source: What Does the Future Hold for Steel Demand?