The last two years have been difficult for steel producers, and a brighter picture is still off in the distance. Although we believe that consumption has bottomed and is rebounding, the journey to recovery is going to be slow. However, this doesn't mean decent profits are a pipe dream. Thanks in large part to China, industry fundamentals are slowly improving, but it is often a game of two steps forward and one step back, especially when you look at how steel prices and raw material costs have behaved this year. No matter which way demand and prices are headed, the best any steel company can do in this environment is prepare for volatility.
Prices Are Not the Indicator They Once Were
It used to be that higher steel prices came from stronger demand, as supply was relatively fixed in the short term. This is no longer so. First, in recent years, steelmakers have increased their ability and willingness to adjust production to meet demand, so supply has played a greater role in determining prices than it has in the past. Second, steel buyers and distributors have improved their working capital management, and are able to operate with much smaller inventories than in the past. Therefore, short-term supply changes can have a much greater impact on steel prices by creating the impression of a shortage when the supply chain is lean. Given the degree to which higher-cost inventories weighed on the earnings of steel mills and steel buyers when prices tanked in late 2008 and early 2009, lean inventories have become de rigeur.
Earlier this spring, steel prices in the developed world reached levels not seen since the fall of 2008, while demand slowly improved and raw material costs increased. Prices of steelmaking inputs iron ore and scrap are sometimes viewed as predictive of steel prices, since mills will attempt to pass any changes in their raw material costs on to their customers. But it was a bit of a "which came first, the chicken or the egg" phenomenon when steel prices soared more than 50% between December 2009 and April 2010. The mills blamed rising raw materials prices for their need to raise prices to recoup costs, while the raw material producers pointed to stronger demand for steelmaking (which should indicate higher steel prices) as the driver of raw material price increases. Still, it is interesting to note that mills had such success in raising prices so dramatically when capacity utilization barely broke 70%. In the past, they never would have succeeded in pushing those price increases through given the weakness in order rates. Again, these are different times. Steel prices then took a 20% slide early in the summer. Once again, many attributed the summer drop in steel prices to a decline in the spot price of steelmaking inputs iron ore and scrap. But, sure enough, those on the mining and scrap recycling end pointed to a lack of buying (i.e., less steelmaking) as the reason for the raw material price declines. Meanwhile, end market demand had shown little change. It appears lean inventories and fluctuating input costs took the reins on steel pricing.
We'll Take our Cues from China
Let's take a look at what role China has played in this price roller coaster. China accounts for about half of global steel production. Given that steel is a globally traded product, steel prices in China have a global ripple effect. This dynamic has been beneficial to steel companies in the developed world through the downturn, given that Chinese steel consumption did not suffer the same dramatic decline, and therefore provided some pricing support. The main source of raw material for Chinese steelmaking is imported iron ore, mainly from Brazil and Australia. Earlier this spring, the pricing mechanism of seaborne iron ore changed, from an annual benchmark to quarterly contracts based primarily on the average spot price of iron ore for the three months prior, with a one-month lag.
The problem with basing contract iron ore prices on prior-period spot prices is that it creates the incentive to overproduce steel during periods of rising spot prices. In April 2010, Chinese steel production hit a record high, as the mills used up their previously purchased lower-cost iron ore just when spot iron ore prices peaked. This hoarding behavior caused Chinese mills to produce less steel during the subsequent months. By extension, they purchased less ore during the period of higher contract prices (which were up about 90% from the prior period), causing spot iron ore prices to plummet. This decline was exacerbated by government efforts to tighten monetary policy, and cool off property prices. The Chinese depleted their excess inventories, and returned to the market mid-summer, causing iron ore prices to rise again. Steel prices in China mimicked this pattern, and the rest of the world followed a similar path. We believe this cycle is likely to repeat, setting up greater volatility in prices for steel and raw materials.
End to the Summer Slump
Declining steel production this summer was not limited to China. Steel mills in the U.S. and Europe also reduced output to try to halt the decline in steel prices. Late summer tends to be a seasonally slow period, so some decline in production and shipping volumes was expected. Steel consumption generally sees an uptick in the fall before experiencing another seasonally slow period following Thanksgiving. Several mills have recently announced immediate price increases expecting to see stronger demand in the weeks ahead. European steelmakers ArcelorMittal (MT) and ThyssenKrupp (OTCPK:TYEKF) have already announced price increases of around 5%, planned for October. But as we have seen, improving demand does not always ensure better prices in this environment. Based on the drop in spot market iron ore prices earlier in the summer, it looks as though iron ore contract prices will fall 10%-15% in the fourth quarter, sequentially. Steel buyers who were previously told they needed to pay higher prices so the mills could recoup higher raw material costs will surely want a price break when iron ore prices fall.
So if costs go down and demand goes up, where do selling prices go? We were skeptical that the mills would be able to maintain these price hikes through the end of the year until China provided another ray of hope just last week. In an effort to meet power reduction targets, the Chinese government sent notices to approximately 50 steel mills requiring up to 70% output cuts for the next month, and some cuts were mandated through the end of the year. This would cut total Chinese steel production by an estimated 10%-20% per month. Assuming these output reductions are enforced, which we believe is reasonably assured, the drop in Chinese steel production should provide global pricing support through the remainder of the year. What will happen to prices and raw material costs heading into 2011? If recent history is a guide, we don't expect stability on either end.
Who Can Best Manage this Strange New Environment Going Forward?
In the long-run, we believe captive raw materials and efficient operations are the keys to solid profits in steelmaking. However, in the current environment, vertical integration is less important, as input prices are exhibiting greater volatility. If steel prices move at a similar pace, it will be difficult to maintain consistent profits when a higher degree of costs are fixed. In the next few quarters, we think managing the volatility of demand, prices, and raw material costs will be the determinants of performance. We believe the following companies are best-positioned to do so.
POSCO is one of the most profitable Asian steelmakers. It enjoys a dominant position in South Korea, with its relatively stable economy. The company exports a significant share of its steelmaking to China, and is therefore poised to benefit from the required curtailments through the end of the year. Also, the company has had more success imposing quarterly changes in selling prices to its customers than some other flat-rolled steelmakers, who are more accustomed to annual pricing.
As the world's largest steelmaker, ArcelorMittal has good exposure to emerging markets, which should mitigate some of the consumption volatility in the developed world. Its large scale and presence in all major steel markets enables better distribution capabilities, and the flexibility to adjust production and exports to take advantage of regional changes in demand. The company also has shown great flexibility at managing its furnaces, and doesn't hesitate to lower production when needed, with the belief that it will quickly regain any market share lost to less-disciplined competitors.
Steel Dynamics (STLD)
Mini-mills such as Steel Dynamics will generally outperform their blast furnace competitors in a quickly changing environment due to lower operating leverage. The company is also very well-managed. Steel Dynamics only lost $0.04 per share in 2009 on a 51% decline in revenue, when most competitors posted significant losses.
Another U.S. mini-mill, Nucor has the greatest product diversification among U.S. steelmakers, with not more than 30% of total sales generated by any major product group. A highly flexible production process and efficient labor allow Nucor to almost instantaneously adjust output to match market demand. Nucor also has superior financial flexibility, and has strategically timed debt and equity raises in the past few years, whereas many cash-strapped rivals found themselves cornered into raising equity at depressed prices.