Steel Outlook 2011 - Volatility Is the New Black

Includes: AKS, CLF, MT, NUE, RS, STLD, WOR, X
by: Michelle Galanter Applebaum

“We are truly, extremely offended by the fact that there will be closures of any capacity in the United States while a single ton of higher-cost foreign steel is imported into this country.”

Get ready for another bouncy ride. We are currently looking for 2011 to have very similar pricing trends as the past two years. Key to our forecast is volatility. Probably the only predictable thing about the steel market in the next few years will be that volatility will dominate, so we expect to see not only new post-recession highs for steel prices in the next year but also prices that most probably will be back at the lows of 2010 as well.

From 2003-2008, the duration of the average pricing cycle ran around a year, with a minimum cycle of 10 months; before 2003, pricing cycles ran 18 to 36 months or more. Sheet prices have experienced meaningfully increased volatility in the past 18 months, with two intact "cycles" since June 2009: a 40-percent up cycle from June through September and a 20-percent down cycle from September to late November, and an ongoing cycle that is up 40 percent so far.

There are a number of reasons this volatility is likely to persist:

1. Empty supply chain. Inventories—at the mill, distributor and consumer levels—normally cushion normal small swings in steel demand, seasonal swings, supply chain disruptions and other nominal increases/declines in orders. For example, as we sit here in late 2010 with some $120/ton price increases announced for flat rolled, customers are beginning to scramble to find material and are quickly sucking down the increase despite an industry-wide operating rate below 70 percent. This is simply because the supply pipeline is so empty and lead times for production increases aren't instantaneous, so the pricing environment is being whipsawed. Sheet prices ran up a whopping 40 percent from July to October 2009, with an operating pickup from 47 percent to 62 percent—hardly a full enough market to get any price increase in historical terms.

2. Overdamping/underdamping exacerbates the problem. This volatility is new. We believe that volatility is enhanced in the "new normal" because of the combination of three things: bare-bones inventories, the nature of the underdamping caused by the blast furnace stop/start cycle, and the relatively low cost of steel as a percentage of the total cost of most finished products made out of steel.

3. "Scarcity signals" contribute to momentum. There are continual messages from steel mills that they would be unable to get material to customers quickly at any sign of a pickup. Even at low operating rates, with plenty of idle capacity, mills often are unintentionally sending a message to customers that they've become more full in recent weeks by renegotiating existing pricing commitments, slowing deliveries, pushing out schedules, etc.

4. Steel pricing inelastic, lead times a barrier. One artifact of the 30-year drought in the steel business is that the cost of steel as a percentage of finished products made out of steel is relatively small. For instance, steel cost 10 percent of a car's selling value in 1981; today, it's around 3 percent. So availability becomes far more important than pricing.

Merger and acquisition activity also is back. We believe that the corporate story in the domestic market will be a meaningful acceleration of M&A in the distribution/processing business. There are currently at least six major middlemen on the hunt for acquisitions. An expected mini-surge of acquisitions at year-end 2010 due to tax changes not only didn't meet expectations, it was seemingly invisible. This screams disconnect—that seller expectations are way off the mark. Even so, a number of the larger players are highly motivated, and there are public companies with public equities that might very well prove to be attractively priced targets.

We also see some opportunities for a permanent restructuring and closure of domestic capacity. As capitalists, we are truly extremely offended by the fact that there will be closures of any capacity in the United States while a single ton of higher-cost foreign steel is imported into this country. And most imports are high cost. Even so, the highest-cost domestic capacity is going to have to go. The mill-recycling process can only go so far when it's about recycling dying or dead domestic industry capacity. We've run out of fixes.

Globally, I see a more aggressive "corporate" China. The Chinese don't seem to understand the rules of engagement, however, so there will be a great deal of noise and little closure.

This is the New Normal. The net result of a combination of bare-bones inventories with occasional demand upticks is likely to bring us to a permanent new normal of oscillating steel prices in cycles far shorter than what we've seen in the past. This means more volatility, and in some ways more opportunities, for those who trade either commodity steel or steel equities. However, this is meaningfully unhealthy for the domestic and global steel industry, as it will wreak havoc with production schedules, capital investment and jobs. M&A in the distribution sector should bring growth to a number of companies, but real growth in terms of new jobs and wealth creation likely will continue to elude us.

Disclosure: I am long RS, CLF, NUE.