Steel Yourself: The Metal is Down But the Stocks Are Up

Everywhere you look in the commodities markets, you see one metal or another (copper, silver, zinc) at or near decade highs. Steel is hardly an exception. But unlike most commodities, the real action in steel isn’t in the spot price, but in the share prices of global steel companies. Physical steel prices in the U.S. actually slipped to a 17-month low in February, mostly due to slowing demand from U.S. auto companies and homebuilders. But the Bloomberg Steel Index, which features 62 of the worlds’ largest steelmakers, has gone nowhere but up. Steel stocks are up 590 percent in the past four years, including a 60 percent gain in 2006 and a strong move year-to-date as well.

The usual rule of thumb in commodity markets is that the shares of commodity companies, like miners, rise or fall largely in line with the underlying metal. With steel, we’ve seen the opposite effect: the price of the actual metal has been trending down, while steel stocks have soared. What gives?

In a phrase: mergers & acquisitions (M&A). Shares of steel companies have soared on M&A activity, both real and speculative. According to Bloomberg, steel companies did 347 mergers and acquisitions in 2006, worth $95 billion. In 2005, those numbers were 270 transactions totaling $33 billion. Some of the big recent deals included Mittal’s $38.3 billion purchase of Arcelor (a record for the industry) and Tata Steel’s $12 billion acquisition of the U.K.’s Corus Group. They ain’t done yet, either: In April, US Steel announced plans to buy Lone Star Technologies, a maker of welded pipe, in a $2.1 billion transaction.

Big time investors such as Warren Buffet and Templeton’s Mark Mobius are betting that steel has more upside. Buffet’s Berkshire Hathaway paid $572 million for a 4 percent stake in South Korea’s Posco (PKX), the third largest steel producer in the world. Mobius, who manages $30 billion in emerging market stocks, added significantly to his steel holdings in the fourth quarter of 2006.

Is steel still a good buy? The bears, like steel analysts at UBS and Standard & Poor’s, say that U.S. steel inventories are near a record high, and that if the U.S. economy slows, that will hurt earnings and lead to lower steel prices later this year. The other risk factors are an oversupply of steel in China (which makes 30 percent of the world’s steel) and a decline in global economic growth, which would certainly curtail demand.

Even the OECD (Organization for Economic Cooperation and Development) is concerned. They say that steel demand is strong, but that higher inventory due to expanded production in several parts of the world (China, India, and Russia) puts the steel bull market at risk.

The bulls, on the other hand, say that the oversupply the bears are talking about is actually behind us, and that any inventory glut is already being absorbed by U.S. and Chinese manufacturers. Just look at the evidence, say the bulls. Arcelor Mittal (MT), the world's biggest steelmaker, has already announced plans to increase prices in the U.S., and recently restarted idled plants because of rising demand and lower inventories. The price of U.S. steel sheet rose for the first time in eight months in March, as producers passed on higher raw material costs to demanding customers. Steel prices in China, the largest producer, are up 4.7 percent this year, according to the China Iron & Steel Association.

The bulls also think that consolidation in the industry will not only strengthen individual steel companies, but that plenty of deals are yet to come. In their eyes, the industry remains very fragmented, particularly compared to other metal industries, like iron ore and copper. If there are more deals in the steel pipeline, they argue, the prices of steel stocks will rise in lockstep.

In the end, steel is a unique commodity for investors for a number of reasons. For one, the ability of small-scale producers to make steel—as opposed to other metals, which are often produced only by large mining outfits—makes the supply and demand somewhat more elastic. Moreover, as a core component of … just about everything … steel is strongly tied to macroeconomic trends, perhaps more so than any other commodity.

And then you have the big point: steel really isn’t a commodity, at least in the sense of having a futures contract that trades on an options exchange. While the London Metals Exchange (among others) has talked about developing a steel contract for years, they’ve met heavy resistance from the steel industry, which claims that it offers too many types of steel to have an effective futures contract. That may be true, but it may also be true that a huge marketing infrastructure has built up around these different types of steel, and that the industry is loathe to see that diminished.

Regardless, investors are left with the reality that the only way to play steel is with steel stocks. There are individual companies that can be bought, like the aforementioned Arcelor Mittal, or investors can buy an index of steel companies through the Market Vectors – Steel (SLX) exchange-traded fund. Regardless, however, it pays to remember steel stocks play by a different set of rules than steel itself: think about the macroeconomic trends and basic metal supply and demand, but don’t forget things like industry consolidation, management, and corporate earnings flow.

For a multimedia take on the steel industry, check out this video from Business Week .

Comments

[AAFinancialFreedom]

The name of the game here is Pricing Power!

We at AAfinancialfreedom.net like the SLX. Here is why, it is a basket of stocks and it also holds some of the best iron ore producers like Vale (old Vale Rio Doce) 'Companhia' (symbol RIO). Moreover, this article touched on the consolidation aspect and did a great job at it so I will move on. Finally, the powers of be around the world were able to raise prices in agreement with the largest nations that consume the steel in the last couple of years and will continue to do so in the foreseeable future.

Sincerely,
The Editor
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