There was no new recession in the US in late 2011 and the European sovereign credit mess did not devolve into a repeat of the 2008-09 financial crisis. An improvement in the outlook for global growth has helped drive a modest uptick in global steel prices and a similarly modest rally in the prices of global steel producing stocks.
To truly understand the dynamics now driving the stock prices of steelmakers, investors must first understand the dynamics of making steel.
Steel isn't a metal but an alloy that's composed primarily of iron mixed with one or more additional elements that act as hardening agents, making steel far stronger than raw iron.
While the earliest steel artifacts are more than 4,000 years old, ancient production methods were inefficient and produced generally lower grades of steel than are possible today. Steel also was extremely expensive to manufacture and used only in applications where no cheaper alternative existed, such as in the production of swords and cutting tools.
However, a series of technological advancements starting in the mid-19th century turned steel from a niche alloy into a mass-produced industrial product that's now one of the world's most important basic materials.
In 2011 alone, the world produced around 1.5 billion metric tons (3.3 trillion pounds) of steel destined for a long list of end uses including residential and commercial construction, automobiles, appliances, energy and industrial machinery.
About 98 percent of all steel produced globally is manufactured using one of two basic processes: oxygen blown and electric furnaces. The main raw material used in an oxygen blown furnace is pig iron, a type of iron that has 2 percent to 4 percent carbon content.
Pig iron is created in what's known as a blast furnace. In a blast furnace, raw iron ore, consisting primarily of iron mixed with oxygen, is heated to extreme temperatures in the presence of carbon in the form of coke, typically produced from metallurgical coal. The carbon combines with oxygen in the iron ore, to produce carbon dioxide gas, effectively removing the oxygen from the ore. The resultant product is pig iron, a rather brittle and useless substance in its own right.
To create steel from pig iron, much of the carbon and impurities must be removed. In an oxygen furnace, purified oxygen is pumped through molten pig iron. Oxygen bonds with carbon, to produce carbon monoxide, and with other impurities to produce slag that can be removed from the molten metal.
The result is steel, a low carbon and low impurity form of iron. The resultant steel can be alloyed with metals such as tungsten, chromium, molybdenum, and nickel to produce a product with various useful properties such as increased strength, lower weight or resistance to rusting.
In contrast, an electric arc furnace essentially uses electricity to heat scrap steel metal, remove impurities and make steel. Producing steel out of such a furnace is cheaper but requires availability of significant quantities of scrap steel to use as feedstock, so it's a far more common technology in developed countries such as the US than fast-growing steel consumers such as China.
Worldwide, 70 percent of steel produced is made in oxygen blown furnaces compared to roughly 30 percent in electric arc furnaces. In Asia, the world's most important steel-producing region, around 81 percent of steel production comes from oxygen blown furnaces. In China, the world's largest steel-producing country accounting for nearly half of global production, more than 90 percent of steel is produced in oxygen blown furnaces.
By contrast, more developed regions such as the US and European Union are more heavily reliant on electric arc technology, with 61 and 44 percent of steel production respectively made using this technology.
Last year wasn't kind to steel-producing firms or to steel prices generally. As the chart shows, global steel producers saw gains of more than 100 percent in 2009 and 2010, followed by a near 34 percent pullback in 2011.
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As you might expect, the main driver of the 2008-09 slump in steel producer stocks was the global economic downturn and financial crisis that crimped demand for steel. The subsequent recovery, led by growth in the steel-intensive emerging markets, was the main driver of upside for both steel prices and related stocks in 2009 and early 2010.
The downturn in shares of most steel producing companies in 2011 derived from two main factors: concerns about global economic growth sparked by the European financial crisis and rising raw material costs.
As I note above, the majority of global steel production comes from oxygen blown furnaces, which require two major commodity inputs: iron ore and the metallurgical or "coking" coal used to make coke, a purified form of carbon.
Iron ore and coking coal prices rose rapidly in 2011 on a year-over-year basis, particularly in the first half of the year (see chart above). While steel prices also rose in the first half of the year, the gains were less dramatic.
Steel production isn't really a mining business but a manufacturing business - producers take raw materials including iron ore and metallurgical coal and use those materials to produce steel. As with any manufacturer, when the value of raw materials rises faster than the value of the product produced, profit margins get squeezed. That's exactly what happened last year.
The effect was exacerbated by extreme flooding in Australia in the first half of 2011 that disrupted the production and export of both iron ore and metallurgical coal, sending prices soaring globally (see chart).
As concerns about global economic growth and the prospect of a new financial crisis sparked by Europe's debt woes intensified after the middle of 2011, steel prices sold off sharply. The move was exacerbated by concerns about a slowdown in demand from China prompted by the government's efforts to cool property prices and speculative construction activity.
Demand: A Look Ahead
China is both the world's largest consumer and the world's largest producer of steel, accounting for nearly half of total global production of the alloy. China's dominance of both sides of the steel industry has been steadily increasing for years and that trend is likely to persist for the foreseeable future.
As recently as 2001, China accounted for just 15 percent of global steel production and a similar share of consumption. The nation's rapid economic growth and development in the past decade has resulted in a dramatic increase in demand for steel and a tripling in the country's share of the global market, as the chart above shows.
The particularly rapid jump in China's share of global steel demand in early 2009 offers another clue as to why China has become such an important driver of the global steel market.
Investors will recall that in response to the 2007-09 global recession and financial crisis, the Chinese government announced a massive stimulus package to reinvigorate growth and encourage lending. That stimulus focused on building out infrastructure such as roads, railroads and encouraging residential and commercial construction. Investment in such heavy infrastructure and construction products is particularly steel intensive and drove a big jump in Chinese steel demand into 2009 and 2010, even as global steel demand remained depressed due to weak economic growth in the developed world.
Chinese dominance of the global steel markets means that domestic steel prices are a benchmark for prices elsewhere around the world. It also means that changes in Chinese steel demand trends are the most important driver of the stocks of major steel producers. The pie chart tells the story.
In China, the single most important end-market for steel demand is construction, accounting for roughly 60 percent of all steel consumption in 2011. This fact explains the steel sector's poor performance in 2011 and the rather lackluster rally in steel prices and related stocks this year, despite an improving outlook for global economic growth and receding fears over Europe's debt crisis.
The Chinese government became extremely concerned about inflation in 2011 and hiked interest rates and bank reserve requirements to cool economic growth and reduce inflation. In addition, the government's efforts to spur lending and stimulate the economy back in 2009 led to a mini boom in real estate prices and construction activity. This gave the Chinese and global economy a shot in the arm but also risked a property bubble.
The government has directly targeted the property sector to prevent the boom from turning into an unsustainable bubble. These policies have pushed down construction activity and, in turn, the world's most important source of steel demand.
The data on the Chinese housing market continues to look weak and the government's efforts to prevent a bubble appear to have been successful. As you can see from the chart directly above, construction of new residential and commercial real estate in China is down sharply on a year-over-year basis while land sales are down slightly.
The last time year-over-year trends in the real estate market looked this weak was towards the end of 2008 and into early 2009, before the government's efforts to stimulate the economy really kicked in. While some of the recent drop-off in real estate activity is due to weather-related delays, there has been a clear downtrend in the growth rate since at least late 2010.
The bullish case for Chinese construction demand in 2012 rests on the government taking further steps to ease monetary policy and prevent the engineered housing slowdown from turning into a collapse. China has already lowered its bank reserve requirement ratio from 21.50 percent to 20.50 percent since last summer and is expected to ease further in 2012.
This removes a major headwind for the real estate market, as the country's reserve requirement ratio was increased steadily from 15.5 percent in late 2008 to 21.50 percent last June. In fact, the economy may already be benefiting from the slightly looser credit market conditions - year-over-year growth in domestic real estate loans jumped in February for the first time in months.
Typically, real estate and construction activity gets a seasonal boost in the spring and autumn selling seasons. While some increase is to be expected, positive seasonality this spring may be a bit less powerful than has been the case in prior years. However, further monetary easing should ultimately have a positive impact on growth and the Chinese real estate market is unlikely to see an outright collapse in 2012. In fact, by the time the autumn selling season kicks in this year, trends in the construction sector are likely to look much healthier.
Recently, HSBC's flash estimate of China's Purchasing Manager's Index (PMI) came in below expectations and under 50. Readings under 50 indicate contraction in Chinese manufacturing activity. Moreover, the Chinese government recently downwardly revised 2012 GDP growth to 7.5 percent. While consistent with the country's long-term target for 7 percent annualized growth, the market seemed to be surprised by this announcement and China-levered sectors such as steel took a hit.
That said, none of this news suggests China is truly in for an economic hard landing. As I said in A Market Correction Rears Its Head, the country has a long history of exceeding official growth targets and is likely to continue a gradual easing in monetary policy this year, even if growth appears to pick up again to well above its 7.5 percent target. The government's efforts to encourage domestic consumption could also mean increased demand for products such as cars and appliances that also require steel.
There are near-term headwinds for steel demand, because of the soft landing in China's real estate market, but the nation's continued strong economic growth and continual easing in credit conditions mean that steel demand is likely to remain firm in 2012.
The Supply Side of Steel
On the supply side, two key trends to watch are producers' supply discipline and Chinese steel inventories.
As to the first point, one concern has been that the recent uptick in global steel prices would encourage producers to ramp up their steel output, flooding the market with a glut of steel just as demand weakens. One statistic to watch carefully is global steel capacity utilization - a measure of actual steel output relative to total global production capacity (see chart).
Global steel capacity utilization currently stands at just shy of 80 percent and has rebounded sharply since late 2011. That jump is a normal seasonal trend: the seasonal demand increase for steel in China means that factories tend to ramp up production to build inventories this time of year.
There are two salient trends to watch. First, capacity utilization dipped to 70.8 percent in December 2011, below the seasonal lows in both December 2009 and 2010. In addition, the current level of 79.7 percent is below last February's 82.4 percent. This suggests that global steel producers have scaled back their output in line with reduced global demand, showing some discipline on the supply side.
Last year was particularly tough for smaller steel producers in China, as rising raw materials costs hit their lower margin operations more than the big producers. It seems unlikely that these smaller, weaker producers would be in a position to ramp up their output this year due to their fragile profitability.
Another important trend to watch is Chinese steel inventories. As the chart shows, Chinese steel inventories have risen in recent months in anticipation of the upcoming high demand season for steel. Inventories remain below where they were one year ago.
Nonetheless, it's also important to differentiate between the types of steel inventories held. Much of the jump in Chinese inventories is in "rebars" and coiled steel, the vast majority of which is used in the construction industry, the epicenter of current concerns about steel demand.
In contrast, inventories of flat steel products are relatively modest. Flat, rolled steel products are primarily used in industries outside the construction sector, including appliances and vehicles manufacturing. Demand for these sorts of products is holding up better than for demand in construction. Investors are likely to continue to favor steel producers focused on flat products over those with more of a focus on coil and rebar steel.
While sluggishness in Chinese construction remains a headwind for Asian stock markets and steel prices, that weakness is already largely priced into the group and easing Chinese monetary conditions will prove a tailwind in the back half of the year. It's a great opportunity to buy the best-positioned steel producers ahead of a rally in the second half.