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In good economic times, industries race to keep up with demand. If new supply cannot keep up with new demand prices will tend to rise. Rising prices send positive signals to industry leaders prompting new investment in people, current production, and additional operating capacity. At some point the industry invests ample capital into new production, people, etc. and collectively, the industry can meet the prevailing demand with sufficient ease. Unfortunately, demand is not a one direction factor and, from time to time, is prone to decline. As demand wanes, inventory begins to build in the supply chain prompting prices to decrease. The implication of price declines is that the most uneconomic plants currently operating become unprofitable and, if prices persist at lower levels, these unprofitable plants will be shut down. While this generic business cycle tends to fit virtually every industry at different times, there is evidence that the steel industry may be entering an inflection point in the cycle.

In an Financial Times article by Peter Marsh, published July 8th, titled "Bleak Outlook from 'peak steel,'" Mr. Marsh explores evidence, which is starting to stack up, indicating that the steel industry may be facing a prolonged period of over-capacity which stands to wreck havoc on the steel industry. The article essentially argues that new investment over the recent years was predicated on demand growing in the future (as opposed to meeting incremental current demand) and as a result, "if the world can no longer rely on the kind of hefty year-on-year increases in steel demand that it has grown used to - albeit with a sharp break linked to the 2008-9 financial crisis - then the plans by the steel industry for how it organizes its activities will need to be dramatically altered."

As industry leaders grapple with their potential options, some companies will opt to sell off their least economic plants to any willing buyers. The article argues that, "the most significant of these was the shock announcement two months ago from ThyssenKrupp of Germany that it is looking for buyers for two big and expensive steel mills in the U.S. and Brazil, costing about €12bn between them, which it started planning before the crisis. ArcelorMittal (NYSE:MT), the world's biggest steelmaker, has refused to rule out reductions in its European plant network."

Other companies are aiming for ways to differentiate themselves from competitors in the hopes that they can retain existing demand thereby avoiding selling off assets or idling assets. For example, "JFE of Japan and Voestalpine of Austria - are putting more emphasis on developing new forms of the material that they hope will give them a competitive edge on rivals, for instance by opening up new demand for strong or corrosion-resistant steel variants." While product differentiation may help at the margin, it is challenging to believe that there is any substantial company that will be able to totally avoid facing some tough choices if demand flattens- or worse yet, declines.

Peter Marcus, managing partner of World Steel Dynamics, a U.S. consultancy, says: "For the next five years the steel industry faces a rutted road strewn with potholes. A lot of companies are going to find it hard to make money." This highlights the need to evaluate the strategic plans of companies in order to evaluate which companies are the best stewards of shareholder capital. In my opinion, companies that find creative solutions to gain a competitive advantage will have a leg up over the companies that employ indiscriminate cost cutting/asset liquidation programs. Nonetheless, if declining steel demand does turn out to be more than just a temporary phenomenon, steel stocks will be a good instrument to hedge (by selling short) against other long positions an investor may be holding as the industry faces a tumultuous period. Good luck and thanks for reading.

Source: Steel Industry Facing Challenging Times