Can Steel Stocks Continue to Climb?

We often hear a lot of discussion, and rightly so, about the prices of crude oil and the agricultural commodities. Their moves over the last year have, in some cases, been parabolic. Their effect on produced gasoline and food prices are also well documented. Less talked about, but increasingly visible and important, is steel.

Steel prices are continuing to rise, with the alloy's average composite weighted price for all carbon-steel products around $1,000 per metric ton (see chart, right, from the WSJ, by way of MEPS International).

Stock prices of related steel companies have also seen a similar rise in the last few months. The SLX exchange traded fund (see below; click charts to enlarge) contains various industry companies that are weighted based on their exposure to the price of steel. The daily chart of the SLX has recently broken out over $100 and is in a nice uptrend. The weekly chart (not shown) has also recently broken out from resistance that was a little below the $90 price.

How are some of the big players in the industry holding up? In a word .... great. Below are the charts for US Steel (X), ArcelorMittal (MT), and Nucor (NUE). Many smaller, less well-known players have similar looking price trends. As seen in the charts, the price patterns all look very similar, and also mimic the recent price pattern in the SLX, as to be expected.

While the charts certainly look nice, you have to wonder how long companies can continue to increase prices - not only in response to demand, which could decrease, but also with regard to raw material cost, which have been rising. Will costs get so high that demand destruction will occur? Will raw material cost increase faster than companies can increase product prices, thereby reducing profit margins?

Both customers and companies are beginning to take action, but in some cases they are at the mercy of the markets. In Turkey, a number of construction companies are going on strike, protesting price increases. In India, transportation and housing projects have been put on hold. Other countries are limiting the amount of steel that can leave the country as exports, while at the same time freezing prices and reducing tariffs to increase imports. Even oil companies are beginning to worry that they cannot build or obtain the equipment they need to extract the oil that is in such high demand.

Steel companies themselves are also taking steps to reduce costs. This is becoming more of a worry as iron-ore prices have risen 71%, while prices for coking coal and scrap steel have more than doubled. To meet the problem head-on, some companies are attempting to purchase iron-ore mines, coal mines, and deposits, as well as hording scrap steel in an attempt to hedge against higher raw material prices. Many are worried that the higher raw material costs, which are forcing them to raise their own prices, will in fact reduce demand as customers start looking for cheaper substitutes, such as aluminum and higher strength plastics.

As it turns out, all is not bad for the steel companies. Construction is still strong in many places outside the U.S., and demand for oil is causing a need for increased production for the capital assets used by the oil drilling, exploration, and services industries. Many of the oil service companies do not have an adequate supply of machinery to service their industry, and many of the machines they do have are wearing out and need to be replaced. This replacement cycle could take a number of years to unwind.

Given the profits that crude oil companies are generating, it is likely that these companies will continue to spend to upgrade and add to their current assets. This of course is good news for the steel makers. Car companies, another user of steel, also need to keep their supply up to meet international demand, yet they too are at the mercy of the steel makers. One such example is Toyota Motors (TM), who is expected to agree to a steel sheet price hike exceeding 20,000 yen per ton from Nippon Steel.

The demand is also not just coming from oil services, automotive, or commercial construction, but from all corners of the globe. This is even forcing changes within the industry. ArcelorMittal is set to increase prices for its flat carbon products that are sold in Europe. The Russian company OAO Severstal is buying the Ohio steelmaker WCI Steel. Nucor has applied for permits to build an iron-making facility in Louisiana that will produce 3 million tons/year of iron, and has reached a joint venture with Sidenor for the production and distribution of long steel products and plate in the Balkans, Turkey, Cyprus, and North Africa. The story goes on. The international growth and level of demand are exciting.

So what is an investor to do? While raw material costs are increasing for steel companies, they are currently able to raise steel prices to keep up with cost, and in some cases, raise steel prices beyond their current cost increases, generating higher profit margins. Given that demand is strong, and inventory levels are low, it is likely that demand will continue to stay strong for the near future, probably through this year and into 2009. The capital expenditures by the oil service companies, automotive industry, and aerospace industry (with its huge backlog) is also likely to keep demand steady, if not growing.

As for an entry point, it is always hard to buy right after a stock has run up so far and so fast, but looking at the charts of X, MT, and NUE, it is hard to argue that these stocks are not in a strong uptrend. Pullbacks are likely, but given the recent price action, global demand story, and current shortages, it is more likely than not that pullbacks to the uptrend line (but not breaking it) present buying opportunities, and not a reason to head for the exits.

Reuters has an article this morning that continues the story regarding rising steel prices. The story begins with a qualifier of how steel prices, currently around $1,100-$1,150 per ton, may drop to $800-$900 a ton in the near future, but will probably not fall back to the $400 a ton that was priced last year. Nonetheless, pricing power remains. ArcelorMittal (MT) raised prices by $186 per ton, a 20% increase, raising prices $40 to $60 per ton for June and July, and has notified customers to expect the same increases in August. AK Steel Holding (AKS) raised spot prices for carbon steel products $150 per ton. The CEO of U.S. Steel Corporation (X) sees flat-rolled steel prices in Q2 rising as much as $300 per ton higher, or 50% higher than the average Q1 price of $646 per ton. Yet, not all analyst see blue skies. Peter Marcus of World Steel Dynamics believes that eventually steel makers will be unable to pass along raw material price increases, and that banks will begin refusing to finance inventories at these prices. Ironically, this may be a plus for U.S. steel makers since rising steel prices, and dollar issues, have made them more cost-effective while making foreign imports less attractive. This is good news for U.S. steel. For additional information on U.S. companies, SeekingAlpha.com has a nice article written a few weeks ago by William Ellard that discusses a few of the smaller steel companies. It is worth a read.

Disclosure: None

Comments

[Thinkingahead]

I agree with your thoughts and I'm enjoying the ride on X and ATI. But I wonder if the steel companies could somehow get caught in the same bind that the oil refiners are in. Remember the talk about "not a single new refiner built in the US in 40 years . . . "? Turns out, they got caught in a squeeze between input cost escalation and anaemic pricing power. I'm just being cautious here, and still holding those X and ATI shares.

[jjc7477]

I'm in the steel service sector of the industry and am also long NUE, PKX and SLX. I typically import about 20% of my annual volume but over the past year this has shriveled to nothing. Every company buying steel in the US or Mexico is part of a captive audience: no where to go for relief due to the dollar, the high cost of ocean freight and fierce demand in other market.

I began to go long in February and believe we are looking at a trend that should last into 2009. Yes, the mills are facing increased raw material costs, but witnessed by Nucor's and SDI's purchase of scrap companies and Nucor's new pig iron operation plans, they are spending their new found wealth prudently and ultimately, these costs will become somewhat contained.