The recession in Europe, reduced economic activity in the U.S., and concerns over China's growth have adversely impacted dynamics of the steel market, and consequently, coal and iron ore markets. China, which is the world's largest steel producer and the largest consumer of steel, iron ore, and coal, plays a crucial role in determining the outlook of these three major industries. The following note summarizes the current developments prevailing in each of these industries, with a special focus on China. We currently advise investors to stay away from these three industries (be very selective in stock picking), and wait for a possible rebound in the second half of 2012, probably by the end of 4Q. Important things that need to be watched out for are a possible improvement in construction activity in China, the end of the hydro power season by September, and possible default by two key coal importers of China.
Steel prices have constantly experienced downward slides, while steel stockpiles have continued their upward incline. The significant decline in global steel prices is not only due to global macroeconomic slowdown, but can also be attributed to Chinese steelmakers' focus on high production, despite weakening fundamentals, so as to keep their existing market shares. The prices of iron ore and metallurgical coal, the two most important steelmaking raw materials, have also declined as a result of reduced steel demand. Thermal coal has also suffered due to persistent switching trend from coal to gas, as a result of the shale gas boom.
Consequently, major Chinese steelmakers like Baoshan Iron & Steel Co. have cut prices as a result of low demand from automotives and appliances, along with a curb in construction activity. While previously mills were raising production to save their market positions, companies have now started to halt their production in lieu of maintenance, so as to cope with the price drop. According to the China Iron and Steel Association, steelmakers' aggregate profit has plummeted by 96% in 1H2012.
Amidst waning local demand and weak prices, Chinese steelmaking companies have sought an alternative route, the export market. Chinese steel exports reached their two-year high levels in May and June, resulting in further problems for U.S. steelmaking companies.
As a result of a decrease in production, China's steel output is expected to fall for the first time in the last 31 years. This projection marks a three-decade turning point in China s heavy industry and may reverse gains in imports of coking coal and iron ore, which are used to make steel .
According to a Shanghai-based iron-ore trader, steel demand will probably pick up from September as construction is still slow in China where the weather is hot in some places and it is raining in other parts.
Peter Yao, a Bank of China international analyst, expressed his views about a possible rebounding of the coal sector:
"Prices can only start to rebound when the hydro power season ends around September. Since Chinese power plants usually start their winter restocking around October, that could be a crucial turning point for coal."
However, the current coal situation is bad as prices are floating at a two-year low. Although gas prices have started to recover from record-lows, fundamentals remain weak for coal. In addition, China's two key coal importers have recently halted shipments after getting their credit lines squeezed from local banks. A probable default by these highly-leveraged firms can trigger further problems for coal.
After dropping by 13% last month, iron ore prices have continued their downward trajectory, as Chinese steel demand stayed low. Last week, prices fell as low as $115.2 per ton, but traders were not expecting them to fall below $110 because some Chinese mills could pick up cargoes to replenish run-down stocks .
In addition, iron ore mining giants like BHP Billiton (BHP) and Rio Tinto (RIO) are cutting costs extensively so as to streamline their financial performance. RIO is reducing its staff in Australia, and its Sydney office is going to be shut down. BHP's profits are going to be reduced for the first time since 2008.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.