What Does the Future Hold for China's Steel Industry?

Includes: BHP, RIO, VALE
by: Erik Bethel

What’s going on in the Chinese steel industry and what does the future look like? It depends who you ask. According to Xinhua News, Baosteel--China’s leading steel company--plans to increase annual capacity from its current 20MM tons to 50MM tons by 2015. Yet there is a cautionary warning. Baosteel’s Chairman, Xu Lejiang recently stated that, “China’s huge economic stimulus package has encouraged steel mills to step up expanding capacity, and that overcapacity is structural” (Caijing Magazine).

What’s the situation on the ground? Well, rather complicated. At the risk of oversimplifying, I distill the issues faced by China related to iron and steel below:

  1. China is the world’s largest steel producer and consumer. In 2008 it produced more than 500 million tons of crude steel.
  2. China does not have enough domestic iron ore to feed its steel mills.
  3. It therefore has to rely on Vale SA (NYSE:VALE), Rio Tinto (RTP), and BHP Billiton (NYSE:BHP) for iron ore. Together, these “Big Three” firms control 80% of the seaborne iron trade.
  4. There are literally hundreds of inefficient steel companies in China. This is a problem for many reasons. Pollution is one reason. But another is that a collection of smaller companies has less leverage over the Big Three iron ore miners than a more compact group of stronger, united players.
  5. Therefore, Beijing is “encouraging” consolidation in the steel sector as part of a plan to concentrate 45% of steel production in the hands of the top 5 players. Authorities have pledged to cut 72 million tons of iron capacity and 25 million tons of steel capacity by 2011, with 100 million tons of iron and 6 million tons of steel to be slashed this year. In early May, the National Development and Reform Commission (NDRC) ordered the closure of blast furnaces smaller than 300 cubic meters and electric arc furnaces with less than 20 tons of capacity.
  6. Yet despite the pledged cuts and consolidation, total production of crude steel reached a record 46.5MM tons in May alone, according to China’s National Bureau of Statistics.
  7. Why is steel production going up? Among other reasons, because of the massive 4 trillion yuan Chinese stimulus package.
  8. Meanwhile, the China Iron and Steel Association (CISA) is trying to negotiate a price reduction with the Big Three but given many factors, it looks like it won’t succeed in getting the concessions it wants.

So what does the future look like?

  1. Today, the Big Three possess a lot of leverage.
  2. But the long-term winners in China could be the large steelmakers. There will be consolidation over the next 12-18 months and the big players such as Baosteel, Angang and Wuhan, to name a few, will benefit.
  3. CISA will likely settle its contract price at a leval similar to Korea and Japan.
  4. The stimulus package will continue to drive up steel production, especially in long-steel products for use in construction and transportation. Don’t forget that the construction-heavy Shanghai Expo 2010 is coming up as well.
  5. We see China seeking to go outbound to acquire iron ore operations globally. The Belinga operation in Gabon, Africa is one example.
  6. Latin America,and Brazil in particular, has ample sources of iron. The problem is that a few entrenched industry players (like Vale) control logistics and distribution.
  7. Therefore it is crucial for Chinese firms looking to make outbound investments link the acquisition of a Brazilian mining asset to rail logistics and ultimately to a port. Entrenched business interests (not to mention Capex) could pose barriers, but Brazil’s iron ore infrastructure needs to change.
  8. We see huge interest on behalf of Chinese investors looking for iron assets and in the next few years we foresee serious acquisitions in the iron sector and in infrastructure related to iron ore.