Steel: Lessons From the New Normal

by: Michelle Galanter Applebaum

From the American Metal Market Monthly – Lessons in the New Normal

If anyone had told me in 1994, when the domestic steel industry was running flat-out with poor pricing in a period we dubbed “profitless prosperity,” that we’d see 50-percent hot-rolled sheet price increases in a four month period with the industry running at 75 percent of nameplate capacity, I’d have been rolling on the floor laughing.

There’s nothing like steel to provide endless surprises and opportunities for humility. Here are some new lessons and new twists on old ones.

Raw material cost increases drive price increases

This is only true if the book that keeps new orders is as full as the book that keeps production. The fallacy in this analysis is misunderstanding that the business of making steel has become less and less fixed-cost over time, so unless pricing is of a sufficiently higher magnitude than costs—meaning margin exists—productive capacity won’t be deployed. So anyone saying that the United States is operating at 75 percent of capacity is missing the boat, because capacity has become fluid. While we might indeed be at 75 percent of nameplate capacity, at current spreads one-quarter of capacity isn’t economic.

And here is what’s different

Theoretically, at an $800-per-ton hot-rolled price it would seem that virtually any productive hot-rolled coil tonnage could be restarted at a profit. However, this just isn’t true anymore because most mill operators would logically and most probably accurately question the sustainability of today’s $800-per-ton pricing since over the past two years steel “cycles” have compressed to four to six months’ duration.

Restarting idle capacity involves huge fixed “lump” costs, such as bringing back laid-off workers (and restarting the clock on their layoff benefits), arranging volatile-priced raw material purchases, etc. The clearing price for the restart of idled blast furnace capacity for only a three-month period might be near infinity.

More is better

Apparently, accumulating mass amounts of anything is a good thing, with virtually every single mining/steel acquisition announced resulting in a bump up for the acquirer’s stock price – even in cases where the purchase price was not disclosed! Either all managements in the sector are acquiring incremental capacity for a great price, or the market is uncritically evaluating each acquisition as a good thing, irrespective of the purchase price. This uncritical approval is evidence of the start of a bubble. The need for capital discipline is far more profound in this type of an environment.

You can avoid reality but can’t avoid the consequences of avoiding reality

Being human means making mistakes. If there’s one lesson to be learned by being in the prognosticating
business it is that being wrong happens. I look back at what might probably have been my single best “call” on steel stocks in August 2008—I managed to downgrade steel stocks a full month ahead of the Lehman crisis. But the back story is that the stocks started to trade down as early as July that summer, and I dug in my heels and said “BUY BUY BUY” over and over again. Just a few weeks later, in early August, there was a tiny crack in the pricing armor. I made a 180-degree turn and told my clients to ignore the strong buy recommendation I gave just two weeks earlier. I was wrong – I was sorry. Nothing is quite so humbling,
or healthy, than saying these words. True profit maximizers will be opportunistic enough to realize that admitting mistakes means providing opportunities to fix them.

Joint Ventures Mean Being Friends/Drop the Ego

I’ve repeated this admonition again and again over the past few years and I’ve been excited by the new and more collegial and cooperative attitude most leaders of the industry have for each other. But now more than ever building on the improved collegiality of the industry, I believe we’ll see more and more joint ventures going forward. An environment of capital constraint and uncertain economic outlook means more of a need for risk-sharing. As more American companies—mills, distributors and miners—move offshore, the need for joint-venture partners is even greater. A historical model is the growth of the iron mining sector in the 1970s, much of

which was structured as joint ventures. What ended up being overexpansion was probably far less of a problem because the mills were combining efforts and thus limiting capacity growth. I’d also point out that the eventual unwinding of most of these mining operations was made far more difficult by the joint ventures as well.

Governments should not be in the steel business/accept globalization/let the best man win (even when it’s a young lady)

High quality, low-cost regions with good access to raw materials, capital and labor aren’t going away and should be viewed less as threats than as opportunities for collaboration. We should embrace partners who can bring true comparative advantage. However, with China at 50 percent of global production and a structurally high-cost producer— with that high-cost structure somewhat, and temporarily, ameliorated by an artificially depressed currency and other subsidies —this remains the single greatest structural impediment to a profitable global steel industry. And the issue goes well beyond the surges of West-bound high-cost Chinese steel. What’s truly daunting is capital is being deployed inappropriately because of this, not only in China but throughout the world. New capacity should have been built in the United States this cycle—the U.S. is a low-cost producer of steel today and we shouldn’t need to import 30 percent of our steel needs in a strong economy. These capital allocation choices have lives of 40 to 50 years, so the damage will be long-lived and needs to be addressed quickly.

Disclosure: I am long CLF, RS.