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Baosteel Cutting Domestic Prices - Implications and Thoughts on Chinese Steel

Summary
 
Chinese steel stocks are reacting poorly to press reports that Chinese price leader Baosteel is lowering the price of hot-rolled sheet by 9-13% and cold-rolled sheet by roughly 13% for the company’s first price cut since November, 2009. 
 
Our thoughts on the weakness in Chinese steel prices:
 
1.      Steel Prices Declining Based on Market Psychology. We think that much of the reaction in steel prices – along with other commodities – is a result of market psychology as speculative froth is being driven out of the commodities market based on fear of tightening – not an actual fundamental decline in demand. Evidence for this is that screen-traded commodities have declined in price far more than physical commodities like steel; screen traded commodities have a far greater speculative aspect to their trading patterns.
 
2.      Chinese Production Cuts – Few and Far Between. We believe that there will be some production cuts in China, but we worry they’ll be too little too late. There have been a number of “maintenance” outages telegraphed via Xinhua and other Chinese press; one report cites 19 mills announcing production cuts. We find it difficult to believe – based on historical patterns - that the Chinese will cut production sufficiently to bring supply & demand into balance in the short run – a far more likely scenario is that the current inventory-bleed will end within the next few months as confidence picks up in the region – again – this is assuming no real fundamental deterioration in demand, rather just the current change in market psyche.
 
3.      Export Tax Rebate “Elimination” – A Dangerous Trojan Horse for the US. There has been extensive speculation that the Chinese will “eliminate” the export tax rebate on commodity grade steels; this is being marketed by China as an attempt at cutting excess high cost capacity and being greeted by the Western press/analysts as good news. It is not – we call this a “trojan horse” because while this appears to be good news to the West, it’s actually misleading – the plan that’s being contemplated by Beijing is to eliminate the rebate on commodity grade hot-rolled sheet, but to also raise the rebate on the more value-added steels such as cold-rolled and galvanized. The net effect is to increase the rebate by widening the spread, dropping hot-rolled steel from 9% to zero rebate and dropping cold-rolled and galvanized from 13% to 9%; a net increase of rebate from 4% to 9% for these value-added steels. This change would be particularly risky for the US because we have high tariffs on hot-rolled sheet only. While some say that the industry could file trade cases on the value-added steels and win – and we agree these trade cases are easy wins – “easy” entails 12-18 months of a process that has in the past sometimes caused an increase in imports between the time a trade case was initiated and final tariffs instituted.
 
4.      US at Greatest Risk of Import. We spend a great deal of time and analysis understanding trade flows because typically the US is the region that is at greatest risk for attracting excess steel supplies from overcapacity created somewhere else in the world. A good example was 1998 – a strong year economically, was a disastrous year for steel because excess capacity in Asia – created by the Asian financial crisis in 9/07 – became a tsunami wave of imports into the US. While many point out that the Chinese are high cost and should not be competitive in this market, we continue to make the case that steel that has already been produced and put into inventory has zero production cost – the only cost really is the transportation to get the steel into the local market. The US is typically at greatest risk of import surges for two reasons – first, our trade remedies are fairly toothless, particularly as compared to other trading partners in the West. Second, however, is that the US is currently the world’s largest importer so that the channels of distribution into this country are far more fluid than anywhere else in the world. It’s a tremendous irony that an estimated 25% of the domestic distribution chain is owned either by foreign steel mills or foreign trading companies – and not a single ton of distribution capacity is owned by a domestic mill – with the possible and somewhat limited exception of Nucor’s recent 50% acquisition of Steel Technologies, the lone exception to the rule. So this is a structural issue in the United States that goes beyond economics, that foreign steel has an easier outlet here than in other regions.