Steel Industry Outlook - Nov. 2010 - Industry Outlook

The U.S. houses one of the world’s largest steel industries. It is rather concentrated in structure, with a few producers accounting for the lion’s share of sales. ArcelorMittal (MT) is the world’s largest steel company, with crude steel production of 73.2 million tons in 2009, representing about 6% of the global steel output.

Steel products are classified into four broad categories: flat steel products, long steel products, scrap and semi-finished products. Flat products include plates, hot-rolled strip and sheets, and cold-rolled strip and sheets. The long steel product category comprises wire rods, beams, reinforced bars and merchant bars. The products under both these categories are rolled from steel slabs, which are considered as unfinished or semi-finished products that are generally not sold.

Historically, the automotive and construction markets have remained the largest consumers of steel, absorbing more than half of the total steel produced. Large automakers such as General Motors (MTLQQ), Ford Motor Company (F), Toyota Motor Corporation (TM) and Honda Motor Company (HMC) depend upon the steel industry. Other steel consuming industries include appliances, agricultural implements, converters, containers, energy, electrical equipment and industrial machinery.

Growth Trends

Accelerating demand in the automobile and construction markets triggered production growth in the steel industry before the recession hit. However, the global economic turmoil that started at the end of 2008 and continued through much of 2009 severely impacted both these markets, with the demand for steel nose-diving as a consequence. Steel manufacturers saw inventories soaring and scrambled to cut production.

With the global economy picking up in late 2009, the steel industry started seeing signs of improvement. However, given its economic sensitivity, we expect global steel demand to improve only gradually, in line with the recovery in the user industries, especially automotive and residential construction. According to World Steel Association (“worldsteel”), steel demand in the U.S. was down 41.6% in 2009 at 57.4 million tons. However, with the economy in recovery mode, the industrial sector is expected to drive a 26.5% increase in steel demand in the U.S. in 2010 and a further 7.5% in 2011 to 78.1 million tons.

The emerging economies reflected growth trends throughout the recession and are expected to continue to drive steel demand, going forward. Worldsteel expects steel demand in India to grow 13.9% and 13.7% in 2010 and 2011, respectively, following a growth of 7.7% in 2009. The European Union experienced a 35.2% decline in steel demand in 2009. Spain and Italy saw a significant fall in steel production with the breakdown of their construction market.

According to the association, in 2010 the European region will see an increase of 13.7% in steel demand, driven by the restocking of inventory. Japan would see steel demand rising 10.3% in 2010 after a 31.7% fall in 2009.

However, worldsteel expects Chinese steel consumption to increase by a modest 6.7% to 579 million tons in 2010, after an impressive 24.8% increase in 2009. Expansionary Chinese economic policies, easy credit and construction initiatives have thus far sustained demand. But with China attempting to rein in its overheated property sector and engineer a soft landing for its economy, steel demand will most likely soften noticeably in the coming months.

Globally, worldsteel anticipates steel demand to rise 10.7% to 1,241 million tons in 2010 in contrast to last year’s decline of 6.7%. For 2011, worldsteel expects global steel requirement to inch up 5.3% to 1,306 million tons.

Production Scenario

The year 2010 started well for the steel industry, with improving demand conditions in several end markets, leading to a steady rise in steel production worldwide. All major steel-producing countries — Brazil, China, Germany, Japan, Russia, Turkey, the U.S. and Ukraine — have recorded healthy production so far this year. According to worldsteel, North American steel output jumped 50.3% year over year to 74.8 million tons in the first 8 months of 2010. However, it is still lagging the 19.4% growth rate seen in 2008.

In the European Union, steel production shot up 37.5% to 115.6 million tons in the first 8 months of 2010 while production in Asia climbed 17.8% to 592.7 million tons. Of this, China experienced a 15.3% production growth to 425.7 million tons while Japanese production leapt 38.1% to 72.7 million tons over the first 8 months. Over the same period, steel production in Brazil soared 40.5% to 22.1 million tons and that in Russia jumped 15.4% to 43.8 million tons. In Ukraine, steel production moved up 11.7% to 21.2 million tons.

Industry Capacity

The global steel industry is capital intensive, cyclical, highly competitive and has historically been characterized by overcapacity. Capacity utilization rates were, however, low (around 60%) at the beginning of 2009, in response to the much softer demand. With steel demand picking up in the latter half of the year, capacity utilization rates increased to above 70%. Utilization rates continued to increase in the first half of 2010, averaging at over 80%. The capacity utilization rate has, however, come down to around 70% again since then.

Steel makers continue to add capacity besides resuming operations at the idled facilities, inspired by the expected rebound in steel industry in the longer term.

Price Trends

The steel industry has long witnessed volatility in prices with a large spot market. Steel prices rose steadily for most of 2008, after which there was a downtrend. Lower prices had an adverse effect on steel producers, who recorded lower revenues and margins, and had to write down finished steel and raw material inventories.

The period witnessed major steel producers slashing production to minimize inventory accumulation. U.S. Steel Corporation (X), the fifth-largest steel producer worldwide, cut down production by almost 62% during the second quarter of 2009, while Korean steel maker POSCO (PKX) cut production by about 15%. This was the first time in its history that POSCO was forced to adopt such a measure, proof of the very adverse operating environment.

Although steel prices have been stabilizing since the latter part of 2009, it is significantly below the pre-crisis level. We believe that a sustained recovery in steel prices remains uncertain in the backdrop of sluggish economic activity.

Factors Affecting Steel Prices

Chinese Imports: The steel industry is also affected by fluctuations in steel import–export and tariffs. China is the largest steel producer globally, with the balance between its domestic production and consumption being an important factor in global steel prices. Consumers in the U.S. are importing cheaper steel from China, which is forcing domestic steel producers to sell at lower prices, and even at a loss, sometimes. To this end, the U.S. government has been imposing anti-dumping duties on Chinese steel imports.

Concerns about the sustainability of economic recovery and question marks about China’s growth momentum come into play in the pricing equation. This relatively uncertain China outlook, coupled with a still tentative recovery in the developed world, is expected to weigh on prices.

Threat from substitutes: Steel has many substitutes like aluminum, which replaces it in the automotive markets. Cement, composites, glass, plastic and wood are also used as steel substitutes. This significantly influences market prices and demand for steel products.

Raw Material Trends

The key input for steel production is iron ore. Apart from this, coking coal and coke, scrap, electricity and natural gas are also used as inputs in steel production. The raw materials industry is highly concentrated with only three major players — Vale (VALE), Rio Tinto (RTP) and BHP Billiton (BHP) – having significant pricing power. The risk lies in consolidation among raw material suppliers. For instance, the announced iron ore joint venture between mining companies BHP Billiton and Rio Tinto would further increase the pricing power of both the suppliers.

Steel makers would face higher production costs if suppliers shift to sales based on spot prices from the long-term fixed price contract system, as spot prices for most of the raw materials, especially iron ore, remained high from 2006 through 2008. In 2009, iron ore prices, which are linked with the London Metal Exchange prices, were about 28% to 33% below the benchmark prices.

Iron ore prices have remained volatile during most of 2010 and are expected to rise sharply in 2011. AK Steel Holding Corporation (AKS) expects a 65% rise in benchmark iron ore prices in the near term. The company assumes reduction of its earnings by $11 million or $7 per ton for each 5% increase in iron ore prices. The prices of coking coal, zinc and nickel, as well as scrap, have followed a similar trend.

Consolidation

Mergers and acquisitions (M&A) have remained an important business strategy in the steel industry. M&A activities prevent additional steel capacity, providing production efficiency and economies of scale. The biggest example is Mittal Steel’s acquisition of Arcelor in 2006 and their merger in 2007. The Tata Steel and Corus merger in 2008 is another good instance of industry consolidation. The industry is likely to see more M&A activity in the coming years as the industry players prepare themselves for a recovery in the long run.

Zacks Recommendation

Iron ore pricing concerns have led to a negative outlook for steel manufacturers. Revenues and average selling prices are lower, as the U.S. and global markets are in a gradual recovery. In the short term, we are negative on steel manufacturers like AK Steel Holding Corporation, Steel Dynamics Inc. (STLD) and Allegheny Technologies Incorporated (ATI).

AK Steel’s cost structure is higher than its peer group due to a greater reliance on an external supply of raw materials such as carbon scrap, purchased slabs, iron ore and purchased coke. Iron ore is the key raw material in steel manufacturing operations. The company expects to purchase about 6 million tons of iron ore pellets in 2010.

One of the largest and most diversified producers of specialty materials in the world, Allegheny Technologies has forecasted operating losses in the near-term. Allegheny has been battling cost-pressures associated with high raw material costs. For Allegheny, a hypothetical $1.00 per mmbtu increase in the price of natural gas would result in increased annual energy costs of about $10 to $12 million.

Costs of scrap and oil are also rising significantly. A change of $1.00 per pound in nickel prices would result in increased costs of about $80 million, while a hike of $0.01 per pound of ferrous scrap would result in increased costs of approximately $5 million.

We remain strongly negative on Steel Dynamics, the third-largest steel maker in the U.S., who is operating its structural steel mills at less than 40% of its total capacity due to uncertain demand conditions.

However, industry giants with integrated business models like U.S. Steel Corp and ArcelorMittal have an edge over their peers. Both steel makers have substantial captive sources of iron ore and coal and source about 75%–80% of their coke and iron ore requirements from owned and/or operated facilities. U.S. Steel Corp returned to profitability in the second quarter of 2010 on improving business conditions.

Similarly, earnings of Nucor Corporation, the largest recycler of steel scrap in the U.S. , broke out from the loss territory in the last quarter of 2009. We expect Nucor to exhibit strong profitability driven by long-term contracts, cost reduction efforts and a dominant acquisition strategy.

Steel Industry Outlook – Nov. 2010 – Industry Outlook

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