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Is the Steel Industry Going Downhill From Here?

Steel has gone through a roller-coaster cycle this year.

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Following a great runup in the first half of the year, steel prices have collapsed since August. The U.S. hot-rolled coil Midwest price declined from its July peak of $1,090 per ton to $760 per ton. Not long after reporting record quarterly results, U.S. steel mills are cutting output by as much as 35% going into the fourth quarter.

So what happened? To make a long story short, a global demand boom over the last couple of years led to higher steel prices and higher raw material prices (raw materials include iron ore and metallurgical coal). U.S. steel mills, which used to be the high-cost, marginal producers on a global scale, suddenly found themselves on a level playing field with their Asian counterparts, as U.S. mills are less dependent on imported iron ore than Asian mills. With steel prices high and input costs in check, U.S. steel producers enjoyed terrific profits. However, the sector turned from a supply-constrained situation to one of demand destruction within a matter of months. Now that steel prices have come down, are the halcyon days of the U.S. mills over for good?

What's Behind Steel Demand Growth
Given the cyclical nature of the industry, an overview of the supply and demand situation will give a better idea of where we are in this cycle. Over the past decade, the BRIC countries (Brazil, Russia, India, and China) have accounted for 75% of world steel consumption growth. Of the four, China is the biggest growth driver. In fact, it is impossible to look at steel demand without mentioning China. The country's steel consumption grew at a compounded annual growth rate (CAGR) of 20% between 2000 and 2007, as shown in the chart below.

China consumes roughly one third of the world's steel. Despite that, the country's per capita steel consumption is still relatively low, at about 307 kg in 2007. This is about half of Japan's and one third of South Korea's levels. History shows that as a country industrializes, per capita steel consumption gradually increases to a point, then starts to decrease. Considering population density, we think China's steel intensity should approximate that of Japan and South Korea over time. As a comparison, South Korea's per capita steel consumption is still climbing northward of 1,100 kg by 2007, and Japan's per capita steel consumption fluctuated at around 700 kg per head for the past three decades (see chart below).

Meanwhile, per capita steel consumption in India is one of the world's lowest, at roughly 43 kg per head. The Indian government is aggressively upgrading the country's infrastructure to support economic growth. Brazil consumes roughly 22 million tons per year, half of which goes to Sao Paolo, which suggests that more construction is forthcoming outside of Sao Paolo. Russia's per capita steel use reached 280 kg in 2007, representing 7%-per-year growth since 2001. As these nations industrialize, the steel consumption of their 3 billion citizens will probably move up in the long run.

In fact, steel consumption in China had been growing at high-single-digit rates throughout the 1990s. The reason this did not lead to sharp price increases sooner is because consumption plummeted in Russia and the Commonwealth of Independent States (CIS) following the collapse of the USSR and its attendant economic turmoil, neatly offsetting increased Chinese demand. But a decade later, this deflationary buffer is gone. Economies in Eastern Europe grew rapidly, consequently consuming more steel. Meanwhile, higher demand for other commodities also led to infrastructure spending on such projects as oil and gas exploration, mining, and alternative energy, driving up steel consumption. It is for these reasons that we believe steel demand will resume on an upward trajectory following the recession. For example, look at what happened in China in 1994: While monetary tightening resulted in a 20% drop-off in steel consumption for the subsequent two years, annual steel consumption had quadrupled by 2007.

Is Overcapacity Returning to the Steel Industry?
In the face of a global economic slowdown, excess steel production capacity has again become a reality. Inventory built up, and prices plummeted. There are widespread fears that China will keep its steel mills running and "dump" steel into the world market just to keep jobs in those mills. However, we think this speculation is more fear than reality. First, priorities seem to have shifted in China, and the government is shutting down less-efficient, highly polluting steel mills. Environmental issues are now incorporated into local government officials' evaluation criteria. Once incentives are aligned, we should see concerted efforts to protect the environment. Second, it is technically difficult for China to become a major steel exporter any time soon, as the country is highly reliant on imported iron ore. While China has plenty of low-grade iron ore reserves, it takes a long time to get the infrastructure in place to fully utilize its domestic iron ore. Right now, most of its mines are still small-scale and cannot satisfy the demand of domestic steel mills. Thus, although the government reinstated export rebates on roughly 4,000 products recently, steel is not one of them. Marginal steel mills are going out of business in China. According to International Iron and Steel Institution (IISI) data, world crude steel production declined by 10.8 million tons from June to September--7 million of which came from China.

Meanwhile, consolidation in the steel industry outside of China has brought more volume discipline. The benefit of higher industry concentration is particularly pronounced in the U.S. After the massive steel company bankruptcies between 1998 and 2003, the top three steelmakers in the U.S. now account for roughly 70% of domestic output. As the economic downturn hits, steel mills are responding by aggressively cutting production. Major U.S. steel mills saw a 10%-20% volume decline in the third quarter, and we expect lower production in the fourth quarter.  ArcelorMittal (MT), which produces 10% of the world's steel, announced that it would cut production by up to 35% in the fourth quarter.

Having said that, we think overcapacity will probably persist for some time. The Chinese steel industry is highly fragmented, and consolidation will take some time to occur without government intervention. While the Chinese government's recently unveiled stimulus plans are a boon to steel consumption, infrastructure (such as railroads, highways, airports, and power grids) is less steel-intensive than real estate. China's real estate sector is decidedly cooling, diluting the efficacy of the stimulus plan on steel demand. Nevertheless, we don't think the industry is approaching permanent overcapacity due to the BRIC countries' low per capita steel consumption. Long-term overcapacity will not be a threat unless growth in these emerging markets slows permanently.

Our View on U.S. Steel Producers
We think the current downturn may be lengthy and will take its toll on U.S. steel producers, but the steel industry is still viable in the long run. We think the biggest steel mills with some form of cost advantage will weather the storm, and we would be comfortable in taking a position when they trade at compelling valuations. However, we would wait until leading indicators show that demand is picking up again before more broadly recommending the industry.

Among the U.S. steel mills, we think the minimills (which feed on ferrous scrap) are better positioned due to the relative consolidation in the steel industry compared with the scrap recycling space. Steel prices haven't declined as much as ferrous scrap prices, and this should help support the profitability of minimills (such as  Nucor (NUE) and  Steel Dynamics (STLD)) going into the downturn. The integrated steel mills, which produce primarily flat-rolled products, will probably face more pressure as Chinese excess capacity is primarily flat steel. The biggest uncertainty facing mills that had benefited from proprietary taconite reserves (low-grade iron ore) is how rational the iron ore miners (namely  Vale (RIO),  BHP Billiton (BHP), and  Rio Tinto (RTP)) will be. Miners had aimed substantial capital expenditures at increasing iron ore output in recent years. These companies are making huge profits at current contracted iron ore prices, and they could still make significant profits even if prices decline somewhat. Should iron ore prices go on a downward trend from now on, some steel mills' taconite reserves will be less valuable, diminishing these firms' value.

Min Ye does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.