Steel industry in today’s world can well be termed as the backbone of the economy, given its varied usage, be it in construction, transport, electrical appliances, food packaging, etc. In terms of its composition, steel is an alloy of iron and carbon containing less than 2% carbon and 1% manganese and small amounts of silicon, phosphorus, sulfur and oxygen.
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 products are wire rods, beams, reinforced bars and merchant bars. The products under both these categories are derived from steel slabs, which are categorized as unfinished or semi-finished products that are generally not sold.
The steel industry is often indicative of economic progress, given its critical role in infrastructural and overall economic development. The world steel industry is a large one. According to the World Steel Association, world crude steel production was a record 1,527 million tons (Mt) in 2011. However, despite its size, the steel industry remains relatively fragmented. The industry is highly cyclical and intensely competitive.
A Sneak-Peek into Major Consumer Markets
Historically, the automotive and construction markets have been the largest consumers of steel, consuming more than half of the total steel produced. The industry caters to large automakers such as General Motors Company (GM - Analyst Report), Ford Motor Co. (F - Analyst Report), Toyota Motor Corporation (TM - Analyst Report) and Honda Motor Co. Ltd. (HMC - Analyst Report).
Houses, buildings, skyscrapers and bridges rely on steel for their strength. Other steel consuming industries include appliances, agricultural implements, converters, containers, energy, electrical equipment and industrial machinery.
Over the last few years, China has emerged as the major consumer of steel. With respect to consumption, the U.S. follows next with Japan, India and South Korea in tow.
Global Production Numbers
As mentioned earlier, world crude steel production was a record 1,527 Mt in 2011, outperforming the 2010 record of 1,414 Mt, a 6.8% jump. In the third quarter of the current fiscal, world crude steel production was 376 Mt, a paltry 0.4% improvement from the prior-year quarter. Year to date, world crude steel production stood at 1,149 Mt, up 0.6% year over year.
China maintained its leadership position among the steel producing countries, yielding almost half of the global output at 47%, growing 1.3% year over year in first nine months of 2012. The United States replaced Japan as the second largest steel producer, producing 93 Mt of crude steel during the period, 3.9% higher than the comparable period last year and accounted for 8% of the total global output. Japan slid down to the third position with a production level of 81 Mt, a 0.4% increase. Asia improved 1.5% to 749 Mt, while Europe dipped 4.6% to 129 Mt.
Performance So Far
After enjoying sturdy growth for most part of the last decade, the steel industry suffered a setback due to the recession in 2008, as consumers utilized existing inventories rather than buying new stock. However, the industry witnessed a turnaround turned around in late 2009 and continued to grow in 2010 and 2011, in tandem with the global economic recovery.
The industry grew remarkably last year notwithstanding the widespread headwinds including the ongoing Eurozone sovereign debt crisis, earthquakes in Japan, the political unrest in the Middle East resulting in a surge in oil prices, and the tightening of government monetary measures in many emerging nations.
Demand for steel has benefited from growth in the developing economies that helped counter the sluggishness in developed economies. Asia, particularly China, continued to be the principal driver of growth. Demand for steel products, nonetheless, remains below the pre-recession levels. Concerns surrounding China’s growth in the future also adds an element of uncertainty to the outlook.
The automotive and construction markets, as mentioned earlier, have been the largest consumers of steel over a number of years. The automotive sector has registered significant growth this year. In September, the seasonally adjusted annual rate (SAAR) went up 13.7% to 14.9 million vehicles from last year, the highest sales rate in the last four years.
The momentum was expected to continue in October as well, but due to the devastating effect of Hurricane Sandy sales dropped to 14.3 million SAAR in October. However, it is still above the lowest mark of 14 million SAAR in May this year. In October, sales increased 7% year over year but were down from 13% growth noted in September.
Notwithstanding the effects of the Hurricane Sandy, auto sales have averaged 14.4 million SAAR and grew a promising 14%, year to date. The robust growth rate in the sector has been fueled by strong pent-up demand, cheap financing, launch of several redesigned and fuel-efficient vehicles, rebound in consumer confidence, and the growing belief that the housing market is recovering. Even though auto sales will be affected in November due to Sandy, pent up demand will help regain the momentum in December and January 2013.
The construction sector had been a drag on the steel companies’ earnings. However, recent figures suggest a turnaround in the non-residential as well as residential construction sectors. According to the American Institute of Architects, after languishing in the negative territory for five consecutive months, the architecture billing index (ABI) climbed back into the positive territory with a score of 50.2 in August.
ABI is an economic indicator that provides an approximate nine- to twelve-month glimpse into the future of non-residential construction spending activity, and any score of above 50 is significant as it indicates an increase in billings. In September, the score further improved to 51.6, the highest in nearly two years.
As per the American Institute of Architects, spending for non-residential construction will go up 4.4% this year. This will be propelled by higher demand for industrial facilities so far this year coupled with sustained demand for hotels and retail projects. The spending is expected to accelerate further to 6.2% in 2013.
In September, both housing starts and building permits were record high in four years. Housing starts increased 35% year over year to a seasonally adjusted annual rate of 872,000 in September 2012 and was 15% higher than August 2012 levels. Building permits in September were at a seasonally adjusted annual rate of 894,000, 45% higher than the year-ago figure and 11.6% higher than August 2012.
In a nutshell, record-low mortgage rates, rising rents and reduced prices of properties are luring buyers. These figures are reflective of the fact that U.S. residential construction is finally stabilizing and is on the road to a much awaited recovery. The pent-up demand that has accumulated from people deferring buying houses will help fuel the recovery.
How Well Did Steel Stocks Fare?
The recently reported third quarter results of the steel companies in our coverage – ArcelorMittal (MT - Analyst Report), United States Steel Corp. (X - Analyst Report), Nucor Corporation (NUE - Analyst Report) and AK Steel Holding Corporation (AKS - Analyst Report) paints a gloomy picture. Revenues were constrained across the board due to drop in average steel prices and shipments.
All the steel players have been plagued by weak steel demand, oversupply in the U.S. steel industry and increased steel imports in the domestic market, which have affected steel prices hurting margins in the process. The weak global conditions are a deterrent factor for volumes.
A preview for the upcoming fourth quarter and fiscal 2012 suggest that steel behemoth, ArcelorMittal is anticipating iron ore shipments to increase 10% in 2012 from last year levels. The company, wary of the global economic situation, particularly Europe, has decided to shut down plants, cutting down its planned 2013 capital expenditures. However, the most dramatic announcement was the company’s intent to slash its annual dividend by 73% to 20 cents per share.
United States Steel expects its segments results to remain affected in the fourth quarter based on the assumption of lower average realized prices as well as lower shipments. The Tubular segment is expected to deliver profits, but significantly below the third quarter levels.
The USSE segment is expected to break even while the Flat Rolled segment is expected to be in the red. Softness in Europe as well as in the emerging markets and the economic uncertainty in North America are expected to weigh down its fourth quarter results.
AK Steel has not yet provided any specific guidance for the fourth quarter or fiscal 2012. The company, however, put forward its expectation of posting a loss in the fourth quarter, which includes a non-cash tax expense. Nucor also expects its profits to be reduced in the fourth quarter.
Now, what will be the exact picture in the upcoming results? The U.S. steel market is plagued by oversupply and increased imports. Although Chinese steel production, which was responsible for causing the glut to some extent, has somewhat slowed down, supply in the steel market still overshadows demand.
Increasing domestic imports along with oversupply in the industry due to a ramp up in operations by other steelmakers, is putting pressure on prices. We expect weak pricing, the European debt crisis and its potential global impact to remain an overhang on the steel industry in the quarter. In terms of end markets, the automotive sector holds promise and the impending recovery in the construction market, if permanent, will definitely provide a boost to the steel industry.
The extent of the impact of Hurricane Sandy that hit the East Coast in late October is yet to be assessed by the steel companies. Nucor temporarily shut down its Connecticut rebar and wire rod mill and United States Steel temporarily stalled its Fairless operation in eastern Pennsylvania.
Fourth quarter results might be affected due to the interruption in operations and associated costs/losses. However, in the near future, the steel companies will stand to benefit from the rebuilding activities necessary following the storm.
Industry Capacity & Demand/Consumption Dynamics
World crude steel capacity utilization ratio increased to 77.7% in September 2012 from 75.5% in August 2012, but dipped 2.5 percentage points from September 2011.
As per the latest data released by the U.S Department of Commerce, U.S. capacity utilization ratio in August 2012 was 76.3%, up from July and reversing the downward trend from recent months. Though the capacity utilization rate has upped 87% from the low levels seen in April 2009, it still remains below historical averages.
In the U.S., apparent consumption, which is used to measure domestic demand for steel, stood at 8.4 Mt in August 2012, up 2.3% from the sequentially preceding month and up 3.4% annually. When we compare it with the trough experienced in April 2009, demand was up a massive 103.5%.
Price Trends Seen So Far
Steel prices are generally volatile, in line with the highly cyclical nature of the global steel industry. Following an extended period of upside in prices, steel prices plunged during the financial and economic crisis of 2008 due to the sudden drop in demand. This was further intensified by massive industry destocking as customers cleared their steel inventories. Steel prices saw a recovery in late 2009 that followed into 2010 but remained below the pre-financial crisis level.
In 2011, steel prices remained volatile, increasing in the first half on the back of strong demand, higher raw material costs, improved activity in the automotive, appliance and other industrial segments but partially offset by weak construction market in many regions. Prices fell in the second half as demand decreased due to uncertainty surrounding the Euro-zone sovereign debt crisis. The fourth quarter was particularly weak owing to a sharp drop in iron ore prices in October and renewed destocking in the wake of uncertain economic environment.
Despite the price improvement in first-quarter 2012, there has been a slump in pricing in the second and third quarter due to a glut in imports, oversupply in the market from zealous steelmakers, weak demand in Europe and tempering growth in Asia. A sustained downside in steel prices would materially and adversely affect margins for the fourth quarter. We feel that the recovery in pricing momentum will be driven by a reviving economy, no further crisis in the Euro-zone and a rebound in construction activity in the developing countries, in particular China, India and South Korea.
A Closer Look at the Factors Affecting Steel Prices
Rising raw material prices: The steel industry consumes substantial amount of raw materials including iron ore, coking coal and coke besides requiring a lot of energy. Increases in raw material prices necessitate a corresponding increase in steel selling prices.
However, the situation gets tricky in the wake of lower demand, when it becomes increasingly challenging to pass on raw material price hikes to consumers. Historically, energy prices have varied significantly. This trend is expected to persist due to market conditions and other factors beyond the control of steel companies.
Overcapacity and fluctuation in steel imports-exports: The steel industry has always suffered from overcapacity. Steel consumption in China and other developing economies has increased at a rapid pace. In response, steel companies have ramped up their steel production capability with scope for further increasing capacity.
Steel production capability, particularly in China, appears to be surplus to China’s domestic market demand. Considering that China is the largest steel producer, the export of the surplus steel at subsidized prices to other markets casts a major impact on world steel trade and prices.
Consumers in the U.S. are importing cheaper steel from China, forcing domestic steel producers to sell at lower prices, and sometimes even at a loss. The U.S. government has thus been imposing anti-dumping duties on Chinese steel imports.
Economic recovery: Steel prices are generally sensitive to changes in global and local demand, which are in turn governed by worldwide and country-specific economic conditions and available production capacity. Although the steel industry has been recovering since the 2008 recession, the recent Euro-zone sovereign debt crisis added to the still-tentative recovery in the developed world has again created a lot of uncertainty in the market. This has resulted in many countries suspending investment in infrastructure and other industries, thus impacting steel prices.
Threat from substitutes: Steel has many substitutes like aluminum, cement, composites, glass, plastic and wood. A shift toward other substitutes, whether due to lower costs or government mandates on the basis of environmental or other reasons, would significantly impact prices and demand for steel products.
Raw Material Trends
The primary inputs for the steel industry are iron ore and coking coal, as well as coke, scrap, alloys and base metal. The industry also uses large volumes of natural gas, electricity and oxygen for its steel manufacturing operations.
Iron ore prices were relatively high in 2009 driven the robust demand from China. The momentum continued in the first half of 2010. However, prices fell in the second half of 2010. After relatively stable iron ore prices through the first nine months of 2011, iron ore prices plunged in October that year due to the Euro-zone debt crisis and slowdown in China.
In the first half of 2012, prices were more or less stable before plummeting to a three-year low in September. However, since then prices have regained ground after Chinese steel mills continued to replenish their inventories.
The iron ore industry is highly concentrated with only three major players, Vale S.A. (VALE - Analyst Report), Rio Tinto Plc (RIO) and BHP Billiton Ltd. (BHP - Analyst Report), having significant pricing power.
Vale’s third quarter profits fell due to the drop in iron prices. The miner, however, hinted toward improved iron ore prices in the fourth quarter. It is expected that China’s $150 billion of infrastructure spending will support iron ore prices in the future. Furthermore, non-Chinese demand for iron ore will also show improvement, driven by growth in some emerging economies, such as Brazil, India and Southeast Asia.
Increase in iron ore prices will put margins of steel companies under pressure. The companies will be able to pass on the high input costs to customers in case demand improves.
Mergers and acquisitions (M&A) have remained an important growth 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. The Tata Steel and Corus merger in 2008 is another instance of industry consolidation. After a lull during the global economic downturn of 2008-2009, M&A activity of various steel and mining players, including Chinese and Indian companies, has quickly picked up.
Consolidation has been primarily driven by the urge to increase global scale and operations, and expand into new markets. 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. Further, steel makers are now focusing on acquiring mines or stakes in mines to secure raw materials at more competitive prices.
A landmark development in this sector was the recent merger of Japan's largest and world's sixth-largest steel maker Nippon Steel Corporation with 27th-ranked Sumitomo Metal Industries to form the world's second largest steel firm -- Nippon Steel & Sumitomo Metal Corporation (NSSMY). With a combined capacity of 46.1 million tons, it is set to replace China's Hebei Group in the second position, which has a production capacity of 44.4 million tons. The merger is targeted to generate savings in the face of increasingly intense global competition.
Going forward, the abatement of the Euro-zone crisis, recovery in the U.S. economy and developments in the Chinese real estate and construction sector will determine the fate of such deals. However, given the prevailing uncertainty, we expect moderate growth in M&A.
Steel Usage Forecasts
The World Steel Association now projects global steel usage to rise 2.1% in 2012, down from its earlier projection of a 3.6% rise announced in April this year. This is a sharp deceleration from 6.2% growth in 2011. This reflects sharper-than-expected slowdown of Chinese steel demand and Euro-zone debt crisis uncertainties. Furthermore, uncertain U.S. growth outlook also loom on the horizon.
China’s steel use in 2012 is estimated to grow 2.5% to 639.5 Mt, following a 6.2% growth in 2011. After a weak performance in 2011, India is expected to grow by 5.5%. In the U.S. market, steel consumption is projected to grow to 96.5 million tons in 2012 on the back of improvement in the construction sector, a better-than-expected development in the automotive industry.
In Central and South America, owing to the poor external economic environment as well as domestic tightening, apparent steel use is expected to rise by 3.8% in 2012. Japan’s steel use is expected to increase 2.2% to 65.5 Mt in 2012 triggered by reconstruction efforts in the wake of the March 2011 earthquake and tsunami and government stimulus measures. Steel usage in the European Union is expected to decline by 5.6% as sovereign debt problems persist.
On a positive note, the scenario is expected to improve in 2013. World steel demand is expected to increase 3.2% to a record of 1,455 Mt. This is based on the premise of recovery in Europe, China and as U.S. successfully deals with the fiscal tightening due in 2013.
China’s steel usage is expected to grow 3.1% to 659.2 Mt from the 2012 projections, aided by government stimulus measures. India is expected to pick up pace and grow 5%, triggered by urbanization and surging infrastructure investment. In 2013, the steel use in the U.S. is envisioned at 100 Mt. Central and South America is expected to grow 6.3% to 50.4 Mt in 2013. After a rise in fiscal 2012, Japan is expected to decline 2.9% to 63.6 Mt in 2013, due to a stronger Yen and falling exports. Europe is, however, expected to recover a modest 2.4% in 2013.
Overall, steel demand in the developing and emerging world will rise 3.0% in 2012 and 3.7% in 2013. In the developed world, steel demand will dip 0.3% in 2012 and then post a 1.9% growth in 2013.
Overcapacity: Even though demand has increased overall in the past two years, growth in steelmaking capacity is still ahead of demand and remains a significant challenge for the industry. This has been further exacerbated by the European sovereign debt crisis, which has stagnated investments in large scale projects in Europe and reduced capital for growth.
The uncertain global economy: The steel industry was significantly affected by the global economic crisis in 2008. Even though it is recovering, demand has still not reached pre-recession levels. The debt crisis in Europe remains a concern and the U.S. has had to resort to quantitative easing to thwart sluggish demand.
The saving grace is the spurt of growth witnessed in the developing economies that helped counter the sluggishness in the developed economies. Asia and particularly China continued to make up for the stalemate in Europe and North America. However, there are signs of cooling in China’s real estate sector, which accounts for almost half of the total steel demand in the country.
China had cut its 2012 growth target to an eight-year low of 7.5%. A slowing Chinese economy will have a negative impact on infrastructure and construction spending and in turn on the steel industry as well. However, we believe the steel industry’s long-term story in the country remains intact, underpinned by China’s urbanization and industrialization programs.
Dependence of margins on raw material prices: The steel companies’ margins are dependent on the extent to which changes in raw material prices are implemented through to steel selling prices. The time lag between the raw material price change and the steel selling price change, and the date of raw material purchase and the actual sale of the steel product in which the raw material was used, are also important factors affecting margins.
To Sum Up
Fourth quarter results will face headwinds in the form of low prices due to overcapacity and surge of imports. Furthermore, the European debt crisis and its potential global impact remain an overhang on the industry. The results will also bear the brunt of Hurricane Sandy.
Global steel demand will improve gradually in line with the recovery in the user industries, automotive and residential construction. Emerging and developing economies will continue to drive growth. China’s recent attempt to bolster its economy by approving 60 infrastructure projects worth more than $150 billion will help lift the steel sector.
Its neighbor India is not lagging too far and will likely be a major consumer driving the steel industry. Prices could potentially stabilize on the back of a rebound in construction activity in the developing countries, in particular China, India and South Korea.
In the developed world, recessionary conditions in Europe will have residual effects elsewhere. The Federal Reserve’s announcement of another round of quantitative easing to boost the U.S. economy will provide an impetus to the sector.