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The steel industry is poised to benefit from solid demand in the U.S and emerging markets like India. However, steel stocks have to struggle with equity market volatility and a host of other broader factors. Below, we discuss some of the key reasons and what investors in the steel sector should be aware of in the coming months and years.

Valuation Questions

Going by the EV/EBITDA multiple (a preferred valuation metric for cyclical industries like steel) the” “steel-pipe and tube” and “steel specialty” have a respective trailing 12-month EV/EBITDA multipleof 24.72 and 19.52, respectively, higher than the S&P 500 EV/EBITDA multiple of 10.8. Meanwhile, the steel producers industry has a trailing 12-month EV/EBITDA multiple of 6.79, which compares favorably to the S&P 500 EV/EBITDA multiple of 10.8. Overall, valuation looks expensive for the steel industry.

A Rise in Cheap Imports in the U.S.

A slump in the domestic property market, which accounts for a significant part of China’s steel consumption, severe credit crunch and weak infrastructure investment are hurting steel demand in China.

China’s steel exports crossed the benchmark of 100 Mt for the first time last year in the wake of shrinking domestic demand and a flagging economy. Notably, China is the world’s top steel producer, contributing around half of the total global output.

The country has built up a massive excess capacity, posing a threat to the global steel industry. These cheap imports hurt the margins of American steel players like Steel Dynamics Inc. (STLD - Free Report) , United States Steel Corp. (X - Free Report) , ArcelorMittal (MT - Free Report) , AK Steel Holding Corp. (AKS - Free Report) and Nucor Corp. (NUE - Free Report) .

Slowdown in China

For 2017, the Chinese government projects growth figure of 6.5% compared with the 6.7% expansion in 2016, which was the slowest growth in 26 years.While rebalancing progresses, the Chinese economy continues to slow down.

Geopolitical Tensions

Performance of some key emerging and developing economies has deteriorated due to internal structural issues, lower commodity prices associated with China’s economic slowdown, and escalating political instability. Geopolitical tensions and political instability in the Middle East, Africa continues to have a negative effect. Political uncertainty in the Brazilian economy has resulted in a sharp decline in steel demand.

Excess Capacity: Perennial Problem

The biggest obstacle to persistent growth and profitability in the steel industry is excess capacity. The industry is under relentless pressure caused by years of excess steel-making capacity, further aggravated by weak demand and uneven economic growth. To solve this problem, steelmaking capacity needs to be reduced for the industry’s profit margin to reach a sustainable level, and to raise the capacity utilization rate from below 80% levels. The industry remains highly fragmented compared with other global businesses. However, the restructuring and consolidation needed to eliminate overcapacity is progressing at a slow pace.

Impact of Low Oil Prices

The energy sector, which was once buoyant due to shale discoveries and rising production of crude oil, accounts for 10% of steel consumption in the U.S. Steel is necessary to make rigs and transport oil. Steel demand from the energy sector is being impacted as exploration companies have reduced capital expenditure budgets in the wake of tumbling oil prices.

Steel products used by the energy industry are also known as oil country tubular goods (or OCTG). U.S. Steel being the biggest supplier of these goods in North America is bearing the brunt of it.

Lower oil prices would urge energy companies to preserve capital to shore up their balance sheets instead of spending money on new exploration. Thus, leading suppliers to the energy sector, such as United States Steel and Tenaris S.A (TS), are likely to be under pressure throughout the year.

In 2017-18 oil prices are anticipated to show a reasonable gain but any spike in oil prices to the levels seen in 2010-12 seems unlikely despite the recent OPEC agreement on oil production cuts.

Low Crude Steel Capacity Utilization

The crude steel capacity utilization ratio remained stubbornly below 80% in both 2014 and 2015. The average capacity utilization in the 2016 was around 69%. Excess steel capacity has been a perennial problem for the steel industry as steel prices generally move in tandem with capacity utilization rates. To remain competitive and rationalize operations, some major steel companies have resorted to idling their steel plants.

Increasing Use of Aluminum in Auto Industry

Currently, steel is the major raw material for the auto industry, the second largest steel consumer. However, major automakers like Ford Motor Co. (F - Free Report) , General Motors Company (GM - Free Report) and others are becoming increasingly aluminum-intensive, given the metal's recyclability and light-weight properties. The global push to improve fuel efficiency in vehicles is expected to more than double the demand for aluminum in the auto industry by 2025. Hence, in order to remain competitive, the steel companies will have to come up with better and lighter varieties of steel.

How to Play the Industry

The short-term prospects are a bit clouded considering the headwinds plaguing the steel industry globally as discussed above. So, it would be prudent to stay away from steel stocks that carry an unfavorable Zacks Rank now. Particularly, we suggest staying away from stocks such as Haynes International, Inc. (HAYN - Free Report) , which carries a Zacks Rank #5 (Strong Sell). Haynes International delivered an average negative earnings surprise of 150.75% in the last four quarters.

However, investors, who can look beyond the near-term clouds to the industry’s bright long-term prospects, and may consider buying some steel stocks based on a favorable Zacks Rank.

We highly recommend ArcelorMittal and Nucor Corporation which sport a Zacks Rank #1 (Strong Buy). You can see the complete list of today’s Zacks #1 Rank stocks here.

Check out our latest Steel Industry Outlook here for more on the current state of affairs in this market from an earnings perspective, and how the trend is shaping up for the future.

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