Softening Steel

Ferrous scrap prices were nothing if not volatile in 2012. The price of shredded scrap delivered to the Midwest fell from about $470 per long ton in January 2012 to $330 per long ton in July 2012 as a result of weakening steel prices as well as increasing ferrous scrap imports, predominantly from Turkey. Although the price of shredded scrap delivered to the Midwest has since recovered to about $385 per long ton, Standard & Poor’s Ratings Services expects volatility to continue in 2013. That’s largely because of erratic steel demand swings that are likely to persist, owing to still-sluggish global economic growth and global oversupply that have led to skittish buyers.

Furthermore, global iron ore prices, which have a correlation to the price of ferrous scrap, also are unlikely to recover significantly in 2013 because of weak steel markets, as China’s economy has slowed and the euro zone has fallen into recession. Throughout the long term, iron ore also will be pressured by announced capacity expansions by several of the large diversified mining companies.

All in all, these factors will most likely lead to increased volatility for the ferrous scrap market.

Weak Global Economy
We believe the U.S. economy will be a relative bright spot; it has been improving gradually since the 2008 and 2009 Great Recession, which may lead to improved demand, and eventually improving pricing, for steel companies that benefit from a strong presence in the U.S. market.

We are less optimistic about Europe. Our economists forecast that euro zone GDP (gross domestic product) will be flat in 2013 and that the chance of another recession is at 40 percent. As a result, we believe steel companies with exposure to European markets face difficulties.

In addition, while our economists are projecting a “soft landing” in China—i.e., GDP growth of around 8 percent in 2012 and 2013—a steeper slowdown in China could exert more pressure on steel and raw material prices.

Cautious Outlook
Global weakness could exert downward pressure on prices, including the U.S. markets, as steel producers in weaker markets seek customers elsewhere. As a result, we believe steel prices will remain relatively weak globally in 2013 in light of continuing economic weakness in Europe and slower demand growth for steel in China, resulting in global overcapacity. However, input costs, including scrap, metallurgical (met) coal and iron ore, also have dropped, which could help steelmakers’ profitability.

U.S. steel market outlook. In the U.S., continued economic growth should help support the credit quality of steel producers. Our economists are projecting that nonresidential construction spending, though still historically weak, will improve in 2013 (Their current target is 3.6 percent growth.), which could help support credit quality for companies producing structural steel in the coming year. In addition, the uptick in housing—our economists are forecasting 1.05 million housing starts in 2013 compared with about 770,000 in 2012—could result in better demand as 2013 progresses, which could help to alleviate overcapacity across the industry.

In addition, automobile production remains relatively strong—our economists are projecting 15.4 million unit sales of light vehicles in 2013 compared with 14.4 million in 2012, which also will boost steel demand. Other pockets of relative strength include special bar quality steel, which producers use in transportation and in industrial and farm equipment, as well as in oil country tubular goods. Although these have shown some signs of slowing, they will likely remain profitable for producers in 2013.

Given the still relatively low demand, we expect mini-mills, which produce steel products from recycled metal, such as Charlotte, N.C.-based Nucor Inc. and Steel Dynamics Inc., Fort Wayne, Ind., to outperform integrated players, including AK Steel, headquartered in West Chester, Ohio, and United States Steel Corp., headquartered in Pittsburgh, because of the formers’ more flexible operating structure. Indeed, in spite of the continued weak nonresidential construction market, mini-mills have been profitable in structural steel, partially because of their flexible operations.

On the other hand, we recently downgraded AK Steel and have a negative outlook on U.S. Steel, which in part reflect our concerns about pricing pressure and high fixed costs among integrated steel producers.

Still, all steel producers will likely enjoy lower input costs in 2013 because of falling raw materials prices.

Despite improving economic conditions in the U.S., global economic conditions are likely to weigh on credit quality. Weak demand elsewhere in the world has encouraged imports into the U.S. and has limited price increases, a trend we expect to continue in 2013.

European steel market outlook. Following multiple negative rating actions in 2012, including the downgrade of Luxembourg-based ArcelorMittal, the world’s largest steel producer, our view on the steel sector in Europe remains negative; we have a negative outlook on about half of the steelmakers located in Europe, the Middle East and Africa.

Despite cost cutting and planned asset sales by some steelmakers, additional downgrades may lie ahead. This is because of the unfavorable global supply-demand imbalance and also because of particularly fragile demand in Europe, a region to which many of the steel companies we rate are exposed. In 2013, our economists project near-zero euro zone economic growth, and we are anticipating that there will be a 2 percent contraction in steel consumption.

In addition to low demand, we’ve seen continued imports from emerging markets, where steelmakers generally benefit from lower costs or integration into raw materials. We, therefore, anticipate that steelmakers’ profits won’t improve in 2013 and may weaken further absent a recovery in GDP growth in the second half of the year. As a result, ratings remain under pressure.

Asian steel market outlook. The oversupply of steel in China is not only of global concern, as it is likely to have spillover effects globally, but also poses a significant risk to the regional steel sector there and to producers of seaborne iron ore and met coal.

In October, we downgraded Korea-based steelmaker POSCO to BBB+ based on our view that it was unlikely the company would be able to obtain sufficient nondebt financing to maintain its rating, as well as our view that industry conditions would remain weak. We expect spare steel capacity in China to be significant, and, as a consequence, an overflow of steel into neighboring countries such as Korea to continue to be the main culprit behind lower profitability in the regional steel industry.

Similarly, in October, we downgraded Japan-based Nippon Steel & Sumitomo Metal Corp. to BBB, in part because of oversupply in East Asia, which has softened prices. In addition, the yen remains at historically high levels, which is likely to prolong a squeeze in export margins, which account for about 40 percent of the company’s steel sales.

Finally, we lowered the rating on China-based Baosteel Group Corp. (to A-/Stable; cnAA) to reflect lackluster operating performance, increasing investments and a weakening in cash flow protection measures.

Still, we believe the credit quality of each company is stable for the current ratings because we see further significant deterioration in their operating performance as unlikely.

We maintain our negative outlook on the steel sector in Asia. However, we are seeing some signs of price stability and improved demand, which if sustained could change our negative outlook to stable within the next quarter.

Rebound Unlikely
Iron ore prices have recovered recently to about $120 per ton from lows of around $90 per ton but are still well below 2011 levels of nearly $180. We believe iron ore prices could recover incrementally in 2013, when restocking activity starts in China in response to a reacceleration of growth in that country. However, prices are unlikely to recover significantly in 2013 because of weak steel markets, as China has slowed and the euro zone has fallen into recession.

However, in the longer term, supply from Australia and Brazil will ramp up significantly in light of the expansion of iron ore projects by the major miners, mainly Vale, Rio Tinto, BHP Billiton and Fortescue Metals Group Ltd. While much of this capacity is unlikely to come online until 2015, it is likely to have a dampening effect on iron ore and, thus, on ferrous scrap prices.

Still, prices below $100 in the near term have an impact on the miners’ capital expenditure plans, and some may delay expansions, particularly those miners that are single-commodity focused. Australian miner Fortescue, for example, had previously committed to an expansion of 155 million metric tons per annum, but slowed it down to preserve cash when prices fell earlier this year.

Overall, we think the market fundamentals for iron ore remain relatively positive in the next two to three years, which should allow some miners to post strong cash flow generation. However, over the longer term, prices will be pressured by new supply. Our ratings take into account our expectation that miners will pare back their large capital expenditures budgets to preserve cash flow in the event prices decline.

Given Standard & Poor’s view that the steel and iron ore markets are unlikely to rebound significantly in 2013 because of weak global economic conditions and the oversupply of steel, scrap prices are likely to remain volatile, as they did in 2012.

The author is associate director, natural resources, for New York City-based Standard & Poor’s Ratings Services.