Steel's New Comfort Zone

The global steel industry has entered a new era, distinctly different from the last period that ended in 2005. The changes are directly related to China, company consolidation and surging worldwide economic growth. The new era is further characterized by sharply rising raw material costs in light of the global supply-demand imbalance. While this new era will not last forever, it’s reasonable to assume the next few years will witness good times for the steel and scrap industries.

The extreme fragmentation that characterized the previous era and helped to generate price volatility as well as downward price pressure is over for the next few years. Older hot ends (i.e., Weirton, WCI and Wheeling-Pitt) will either be shut or modernized (i.e., Nucor’s 25-year-old electric furnace operations).

The stunning yet unpredicted growth of the Chinese economy has transformed the global production and consumption of steel. China’s economic expansion was generated by a perfect storm of rapidly expanding markets, cheap labor, a solid infrastructure, focused investments and abundant capital, which all came together in a very short period of time. The bedrock for the economic boom was the production of massive quantities of steel for application throughout the economy. The resulting growth placed China far ahead of any other steel producing country. Currently, China accounts for more than one-third of global steel output and is expected to produce about 485 million metric tons this year, up from 348 million metric tons just two years ago. In fact, some experts see Chinese production hitting a staggering 580 million metric tons by 2010.

CHINA’S CONCERNS. Not without problems, the Chinese steel industry is hampered by lots of inefficient, smaller mills and significant environmental problems. The top 10 mills in China only comprise 33 percent of total output. (In the United States, the top three producers account for about 65 percent of total steel output). In fact, there are 800 steel mills in China, mostly smaller plants, with less than 1 million metric tons of capacity. As a result, inside China there is brutal price competition, which the central government is struggling to address.

But the biggest problem is the growing imbalance between Chinese production and consumption and the threat that unchecked overcapacity will flood the world steel market with inexpensive exports. Between 2002-2005 China absorbed a lot of the excess imports that were plaguing the world market and not finding a home in the U.S. But in 2006 China became, for the first time, a net exporter of steel, and experts began to ask if China would flood the world market with excess steelmaking capacity. In 2007 most observers now expect China to export about 77 million metric tons, a frightening figure. But the Chinese central government has made it abundantly clear that this is not what it wants to see happen. The government doesn’t want to use precious foreign currency to import expensive raw materials and then export the products on the world market. That is surely not a profitable business model.

The central government has sought to curb production and balance supply and demand. The goal is to raise the market share of the country’s top 10 producers to 50 percent (from the current 33 percent) by 2010, through closure and consolidation of smaller mills, to make the industry more manageable. By 2020, the central government would like to see the top 10 steel producers at 70 percent market share, eliminating additional smaller inefficient mills. But there is a great deal of resistance at the local level to any loss of jobs, especially when it comes to closing steel mills. Yet I think the central government policy will prevail.

In addition, the Chinese recently imposed new export taxes on semi-finished and finished steel products, eliminating most VAT (value-added tax) rebates to further cut exports.

In essence, the main factors arguing against China flooding the world market with excess steel are: (a) the steady growth in strong internal demand, (b) the shortage of cheap raw materials makes it unlikely China can afford to export steel products, (c) pollution concerns should limit future capacity expansion by requiring the closure of smaller, less-efficient mills and (d) the central government is opposed to sizeable exports that will force foreign governments to limit Chinese exports of steel and many other products.

Outside of China, the strong world economy has driven up demand and prices, largely in light of a global construction boom centered in the Middle East, Asia and Russia. Infrastructure and commercial development projects have lifted demand and prices for plate, structurals and beams because steel is crucial for all heavy construction. When construction booms, steel booms. We can easily see a worldwide supply-demand crunch emerging next year if current trends continue and, as a result, world prices will remain high in the next year or so.

PACE OF CHANGE. What’s happening with the U.S. market? So far this year, prices have sagged, but not crashed, in the face of softening demand. But non-residential construction remains firm, and heavy construction equipment and infrastructure projects remain strong. Moreover, the U.S. is exporting a lot of steel-containing goods as a result of the weaker dollar and the robust demand abroad. We should see some recovery in auto sales next year that should help to boost demand. Finally, imports, after hitting a real high last year, continue to decline as higher prices abroad and rising transportation costs keep steel products out of the U.S. While it used to cost $40 to $50 to bring a ton of steel into the U.S., it now costs closer to $80 to $90 to bring in that same ton.

The other major factor helping to stabilize the U.S. (and world markets) is the wave of consolidation that hit the steel industry during the past five years. Mills have successfully adjusted production to better fit demand.

In 2007 mills have been slower to pull back production when the market softened and prices fell to $500 for hot-rolled band, despite lower import levels. But even at that level, mills are able to break even or make a little money, thereby avoiding a disaster. There is an indication that pricing discipline weakened, but not to a crisis point. We expect prices next year to reach $600 per ton for hot-roll band, $725 for cold roll and $860 for SBQ (special bar quality) bar products.

I don’t see the pace of consolidation slowing down one bit. There’s plenty of room for more mergers and acquisitions, especially across borders. In fact, the world carbon steel industry is rapidly moving toward five to 10 mega players, each with 50 to 150 million metric tons of capacity. The remaining integrated U.S. orphans—AK Steel and WCI (Warren Consolidated Industries)—will quickly find partners, and the mini-mill world, especially major long-product producers, are seeking acquisitions. A major backer of consolidation, the United Steelworkers, is hard at work structuring deals to enhance concentration and thereby stabilize the market. Moreover, we need to recognize that trans-national ownership helps reduce irrational global trade—the shipment of under-priced goods to foreign markets. When an exporter has operations in a foreign country, it is reluctant to ship under-priced goods to that same market and destroy its own assets.

Another important sign that the U.S. market has entered a new era is the construction of greenfield plants in the U.S., mostly in the South. ThyssenKrupp has decided to build a massive new mill that will annually produce 4.5 million metric tons of high quality carbon sheet for the auto market as well as 1 million metric tons of stainless. Severcorr, a 1.5-million-ton mini-mill, just commenced operations in Mississippi, targeting the transplant auto market as well. A major Russian mill, MMK, has also announced its intentions to build a new carbon sheet mill in Ohio or Ontario with 1.5 million tons of annual capacity. Finally, Nucor is restarting its Birmingham SBQ mill, which will turn out 850,000 tons of high-quality bar. Both Nucor’s Birmingham bar mill and Severcorr’s sheet mill are electric furnace operations, requiring some 2.5 million metric tons of scrap. That alone will put heightened pressure on scrap, pig iron and DRI supplies, sending domestic prices even higher.

RAW MATERIAL ISSUE. The amazing jump in Chinese capacity has put enormous pressure on supplies, driving up raw material prices to record levels. There was a tremendous spike in prices in 2005 and 2006 and a relatively small increase in 2007. I expect a significant rise in raw material prices next year, with iron ore increasing 30 percent or more. Scrap prices remain very high and, from all indications, they will go higher. The U.S. is exporting 38 percent more scrap than it did last year and is heading for a record 16 million metric tons. The world market for scrap, clearly driven by a construction boom, is extremely strong, drawing scrap out of the U.S. market and forcing up the domestic price.

As a result of the dramatic rise in raw material prices, steel companies, both integrated and mini-mills, are purchasing raw material suppliers, especially iron ore mines and scrap dealers. Arcelor Mittal and several Chinese firms have secured major iron ore facilities around the world, spending billions to further develop these operations. And to the surprise of many, Steel Dynamics (SDI) here in the U.S. recently announced the purchase of OmniSource, one of the largest scrap dealers in North America. SDI is also building an iron ore nugget plant in Minnesota. This makes a lot of sense, since the iron unit costs for a mini-mill constitute about 60 percent of its total costs. All of these efforts—and there are sure to be more scrap dealer acquisitions—make it clear that steel mills once again feel it is necessary to own their raw material vendors to guarantee supply and lower their costs. More companies are concluding that future high quality scrap supplies will fail to meet rising demand and that more scrap substitutes will be essential.

It’s important to note that with scrap prices rising, integrated mills will become more competitive. Scrap prices will determine profitability for mini-mills, especially with auto bundles at $280 and rising per metric ton. When scrap prices reach $300 per metric ton, EAF costs can be higher than those of integrated mills. When scrap prices rise, so do DRI and pig iron.

What does all this mean for ferrous scrap dealers? First, with the rise in scrap prices and the move toward value-added products, mini-mills will require higher quality metallics and better service. They will increasingly look for better scrap segmentation by size and quality, lower emissions, predictable prices over a fixed period and access to scrap substitutes as needed. Dealers who can offer these types of services should be able to charge a premium price. In short, the value of well-functioning scrap dealers will continue to rise, as the products they sell are increasingly in short supply.