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Steel industry sees disconnect in supply-and-demand cycle

Keywords: Tags  Aldo Mazzaferro, Macquarie Capital USA Inc., U.S. steel prices, China, Turkey, U.S. steel mill capacity utilization rates, automotive market, Thomas J. Gibson Lawrence W. Kavanagh

Global steel production rates and prices should remain stable through the remainder of this year and beyond, analysts and key market players say, but other forces, including demand, could be less reliable, potentially creating some volatility.

“In general, supply/demand is actually in balance,” Aldo Mazzaferro, senior steel analyst at Macquarie Capital USA Inc., said. “Ore is weaker and scrap is weaker, but so far there has been fairly good production discipline from mills.” He suggested there is likely to be little change in that situation worldwide through the balance of the year, and that will act as a natural hedge in North America against imports.

“Demand is missing in action, but supply is well-behaved,” Mazzaferro and his team concluded in a recent MacSteel report. “There is little confidence and little motivation to hold inventory of anything, so mills have been slowing production, service centers have been living hand to mouth, and consumers are in a just-in-time mode. Foreign trade is getting modestly better, with lower imports expected as U.S. price levels in many cases are not high enough to justify the additional freight and delivery costs of imports. This could change quickly, however, with the evolvement of global price trends and currency levels. Domestic steel pricing is likely to go sideways.”

Mazzaferro said that U.S. steel prices are volatile within a narrow range of plus or minus $20 to $30 per ton, and he expects them to stay between $570 and $600 per ton as long as scrap and iron ore are soft. He also expects production rates to remain stable in the mid- to upper-70-percent range.

“Either demand must increase or supply must decrease for market forces to begin to move steel prices up again,” Mazzaferro said. “Company earnings are likely to diverge, with a split between losses from high-cost, mostly integrated steelmakers compared to modest profits for lower-cost players, largely mini-mills. Service centers should do well in a more stable pricing environment, as profit margins should no longer be whipsawed by volatile pricing. Rising prices would be better, but service centers can do well in stable pricing, especially those investing free cash flow advantageously.”

Looking worldwide, Macquarie said that scrap and raw material prices are likely to rise and fall with the level of global scrap and steel demand, including that from China, Turkey, and elsewhere in the eastern Mediterranean and Asia.

“We expect stability in scrap and iron ore. Ore prices are probably the most important underlying factor up and down the steel spectrum,” Mazzaferro said. “Some concerns include the high levels of Chinese steel inventories because a destocking as pricing there declines could cause a cutback in steel production, which would then create some downside volatility in ore that might bring down the scrap and steel price spectrum globally.”

With U.S. steel mill capacity utilization rates hovering in a range of 75 to 79 percent during the first half of this year, steelmakers are looking at a mixed but generally positive picture for the rest of the year and into 2014.

“The automotive market has improved markedly over 2012, and energy is still looking relatively strong, even though that segment has seen a lot of import penetration,” Thomas J. Gibson, president and chief executive officer of the American Iron and Steel Institute, said. “Overall, imports are running at 24 percent, which is higher than the recent average. Construction markets remain depressed from pre-recession highs, with some better subsegments, such as warehousing and hotels.”

Energy is a bright spot, and not just as a source of demand for line pipe and oil country tubular goods, said Lawrence W. Kavanagh, Steel Market Development Institute president and AISI treasurer. He said the boom in shale oil and gas has pushed up demand for sheet steel for storage tanks and rail cars.

“We are an energy-intensive industry, and the lower cost of power from gas-fired generation is a benefit,” Kavanagh said, noting that natural gas also is being used in blast furnaces, not just as an accelerant but also as an economical replacement for some of the carbon and fuel components provided by coke and coal.

As for primary steel inputs, prices for iron ore and scrap are coming off recent peaks, said Jessica Fung, global commodities analyst at BMO Capital Markets Ltd. in Toronto. “Chinese and Indian mills were running very high, which was supporting high ore prices. In mid-May, traders were not buying,” she said. “Upstream of steel, we are expecting an onslaught of raw material supply. That is not so great for the mines, but good for the mills.”

Overall, sellers, buyers and traders are disappointed with the way the market has behaved lately, Fung said. “We have seen some real shocks in ore prices, which is something of a surprise. When the industry moved off annual contracts in 2010, many people thought that would be great for capturing better prices. In (any) event, no one is happy with the volatility, and there has even been some talk of going back to some form of contract, perhaps quarterly, like coal. I doubt that will happen, but the sentiment is clear.”

The downstream demand recovery varies greatly by sector, Steel Manufacturers Association (SMA) president Thomas Danjczek said. “The bright spots are automotive and energy. Long products are also bright for both residential and nonresidential. That includes rebar, wire rod and structural shapes, but not (special-bar-quality products). Long products are up 24 percent this year, but bear in mind that is off a utilization rate of about 60 percent last year.”

There are still uncertainties surrounding low capital investment around the country, low hiring rates and government gridlock, including over debt and regulation, said Adam Parr, SMA’s vice president of policy and communications. “The largest drag on our industry is Europe. They produced 200 million tons in 2007 and now just 150 million tons. What is going to happen to all that excess capacity? That is really acting like a wet blanket on the global steel business.”

Overall, “we are seeing a pickup in all areas, but no one is happy just growing at 3 percent a year,” Danjczek said. “At least we can say that the likelihood of a second dip into recession seems to be behind us. People may be disappointed with the rate of growth currently, but at least it is growth and not recession. My members are not necessarily confident, but they are more optimistic. We try not to get caught up in the averages of this quarter better than that quarter but worse than the other quarter. There are variables in all sectors, but this is still a good time to be in the primary steel business.”

One way steelmakers have attempted to control their input costs has been to integrate vertically upstream, but those initiatives seem not to have played out as hoped. “We have seen several mills acquire mines, but that was mostly done when ore prices were higher,” Fung said. “But now, when ore prices are coming down and mine valuations are lower, is the time when the mills should be making deals with mines. It never seems to work out that way, though.”

If back-integration from the mill to the mine has delivered mixed results, combinations in other segments of the supply chain have shown positive returns. One of them is Nucor Corp.’s $750-million, 2.5-million-ton direct-reduced iron (DRI) project in St. James Parish, La. The DRI process is a heavy user of natural gas, and late last year the Charlotte, N.C.-based steelmaker struck a 20-year supply deal with Canadian energy firm Encana Oil & Gas (USA) Inc. for an onshore natural gas drilling program. Chesapeake Energy Corp. and methanol producer Methanex Corp. recently reached a similar deal, demonstrating how high-demand industrial users and energy suppliers are moving beyond simple spot purchases.

Nucor previously said its DRI plant was on schedule for a mid-2013 startup, with plans to construct a second DRI plant of the same size at the same location once the first is up and running. A knowledgeable industry source said the first train is “likely to be in service later in the year, perhaps even toward the end of the year.” Nucor did not respond to requests for comment.

Meanwhile, Interpipe Group has been effusive about its upstream integration to primary steel production at its pipe mill in Ukraine. One of the company’s most important projects has been its $780-million, 1.3-million-tonne Dneprostal steel mill, according to Interpipe North America president Daniel Valk.

The company’s new electric-arc furnace was commissioned in October 2012 and supplies the billet needs of all of Interpipe’s pipe mills, Valk said. “We ship semifinished green pipe to the U.S. and upgrade here, primarily threading and heat-treating. The huge advantage to having our own steel production is that we can control quality and reduce lead times to very short.”

The pipe business in North America is slower so far this year than it was in 2012, Valk said. “We have seen volumes and margins decrease because oil and gas companies are concerned about overproduction and lower prices, so they have reduced drilling. We do anticipate increases in oil and gas prices, and when that happens drilling will resume, but for the moment they, and we, are just holding.”

He also noted that there are still many players in the pipe business throughout Europe, India and Asia competing for markets in the Americas. “People think about the North American market in particular as a bottomless pit, but it is not,” he said. “And we are finding the bottom. In recent years, there would typically be a two- to three-month supply of pipe on the ground in the U.S. Now that has increased to a four- to six-month supply.”

With no major macroeconomic developments in global supply and demand shifts, industry observers are watching for more subtle signals.

“We are seeing lots of small things,” said Josh Cole, a principal with accounting and consulting firm Crowe Horwath LLP. “We are seeing companies of all sizes making investments to move closer to their customers by investing in additional value-add(ed products) for their end customers. They could be responding to a need from a customer to outsource some operation, or it could even be replacing a customer operation.”

Up and down the steel supply chain, companies are evaluating where their profits are, where their costs are and where their expertise lies, Cole said. “Where businesses have been commoditized, they are raising the barriers to competition in the places that they best can.”

Cole said that trends toward value over volume stop at the mill gate. “Generally, the primary steel world is still about running at a capacity to achieve efficiencies,” he said. “Their margins are dictated by the price of their metal and their cost structure back to raw materials.”

David Hannah, chairman and chief executive officer of service center chain Reliance Steel & Aluminum Co., said his company is not focused on tons. “We rarely even talk about tons. Our focus is on maximizing gross profit by turning inventory.” Reliance recently completed its acquisition of Metals USA Holdings Corp., Reliance’s largest ever in terms of value but just the second public company it has purchased of a total of 55 acquisitions.

“Metals (USA) did a very good job. Their returns were only second to ours in the sector, with gross profit of about 22 percent. The new target is 25 percent,” Hannah said. “That might not sound like a big deal, but with a $2-billion operation even a few percentage points makes a big difference on the bottom line.”

The same principle applies to operational efficiency. “Metals (USA) were turning their inventory 3.5 or four times. We have set a new target of five times,” he said. “If that can be accomplished, it would free $100 million in capital.”

Analysts lauded the companies’ complementary product lines and geographical advantages, noting that the deal would be immediately accretive to earnings for Reliance.

Hannah agreed, adding that integration is being led from the field, not the head office in Los Angeles. “We don’t draw lines around products or geography,” he said. “As we said when we closed the deal, this is accretive straight out of the box, so there is not a lot of integration in the traditional sense. We are letting the people in the field drive this combination. We are not planning any redundancies in people or locations. This business is based on relationships, and we don’t want to harm those. We don’t have a lot of geographic overlap, and there is not a lot of duplication in lines of business even when we are in the same geography. But even if Metals (USA) has a location near a Reliance location, we are not going to close one or the other. We leave all the names in place, and we have seen a great deal of cooperation already.”

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