Analysts: Discontinuity
‘Surprises’ Steel Market

Editor’s note: This article is an edited transcript of remarks by Peter F. Marcus and Karlis M. Kirsis, managing partners of World Steel Dynamics, who spoke at last month’s Steel Success Strategies conference in New York.

Since mid-2003, the steel market has been witness to frequent, unexpected, often amazing and sometimes violent surprises. The managing partners of World Steel Dynamics ranked the five biggest surprises, and assessed the consequences to steel suppliers around the globe.

Surprise #1: The period of declining hot-rolled band prices ended in June 2003, sooner and with a shallower bottom than expected, avoiding a pricing death spiral. A few months later, steel raw material prices started to soar. Then, in fall 2003, world steel export prices took off.

What’s the consequence? In early 2003, the global steel industry entered an age of discontinuity. Since then, the pattern of events has been inconsistent with those of the prior years. In mid-2003, the industry entered an age of steelmakers’ metallics, which culminated in 2004 with extraordinary increases in steel prices and in early 2005 with a massive increase in iron ore and coking coal prices.

Surprise #2: Hot-rolled band prices have collapsed [in recent months].

It’s truly a surprise to see how quickly pricing power can shift in the psychological war between buyers and sellers. In China, some steel mills are offering hot-rolled band f.o.b. the steel plant at $370 per metric ton. In March, the price was $545; that’s a drop of $175 per metric ton in three months.

In Europe, there are stories of one-time transaction prices for hot-rolled band at less than $450 per metric ton; the price not long ago was $650.

In the United States, where prices are under pressure, the price today is probably $450 to $460 per net ton for hot-rolled band.

What’s the consequence? Hot-rolled band prices on the world market are sliding rapidly down, with pricing likely to bottom out in the months just ahead. An obvious question: will hot-rolled band prices bottom out at death spiral levels, which equates to the global steel mills’ average marginal cost, or at a higher level, which equates to their average operating cost?

Based on the results of the recently completed World Steel Dynamics cost curve for steel sheet mills for 2005, WSD pegs the global average operating cost to produce hot-rolled band in June at about $370 per ton, and the marginal cost at a low of $305 per ton, before depreciation and interest expense.

Once hot-rolled band prices reach bottom, we expect a robust recovery in the next two quarters, for several reasons: Episodes of widespread panic among steel buyers and sellers historically have not lasted for more than a quarter. In the U.S., mills seem to be producing steel at a rate about 10 million tons lower than what is needed. So we expect a good recovery in the order entry books in the fourth quarter.

Global steel demand in 2005 will be higher than in 2004, although the year-to-year gain will be less than in 2004. Steel scrap prices have fallen enormously since November 2004. Prime automotive scrap delivered to the steel plant fell from $470 per ton last November to $155, but recently recovered to about $175 or $180.

Surprise #3: China’s steel output in May rose to a colossal 350 million tons annualized.

Three factors have stimulated this extraordinary production surge in China: First, from January to mid-March, they went order-entry crazy as users and steel traders expected prices to rise in the second quarter. Second, the world price in the first quarter was higher than the price in China, and mills weren’t exporting there. Third, capacity was higher, reflecting the $20 billion in capital improvements spent last year in China.

However, we believe China’s steel output seems poised to fall. In May 2005, we estimated that apparent steel demand in China was as much as 42 million tons (annualized) more than real demand, because steel users and steel traders may have built up 3.5 million tons of inventory. Hot-rolled band prices in China have declined by about $175 per ton since March. Traders have suffered massive inventory losses, and there are stories that many will go bankrupt.

In June and July of this year, steel users and traders will have cut inventory by 2.5 million tons per month. This, in effect, is a 6 million ton swing in inventory change from May until now, or 72 million tons annualized. On top of that, export orders from Chinese mills are down 50 percent. We calculate that if the Chinese mills want to avoid adding to inventory, steel production in the country has to drop to an annual rate of less than 300 million tons, vs. 350 tons in May. A drop of this sort has never been seen anywhere in the world.

What’s the consequence? WSD thinks the outlook for the Chinese steel mills in the years ahead would appear to be far less positive than previously thought. An oversupply of steel in China, for both steel sheet and long products, will be viewed as a permanent condition. Future gains in steel production in China will be perceived as a function of apparent demand in the country and not a function of export opportunities. Government policymakers are quite against high exports by the Chinese industry. They have cut back a number of export incentives this year. And they would like to see lower steel production, if just to free up existing portions of the country’s infrastructure. Other industries have been crowded out. With disinflation [of steel production], they could grow on a more effective basis.

Surprise #4: A dramatic shift in steelmakers’ costs in the past 18 months—reflecting the surge in iron ore and coking coal costs—has significantly damaged the cost position of many previously well-positioned traditional steelmakers in Japan, South Korea, Taiwan, Western Europe, China and elsewhere.

What’s the consequence? There has been a dramatic repositioning in the past year of steel mills on WSD’s World Cost Curve, as operating costs for integrated mills rose from 2003 through May 2005 by $109 per ton in the United States, $175 in Western Europe and $126 in China.

The lowest cost steelmaker is located in Kazakhstan, although it incurs a huge freight expense to get to the market. Other countries with low costs include India, Brazil, Russia and Ukraine, with some Chinese mills positioned about $85 per ton above this level. A number of the higher-cost steelmakers are located in Western Europe, Japan and the United States.

WSD’s rating system for world-class steelmakers has seen a shift among the rankings of the top-rated companies due to the surge in raw material costs. A year ago, the five top-rated companies were POSCO at No. 1, followed by Severstal, Baosteel, Tata Steel and BlueScope. The rankings today are Tata Steel at the top followed by POSCO, Severstal, Baosteel and Nippon Steel.

Surprise #5: The huge increase in steelmakers’ cash flow in 2004.

In China, EBITDA rose to about $19 billion in 2004, vs. $13 billion in 2003. Outside of China, EDITDA rose to $94 billion in 2004, vs. $48 billion in 2003.

What’s the consequence? Balance sheets in the steel industry are extraordinarily improved. Most steel companies have M&A on the mind. They have the cash and the currency, that is the stock market, with which to engage in mergers and acquisitions.

In the past, WSD made a profit forecast based on the supply-demand balance, on the probability of different pricing events, shakeout periods, etc., over the cycle. We think this approach no longer works. A better way to think about this is from the point of view of an individual company, but within the context of a complex and changing environment. What is the company doing to increase its economic strength or its competitive position?

The steel industry is composed of winners, also-rans and losers. The performance of companies positioned as winners should be far better than others in an ever-changing and surprise-laden environment. We expect that the actions of winning companies will influence the shape and structure of the steel industry of the future.