What Recession? Steel’s Poised
for Profits Despite Poor Demand

With steel demand weakening along with the U.S economy, how can steel prices be so high?

Steven Randall, managing director of The Steel Index for London-based Steel Business Briefing, explained this contradiction during SBB’s annual conference in Chicago last month.

Steel prices increased by more than 40 percent in the past seven months, topping $800 per metric ton and eclipsing the previous record set in 2004. In fact, steel prices are similarly strong in markets all over the globe, which is contributing to the dearth of imports in North America.

“Prior to 2004, it typically took two to three years for steel prices to move 40 percent. Now we are seeing 60 percent swings in less than a year. There’s been a step change in price levels and a step change in volatility,” Randall said.

With industry EBITDA in the 15 to 20 percent range, he added, “2008 will be one of the strongest years the steel industry will see in its history.”

While many expected steel industry consolidation to bring greater price stability, that’s obviously not the case given current market conditions, Randall noted. Though the top five producers in the U.S. market now account for more than 70 percent of domestic production, steel remains highly fragmented on a global basis, with the top five accounting for only about a 20 percent share.

Unlike in 2004 when prices peaked because demand was so strong, today’s high prices have little to do with demand. “These dramatic price increases are a function of supply limitations, in particular the scarce availability of low-priced imports,” Randall explained. “The U.S. steel market depends on imports for around 20 percent of its consumption, so when imports are not available and stocks are at low levels, it’s not surprising that a consolidated regional industry is able to command high prices for its products.”

Since 2001, steel production globally has grown at a strong 6 to 8 percent annual pace, driven in large part by China. Steel demand outside China also has increased by nearly 200 million tons in the past seven years. Since China switched from being a net importer of steel to a net exporter in 2006, the rest of the world has been able to absorb the Chinese exports. “We are looking at a situation where Chinese exports are going to be down this year—partly due to new taxes, which make the prices higher. Those exports can find destinations in growing markets closer to home, rather than competing for customers in North America,” Randall said.

So what will happen to steel prices in the next year, as the U.S. economy struggles? The unprecedented market conditions bring new uncertainty to any predictions. “No one has ever seen prices rise in the face of such lackluster demand,” Randall noted.

He described equally plausible scenarios in which steel could top $900 per metric ton, or fall to less than $600 per ton, in the coming months. “There’s a $350 per ton difference in where the price might be in a year, depending on which scenario one prescribes to. For anybody involved in the buying and selling of steel, that presents quite a challenge.”

Randall is a proponent of steel futures trading. SBB would like to see contracts traded based on its Steel Index pricing data. “Steel futures themselves will not reduce, eliminate or arguably have any impact on steel price volatility, but they will help to manage it. What they offer is for people in that market environment to hedge and secure prices forward, and thereby remove the volatility in terms of their own exposure.”

Steel futures trading is already under way on the London Metal Exchange and in the Middle East, while the New York Mercantile Exchange prepares to begin trading later this year, but the concept is still in its infancy. “For those in North America, a rebar billet contract in the Middle East is not much use. I don’t think we will see steel futures really take off in North America and Europe until flat-roll contracts [are offered on the major exchanges],” Randall said.

“I’m glad the steel futures haven’t been launched because the skeptics undoubtedly would be attributing this increased price volatility to the futures,” he added. “This is not about that. Today’s pricing is due to a combination of other factors, supply and demand, and raw material costs at record levels.”

“Today’s prosperity is far more a function of a lack of supply than it is any expectation of a big recovery in the second half for the economy,” agreed Mark Parr, managing director and equity research analyst with KeyBanc Capital Markets in Cleveland, who also addressed the SBB audience.

Steel prices have been “going crazy,” not because of increased demand or restocking momentum at the service center level, but because of the weak influx of imports. Unlike in the past when Chinese steel was cheap and ripe for export to North America, U.S. and Chinese prices have been moving in tandem.

“Bottom line is that the supply scenario—the lack of imports—is really having an impact on U.S. producers,” which are operating near capacity despite declining demand. “With the weakness in imports, 2008 production could increase 5 to 10 percent in a market where demand declines 5 to 10 percent,” Parr said.

How can shipments go up when demand is down? Because of three factors, he said: the dramatic reduction in imports, a reduction in inventory destocking as service centers have reached minimal levels, and a sharp increase in exports fueled by the weak dollar. “Not only do we have pricing going up, but there is a volume story here for the industry in 2008. The earnings outlook is as good as it has ever been, even though we’re looking at a recession.”

Parr expects hot-rolled steel to approach $800 per ton for May. “I think there is still plenty of room for the domestic hot-band price to rise in the context of following global markets. We’re in between Europe and Asia right now. There is plenty of room for U.S. pricing to go higher.”

In his forecast for the SBB crowd, analyst Chuck Bradford, president of Bradford Research Inc. in New York, concurred that the steel industry will defy the economic trends in 2008. “I can’t find a significant market except for energy that is doing well,” he said. Yet, ironically, he also expects a record year for steel producers and distributors.

He estimates the adjusted net flow of imports could decline to as little as 4 million tons this year, down from 14 million tons last year and 24 million in 2006. “That’s a pretty substantial decline in net imports. That’s what’s making the market, not consumption,” he said.

David Phelps, president of the American Institute for International Steel, which represents foreign producers, emphasized that current market conditions cannot persist indefinitely, because the U.S. market’s steelmaking capacity still falls far short of its consumption. “We need imports. At some point, something has to give.”