Year in Search of Clarity

Steel consumption came to a screeching halt during the fourth quarter, prompting drastic cutbacks in production and expected losses for steelmakers. Where will the steel market go during the early part of 2009?

By Dan Markham, Senior Editor

Since the North American steel industry began consolidating over a decade ago, steelmaking executives have trumpeted the mills’ newfound flexibility to match supply with demand and remain profitable through all cycles. The current economic environment will put that theory to the test.

After enjoying a typically profitable year during the first three quarters, steel mills saw orders disappear in early fall and remain out of sight for the rest of the year. The price of hot-rolled coil, which spiked to more than $1,000 per ton earlier in the year, plummeted below $600.

Service centers stripped inventory to bare-bones levels, while a similar scenario unfolded among end-users. Liquidity became paramount and credit became scarce as the crisis in the financial markets began to rear its head in the steel industry. Buyers “just shut off the pump,” says metals analyst Christopher Plummer, managing director of Metal Strategies Inc., West Chester, Pa.

In the most recent Manu­ facturing Business Survey from the Institute of Supply Management, manufacturing declined in Dec­ ember for the fifth straight month. New orders were at their lowest level since ISM began the survey in 1948.

And the most recent government estimates indicate the U.S. was in technical recession for all of 2008, already two months longer than the average post-World War II recession. Furthermore, there’s no clear sign ahead when the current recession may end.

So where does that leave the steel industry heading into 2009? While industry analysts and insiders don’t expect demand to rebound any time soon, many hope the outlook will at least start to focus as the new year begins.

“It sounds a little heretical to say this, but given how bad the economy looks and how bad the financial markets look on Wall Street, I don’t think the steel industry cycle is in that bad a shape,” says Aldo Mazzaferro, who spent 28 years analyzing steel for Goldman Sachs before leaving to take a position as chief financial officer for the newly formed Steel Development Co.

Mazzaferro says the conditions in place before the crash should soften the impact. “When we entered this downturn in the summer, the inventory levels weren’t that built up. The service center inventories were pretty much under control and the demand levels globally had been good enough that it looked like the world was in a bit of a net shortage toward the early part of the summer,” Mazzaferro says. “We didn’t enter this cycle with an overabundance of inventory, and that’s going to keep us from having a deep, prolonged cycle on the downside.”

Demand will continue to be a problem through the first half of 2009 as several markets—particularly automotive and housing—remain moribund and the export market flat. But it’s possible the mills have cut production below real demand levels.

In response to the absence of orders in the fourth quarter, several mills took immediate steps to curtail production. For example, ArcelorMittal announced worldwide cuts of up to one-third of its production, while U.S. Steel idled several domestic plants, shifting production to a handful of others.

The production cuts and diminished profitability are being felt throughout the industry, not just at the integrated mill level. Nucor Corp., Charlotte, N.C., in its fourth-quarter guidance report, announced that production in the quarter was down about 40 percent compared to the previous quarter, with capacity rates just above 50 percent. Steel Dynamics Inc. expects a similar capacity utilization rate for the final three months of 2008, and is projecting a rare quarterly loss.

“If you look at the American Iron and Steel Institute numbers, the industry is operating at well below 50 percent right now. The industry as a whole has only operated below 50 percent four times in 110 years. The last time was 1982-83,” notes Plummer.

With more flexible cost structures, the minimills historically have been better able to absorb price declines and cuts in production, though the integrated mills are better positioned to adjust than they have been in the past due to new labor agreements and a greater number of facilities under individual company control. While mills of any type are not likely to thrive if production remains below 50 percent for a long stretch, the previous five years of profitability gives them the resources to manage through the downturn.

“Once [the market] stabilizes, companies will have the ability to restructure their costs to a level where they should be able to remain profitable at lower volumes. If pricing goes down to $200 per ton for hot-roll, I don’t know if anybody’s going to stay profitable. But I think pricing will stabilize. Even with the market demand down 20 percent, we’ll still be in relative balance in terms of capacity vs. consumption. I don’t think we’ll have a serious problem with profitability,” Mazzaferro says.

If nothing else, the rapid cuts to production do support the mills’ claims that consolidation would allow them to better match production to demand. “In the past, there were a number of mills in a single location that had to operate no matter what,” Plummer says. “Here, companies can selectively choose their weakest mills and shut or partially shut them down, then load their best mills with the sweet spot business.”

But this strategy is not foolproof, says analyst Charles Bradford of Soleil-Bradford Research in New York, who believes the mills were too slow to react to the impending drop in demand. “They were way too late in making the moves they made. The idea of matching supply and demand makes eminent sense. It makes no sense to build inventories of steel. But they tried to hold prices. Take a look at prices today. Does that look like they were all that disciplined?”

Most observers believe the erosion in the steel price—which lost about half its value since mid-year—should be nearing its end.

“I don’t see the hot-rolled price collapsing further,” says Mazzaferro. “I think it’s going to stabilize in the mid-$500 range, and the same is true for other products as well.”

Buoying the view that prices will soon level off is the belief that demand is poised to pick up as service centers begin to rebuild depleted inventories. Additionally, the price of scrap has begun to rebound from its precipitous fall in late 2008, adding to the chances of a turnaround in the price trend.

Lourenço Gonçalves, president and CEO of Houston-based Metals USA, also believes that the price has reached its low point. “Service centers have low inventories, and end-users are naked. I can’t call them depleted, because they’re basically empty.”

Gonçalves predicts the market will bounce back this month, for reasons both current and historical. “January will be better than December or November. 2009 compared to 2008 could be like 1998 compared to 1997. The normal uptick that happens in January could reignite the fire.”

According to David Phelps, president of the American Institute for International Steel in McLean, Va., “a perfect storm” over the previous two months kept steel buyers on the sidelines. Besides the decline in demand, service centers and other end-users had difficulty obtaining credit. An inventory tax in some states also caused some companies to pare down stocks as the year drew to a close.

“When January comes, you start to see people filling in their inventories,” Phelps says. “Cyclicality suggests the second quarter is the best quarter in the industry. Will it be this year? I would point to the increase in scrap prices, which has been an awfully good indicator of where our market is going in the past.”

While all agree that demand is going to be weaker in the early stages of 2009, there is some disagreement on how much weaker vs. 2008. One major difference is the export outlook year to year. Demand from foreign buyers offset weakness in the domestic market and helped the steel industry thrive for most of 2008 while the rest of the U.S. economy was in recession. Today, with prices of foreign and domestic steel, as well as currency values, closer to parity, U.S. exporters no longer hold such a large trade advantage. Moreover, the rest of the world has begun to experience the same kind of economic slowdown as the United States, softening demand for steel abroad.

Phelps, whose trade group represents foreign steel interests, says import ordering in November was as abysmal as orders placed with domestic mills, so very little steel will be arriving on U.S. shores during the first quarter. But with a strengthened dollar and cheaper fuel prices, steel distributors are more likely to begin sourcing foreign material later this year.

He’s particularly enthused about the plummeting fuel prices, which could spur consumption across the country. “For practical purposes, that’s a pretty sizable tax cut. It’s a better stimulus package than a government package, in my opinion,” Phelps says.

Plummer says the domestic industry will keep a watchful eye on imports, particularly if the U.S. market softens further. “Historically, any time you have a downturn in the market, that’s the time when antidumping and counterveiling duty cases go up,” he says. “We’re likely to see a very responsive reaction in that regard if imports continue to climb higher, especially those from China.”

Another market that sustained the North American steel industry in 2008, but is more uncertain this year, is nonresidential construction. Bradford believes that a stagnating nonresidential market represents the biggest threat to domestic demand.

“All indications are that it’s headed for the next collapse,” Bradford says. “A lot of people are very worried about real estate loans collapsing just like the individual mortgages did.” Office vacancy rates reportedly could hit 20 percent, up from around 6 percent today, which would undercut the need for new construction. “Architects say [nonresidential construction is] likely to be hurting for at least a couple of years,” Bradford adds.

Commercial, office and infrastructure markets may all get a boost from the incoming Obama administration’s plans to fund a major jobs program aimed at upgrading the nation’s aging roads and bridges.

“Obama’s infrastructure program has the potential to be huge for some of the commodity grades of steel such as rebar, structural beams and some plate,” says Mazzaferro, whose company’s first project is SDC Armory, a rebar plant being built in Mississippi. “If you add $100 billion of infrastructure, that would generate 6 million to 6.5 million tons of incremental demand to the rebar market, which is about two-thirds the size of the annual market. And when you specify the consumption has to be satisfied by domestic material, it suggests the market is going to be good.”

Bradford is also supportive of the infrastructure build, but questions its impact in 2009. “Even if you had something ready to go, as a lot of governors are claiming, ‘ready to go’ is 180 days away. It’s probably 120 days just to put out bids and get them back.”

Moreover, Bradford says, there are concerns about who will do the work. “There aren’t that many construction workers available. I can’t see a lot of the financial people who have lost their jobs going into construction.”

While support for infrastructure development is universal among steel executives, there is less unanimity on bailouts for the financial and automotive sectors. Don McNeeley, president of Chicago Tube & Iron Co. in Romeoville, Ill., says the government’s willingness to support these industries undermines the free-market foundation that has supported the country’s tremendous growth.

“As the world beats a path to emulate our system, we’re abandoning the principles that made us great through nationalizing industry and government bailouts,” McNeeley says.

Bradford also questions the wisdom of the auto bailouts, and believes the steel industry would be best served by loosening its ties to the automotive companies. “There is a long-term negative situation as far as the automobile industry is concerned. Even when the economy returns to normal, the percentage of steel per car is going to shrink. There is a mandate that automobiles become more efficient, and the easiest way to do that is to make them smaller and lighter, so use less steel. This is a shrinking market.”

For the time being, the steel producers and distributors are just hoping to get a clear idea of where demand will come from in 2009—and they may not have long to wait, predicts Plummer. “Everyone wants to get the extraneous stuff out of the way as quickly as possible to see the true underlying picture,” he says. “We may be near that picture within 30 to 60 days.

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