Steel: A Chinese Puzzle

Steel-related stocks have had a tough run in 2012, with the Bloomberg Global Steel Producers Index off 9 percent year-to-date compared to a 15 percent gain for the Morgan Stanley Capital International (MSCI) World Index.

Steel is an alloy that’s composed mainly of iron ore mixed with other metals used for hardening, rust resistance or to produce other desirable qualities. As an alloy, steel is not mined directly from the earth but is a manufactured product. As with any manufactured product, steel entails three key fundamentals for investors to watch: demand, supply and raw materials input costs. China is the key to understanding all three elements of this equation.

Steel Demand

China is both the world’s largest consumer and the world’s largest producer of steel, accounting for nearly half of total global production of the alloy and a similar percentage of apparent demand. Data on global steel production is more timely and available for a longer historic period than data on consumption, but the trend in both series is similar. China’s dominance of both sides of the steel industry steadily increased from the late 1990s to 2009 but has since flattened out (see chart, below).

Source: Bloomberg

One of the main drivers of China’s rising importance in the global steel market is the country’s large fixed asset investment (FAI). FAI includes investment in assets such as real estate, manufacturing machinery and rail infrastructure; essentially FAI is investment in assets designed to last for more than a year. Since building homes, office buildings and railroads is relatively commodity and steel-intensive, economic growth in countries with a large ratio of FAI to gross domestic product (GDP) is particularly bullish for commodity prices. That’s certainly the case with China (see chart, below). This chart shows the ratio of capital formation—a measure of FAI plus changes in inventories—to GDP for three major global economies. It’s clear that Chinese FAI is far higher than in either the US or Brazil.

Source: Bloomberg

Note that China’s capital formation ratio really soared between 2007 and 2010. This was partly due to the massive $586 billion stimulus package that the Chinese government passed in 2008 in an effort to stem the nation’s severe economic slowdown and contain the domestic fallout and contagion from the global financial crisis. Because the Chinese stimulus package focused on heavy infrastructure projects, it provided a real boost to FAI and capital formation.

A comparison of China’s share of global steel production and its capital formation ratio also reveals some interesting trends. Most importantly, from roughly 2000 through early 2008, China’s capital formation ratio and share of global steel production rose almost in lockstep; increased demand for fixed investments in infrastructure drives steel demand.

One of the most common bearish arguments for steel prices over the long term is that China’s huge FAI isn’t sustainable and will need to come back down to earth, reducing the steel intensity of Chinese economic growth.

It’s true that China has longer-term plans to promote consumer spending rather than relying solely on infrastructure investments to drive growth and there’s clearly not much upside to the nation’s already sky-high capital formation rate. However, investors should remember that the shift in Chinese growth engines is a long-term evolution, not an overnight change.

In the short-term, in fact, the Chinese government has taken several steps to help shore up the Chinese economy that are likely to result in increased steel demand. The government engineered a slowdown in the Chinese economy by hiking interest rates and bank reserve requirements throughout 2010 and the first half of 2011.

In particular, China’s one-year benchmark lending rate soared from 5.31 percent in August of 2010 to a high of 6.56 percent by the middle of 2011. Bank reserve requirements—the amount of capital banks must hold to support their lending book—was hiked from a low of 15.5 percent in early 2009 to a peak of 21.5 percent in mid-2011.

The Chinese government took these steps to try to quell inflation. China’s consumer price index (CPI) was up at a 6.5 percent year-over-year pace in the middle of 2011, a rate that’s far above the Chinese government’s comfort zone of 4 percent annualized inflation. But these efforts to tighten monetary policy and rein in property price speculation succeeded in reducing inflation to less than 2 percent this year.

Now, the government has turned its attention from fighting inflation to preventing a further slowdown in Chinese economic growth. On the monetary front, China has cut interest rates to 6 percent and cut bank reserve requirements back to 20 percent with further cuts likely to come. These efforts appear to be yielding some results, as reflected in resurgent Chinese bank lending activity (see chart, below).

Source: Bloomberg

As this chart shows, Chinese lending activity boomed in the wake of the government’s $586 billion stimulus package in 2008 but slumped towards the end of 2011 as the government tightened monetary policy to calm inflation fears. This year, however, lending activity has begun top pick up again, although at nothing close to the pace of the 2008-09 stimulus boom.

In early September, Chinese officials also launched another round of fiscal stimulus, announcing the approval of 25 new subway lines, 13 highway projects, airports, energy production and wastewater treatment facilities. The total investment in infrastructure projects approved since the spring is around $135 billion.

While that’s a far cry from the $586 billion the government spent during the crisis of 2008 and 2009, the Chinese economy is in much healthier shape today than was the case 4 years ago. On the margin, the stimulus spending will boost fixed asset investment and steel demand.

From a longer-term perspective, it’s also important to understand that Chinese steel consumption is likely to shift. Global steel demand is driven by demand for steel in construction and machinery (see chart, below).

Source: Bloomberg

China steel consumption is even more dependent on construction and machinery infrastructure demand than the global market. The China Iron and Steel Association (CISA) estimates that 73 percent of Chinese steel demand is used by the property construction, infrastructure and machinery industries, all parts of the economy that do well when there’s high fixed-asset investment.

However, the same is not true in all countries around the world. For example, in the US construction and infrastructure account for about 42 percent of steel demand, but automobile manufacturing chips in another 24 percent and energy-related steel demand accounts for 7 percent of the nation’s consumption. In Japan, automobiles are the largest source of steel demand accounting for about one-quarter of the nation’s needs.

Over the long term, the Chinese government wants to encourage domestic demand and consumption in China and make the nation’s economy less dependent on infrastructure investment for growth. While this may have the effect of reducing growth in steel demand from China’s property sector, it would boost the importance of steel consumption in other sectors that benefit from domestic demand such as automobiles and appliances.

Automobiles in particular account for less than 6 percent of Chinese steel demand and appliances just 1.8 percent; these industries are far more important sources of demand in more consumer-oriented economies such as the US.

Supply Side

On the supply side of the equation, one of the most important figures to watch is capacity utilization, a measure of the portion of global steel capacity that’s actually producing steel at any given time (see chart, below).

Source: Bloomberg

Historically, when global steel capacity utilization falls into the low 70s or below, it leads to at least a short-term rally in steel prices and steel producer stocks. This is logical because lower steel capacity utilization means that steel producers are cutting supply output, tightening the supply-demand balance.

During the global financial crisis of late 2008 and 2009, steel capacity hit record low levels under 60 percent and just a few months later steel and related stocks soared. In the winter of 2010, 2011 and 2012, capacity utilization also fell, helping to support prices.

It appears that steel producers are once again exercising some discipline this year. Given weakness in steel prices over the summer, steel capacity utilization never rose as much in the summer of 2012 as it did in either of the previous summers.

While steel capacity utilization always falls seasonally into the winter, ithis normal drop-off is occurring a bit sooner and is more dramatic that in either of the past two years. If capacity utilization falls under 70 percent this year (below its December 2011 low) that would be a major upside catalyst for the group. It’s also worth watching Chinese steel capacity utilization separately, because the country is the world’s dominant producer (see chart, below).

Source: Bloomberg

China’s steel industry continues to face overcapacity, partly stemming from a large number of high-cost small producers in the country. The good news is that with domestic steel prices as low as they are today, these small producers are unprofitable and have shuttered production. Over the summer, China’s steel capacity utilization hit highs of around 80 percent, well under the 85 percent level that acted as a ceiling in the previous two summers.

Capacity utilization at the end of August was already down to about 76 percent. And, even more timely data released by CISA suggests that Chinese steel production, especially from small producers, continued to fall in the first half of September.

The impact of greater supply discipline is also evident in export statistics from two of the world’s dominant steel producers, China and Japan (see chart, below).

Source: Bloomberg

Chinese steel exports in particular spiked over the summer months, as the country produced more steel than it could use domestically. But as producers cut back their output, they’re also pushing less cheap steel on the international market, helping to improve the global supply and demand balance.

Raw Materials Costs

About 98 percent of all steel produced globally is manufactured using one of two basic processes: oxygen blown and electric furnaces. The main raw material used in an oxygen blown furnace is pig iron, a type of iron that has a 2 percent to 4 percent carbon content.

Pig iron is created in what’s known as a blast furnace. In a blast furnace raw iron ore, consisting primarily of iron mixed with oxygen, is heated to extreme temperatures in the presence of carbon in the form of coke, typically produced from metallurgical coal. The carbon combines with oxygen in the iron ore, to produce carbon dioxide gas, effectively removing the oxygen from the ore. The resultant product is pig iron, a rather brittle and useless substance in its own right.

To create steel from pig iron, one must remove much of the carbon and impurities. In an oxygen furnace, purified oxygen is pumped through molten pig iron. Oxygen bonds with carbon to produce carbon monoxide and with other impurities to produce slag that can be removed from the molten metal.

The result is steel, a low carbon and low impurity form of iron. The resultant steel can be alloyed with metals such as tungsten, chromium, molybdenum and nickel to produce a product with various useful properties such as increased strength, lower weight or resistance to rusting.

In contrast, an electric arc furnace essentially uses electricity to heat scrap steel metal, remove impurities and make steel. Producing steel out of such a furnace is cheaper but requires availability of significant quantities of scrap steel to use as feedstock, so it’s a far more common technology in developed countries such as the US than in fast-growing steel consumers like China.

Worldwide, 70 percent of steel produced is made in oxygen blown furnaces, compared to roughly 30 percent in electric arc furnaces. But in Asia, the world’s most important steel-producing region, around 81 percent of steel production comes from oxygen blown furnaces. And in China, the world’s largest steel-producing country accounting for nearly half of global production, more than 90 percent of steel is produced in oxygen blown furnaces.

In contrast, more developed regions such as the US and European Union are more heavily reliant on electric arc technology, with 61 and 44 percent of steel production respectively made using this technology.

Given the global importance of oxygen blown furnaces to global steel supply, especially for China, the two most important steel raw materials to watch are iron ore and metallurgical coal (see chart, below).

Source: Bloomberg

As the chart shows, iron ore prices are at their lowest levels since late 2009 and early 2010, just as the global economy began to emerge from the financial crisis. Prices slipped below $100 per metric ton in the late summer, a level at which a significant portion of global iron ore mining capacity is unprofitable.

While prices rebounded on news of China’s new stimulus package, iron ore’s significant 2012 downtrend remains unbroken. There’s unlikely to be much additional downside for iron ore over the next two years, because too much global supply would be unprofitable and output would quickly fall below demand.

A collapse to 2008-09 lows of around $60 per metric ton is unlikely, barring a global economic collapse. That said, with prices at current depressed levels, any increase in steel demand and prices would quickly push up profitability for steelmakers.

Much the same is true of metallurgical coal costs. Prices have fallen under $200 per metric ton compared to about $330 in the first half of 2011 when floods impacted Australian metallurgical coal output and exports, tightening the world market.

Bottom line: The 2012 slide in steel prices and the stock prices of steel producers is grounded in fundamentals. Demand has weakened with the Chinese economy and it has taken a few months for producers to cut back on their supply to try and balance the market. That said, steel is unlikely to see much additional downside and there are some short-term catalysts such as falling spare capacity, Chinese stimulus and low raw materials prices that aid profitability.

With steel producing stocks already pricing in lower steel prices, now marks a good time to purchase quality producers at bargain prices. See this issue’s Stock Spotlight for our favorite pick.

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