The steel industry is poised to benefit from solid demand in the U.S and emerging markets like India. However, concerns linger around the steel industry stock space in the near term. Below, we discuss some of the key reasons and what investors in the steel sector can look forward to in the coming months and years.
Slowdown in China
Demand in China, that alone accounts for almost half of the total steel consumption, has slowed down due to the country's tepid property market and weaker infrastructure investment. China’s economic growth slowed further to 7% in the first quarter of 2015 from 7.4% in the fourth quarter of 2014. It is the slowest pace witnessed in the last 6 years.
Monthly retail sales, industrial output and fixed asset investment data released with the GDP figures all missed analyst expectations. Industrial output grew at its weakest since the global financial crisis in 2008. Further concerns were raised by the real estate sector, where investment increased at an annual rate of 8.5%, the weakest rate since 2009.
Excess Capacity: Perennial Problem
The biggest obstacle in the path of persistent growth and profitability of the steel industry is its excess capacity. The industry is under relentless pressure caused by years of excess steel-making capacity further aggravated by weak demand and uneven economic growth.
To solve this problem, steelmaking capacity needs to be reduced for the industry’s profit margin to reach a sustainable level, and to raise the capacity utilization rate from below 80% levels. The industry remains highly fragmented compared to other global businesses and the restructuring and consolidation needed to eliminate overcapacity is progressing at a slow pace.
Falling Oil Prices
The energy sector, which has been buoyant due to shale discoveries and rising production of crude oil, accounts for 10% of steel consumption in the US. Steel is necessary to make rigs and transport oil. Steel demand from the energy sector is being affected as exploration companies have reduced their capital expenditure budgets in the wake of lower oil prices.
The steel products that the energy industry uses are also known as oil country tubular goods (or OCTG). United States Steel Corporation (NYSE:X) is the biggest supplier of these goods in North America and is thus bearing the brunt of the the slump in oil prices.
Rise in Cheap Imports in the U.S.
Despite a slowdown in steel demand in the country, production is still increasing in China. Hence, the surplus enters the international markets. The subsidies that the Chinese government provides to its steel industry as well as the devalued Chinese currency, which makes steel imports cheaper from the country, are partly responsible for this situation.
In the first quarter, U.S. steel imports surged 20% year over year to 10.6 million metric tons. These cheap imports hurt the margins of U.S. steel players like U.S. Steel, Steel Dynamics Inc (NASDAQ:STLD), Arcelormittal (NYSE:MT), AK Steel Holding Corporation (NYSE:AKS) and Nucor Corporation (NYSE:NUE).
U.S. Steel, in particular, swung to a loss in the first quarter of 2015, hurt by a barrage of cheap steel imports. The company, once the country’s first billion-dollar corporation, faced a challenging operating environment as high levels of imports led to lower volumes and lower steel pricing in the quarter. The company also faced headwinds from the drop in oil prices as mentioned earlier.
Low Crude Steel Capacity Utilization
The crude steel capacity utilization ratio remained stubbornly below 80% in 2014 and continued to stay so in 2015. The average capacity utilization in 2015 so far is at 72.5%. Even though, steel production is on the rise, the capacity utilization rate has gone downhill. Excess steel capacity has been a perennial problem for the steel industry and steel prices generally move in tandem with capacity utilization rates. To remain competitive, some major steel companies have idled their steel plants in a bid to rationalize operations.
Increasing Use of Aluminum in Auto Industry Poses Threat
Currently, steel is the major raw material for the auto industry, the second largest steel consumer. Major automakers like Ford Motor (NYSE:F) Co., General Motors Company (NYSE:GM) and others in specific and the industry as a whole is also becoming increasingly aluminum-intensive, given the metal's recyclability and light-weight properties.
The global push to improve fuel efficiency in vehicles is expected to more than double the demand for aluminum in the auto industry by 2025. Hence, in order to remain competitive, the steel companies will have to come up with improved and lighter varieties of steel.
Falling Iron Ore Prices
Iron ore prices continues to plummet due to continued slowdown in China, coupled with a surge in supply. In the next few years, a wave of new supply of iron ore is slated to hit the market as the major producers are going gung ho with their expansion plans to augment production capacity. Brazil and India will also step up their exports. A combination of weak demand and oversupply will continue to pressure iron prices in the near term.
Companies like ArcelorMittal and U.S. Steel Corp. fulfill their raw material requirements through their captive iron ore mines. While the steel operations of these two companies will reap the benefits of falling iron prices, the profitability of their iron mining operations are likely to be affected by the same.
Bottom Line
As you can see, there are plenty of reasons to be pessimistic about the steel industry. But what about investing in the space right now, are there opportunities for short-term investors?
Check out our latest Steel Industry Outlook here for more on the current state of affairs in this market from an earnings perspective, and how the trend is looking for this important sector of the economy now.