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How to Play North American Steel

The macro outlook is cloudy but we think steel valuations should look appealing to investors with a longer time horizon.

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Steel is a highly cyclical sector that depends on strong economic growth to drive infrastructure spending as well as consumer demand for cars and appliances. 2009 was undoubtedly a disastrous year for the North American steel producers, but fundamentals started to turn the corner in 2010 and into the first half of 2011 as the supply chain thinned out, high input costs provided steel pricing support, and demand from the automotive, agriculture, and energy sectors picked up speed. However, the past year has undone much of this progress in earnings and this is painfully evident in steel company valuations. Indeed, the Market Vectors Steel ETF (SLX) has plummeted 40% since last July. Economic woes in China and Europe are the main culprits, as steel is a globally traded product whose selling prices and input costs are correlated all over the world.

The U.S. is a relative bright spot as demand continues to grow with the World Steel Association forecasting a 6% growth in consumption in 2012 and 2013. This compares to a 2012 expected contraction in Europe and very little growth in China, a big factor since the country consumes nearly half of all global steel produced. If we take out China, the world is still consuming about 10% less steel than it did in 2007. Considering the increasing investment in underdeveloped economies, infrastructure needs in the U.S., high oil prices, and population growth--global steel consumption needs are still growing even while they might suffer short-term lulls. In the meantime however, U.S. steel mills are feeling the pressure of slower growth elsewhere. Steel imports surged more than 30% for the first four months of 2012 before stabilizing through the summer as steel prices slumped to match weakness in Europe and China. Raw material prices remain high by historical standards, but we believe we are past the worst of the margin contraction from an input cost perspective and are starting to see some sustained relief. The price of coking coal has fallen some 20% year-to-date and although the price of iron ore has plummeted in the last week in what we think is a short-term blip, it has averaged about 30% below last year's peak for most of 2012. We see room for further cost relief in the next few years. However, we expect U.S. steel prices to continue to struggle until Europe and China regain their footing.

Bridget Freas does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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