The Finest Steel Must Endure the Hottest Fire
Short-term headwinds portend an ugly 2015 for U.S. steelmakers, but stock prices imply overly bearish long-term expectations.
With U.S. GDP, construction spending, and industrial activity all on the upswing, one might surmise that 2015 is shaping up to be a banner year for the steel sector. But with weak crude prices undercutting demand from the energy sector and a wave of imports washing ashore, that's unlikely to be the case. We expect 2015 to mark a cyclical trough as spot prices fall and capacity utilization remains unfavorable. Thereafter, we expect a proliferation of strong, broad-based end-market demand to drive improved utilization and margin expansion as headwinds abate. On the basis of U.S. steelmakers' current valuations, the market assumes no such recovery, and we assert that U.S. steel stocks have been unjustly punished in recent months. We see attractive valuations across the space for long-term-oriented investors. Low-cost, lightly leveraged Nucor (NUE) offers the best risk-adjusted return potential, as the company should have no problem navigating lower free cash flow in the near term as its direct-reduced iron project takes hold.
Elevated Import Volumes Unlikely to Moderate
We expect import volumes to rise further due to a historically high spread between U.S. steel prices and international steel prices and the impact of a strong U.S. dollar, which makes steel produced abroad more attractive on a relative cost basis. Monthly steel import volumes moved above 3 million metric tons last April and picked up as the relative value of the U.S. dollar picked up steam over the second half of 2014. Import volumes even briefly eclipsed the 4 megatonne mark in October, marking an all-time high. In 2014, monthly steel import volumes averaged 3.349 Mt, a 38% increase relative to the 2013 monthly average of 2.430 Mt.
In December, Canada, Russia, and Brazil remained the top three sources of imported steel, each accounting for more than 10% of total import volumes. However, over the course of 2014, imports from Turkey increased more on both an absolute and percentage basis than imports from any other country. In 2013, the United States imported a monthly average of 91 Mt of steel from Turkey; over the course of 2014, this increased to monthly average of 167 Mt. The majority of tonnage imported from Turkey consists of long steel products, as scrap-dependent electric arc furnaces constitute roughly 70% of the country's installed asset base for steel production. According to Commercial Metals' (CMC) management team, Turkish rebar imports have been flooding the U.S. market, keeping product prices low and weighing on shipment volumes for U.S. steelmakers.
We expect the growth rate of U.S. steel import volumes to slow significantly as the relative appreciation of the dollar and the wide gap between U.S. and international steel prices contract. Although high import volumes currently are weighing on utilization rates and therefore profitability, we don't think higher utilization rates through the end of the decade would require that import volumes revert to the much lower levels witnessed over the previous business cycle.
If we hold total installed capacity, import volumes, and export volumes steady, 2% annual U.S. steel consumption growth would lead to an 85% capacity utilization rate by 2018 and a 90% rate by the end of the decade. In a more likely scenario, assuming a 3% annual increase in steel import volumes, similar capacity utilization rates would be achieved if U.S. steel consumption grows only 3% each year.
Capacity Utilization Unlikely to Exceed 80% in 2015,
but Should Recover Thereafter
For the U.S. steel industry, capacity utilization rates oscillated between 75% and 80% in 2014, in line with 2013 levels. Even in a reasonably healthy demand environment for steel in the U.S., the rising tide of steel imports will probably prevent domestic capacity utilization rates from improving much beyond the current 78% level in 2015. Over the long term, however, we expect improving steel demand in the U.S. and moderating import volumes to drive utilization rates toward 90%. This is a key assumption to highlight because it plays into our long-term midcycle operating margin forecasts for steelmakers with U.S. exposure under our coverage.
Steelmakers are subject to considerable fixed costs, and spreading these fixed costs over large production volumes is critical in supporting profitability. For this reason, even if steel prices rebound in the coming years, companies in our steel coverage universe will be unlikely to return to margin levels witnessed before the onset of the global financial crisis unless capacity utilization rates also improve. In the U.S., this is particularly true for companies that rely predominantly on blast furnace production, such as AK Steel (AKS), ArcelorMittal (MT), and U.S. Steel (X). Once production is initiated, blast furnaces often operate for years at a time and therefore are subject to a high degree of operating leverage. Although electric arc furnaces are also subject to relatively high operating leverage, their operation involves a modestly lower proportion of fixed costs, as they can be turned on and off to adjust for changing production schedules in response to fluctuating demand. Along these lines, although blast furnace operators might face more obstacles in 2015 as utilization rates remain range-bound, they ultimately offer greater margin expansion and earnings growth potential over a longer time horizon.
In part, lower present-day capacity utilization rates stem from the fact that many steelmakers brought greenfield capacity on line just before the onset of the global financial crisis when steel prices were high, margins were wide, and balance sheets were flush.
This situation is complicated by the impact of rising import volumes and China's emergence as a net exporter of steel after being a large-scale net importer for the majority of the previous decade. Not only is China exporting more steel than ever before, but some displaced export volumes from other countries that would have historically been routed to China are now being dumped illegally in the U.S. In 2014, however, China’s steel consumption declined 3.4% year over year to 738 Mt, the first decline in three decades. Even so, China’s 2014 steel output rose a modest 0.9% to a record 823 Mt.
Given our view that import volumes are likely to remain elevated through 2015, it appears unlikely that U.S. capacity utilization rates will recover above 80% in the near term. Even so, we expect the operating environment to become much more conducive to earnings growth after the conclusion of a challenging 2015 as capacity utilization rates recover toward historical midcycle levels. At that point, the benefits of operating leverage will become a tailwind for U.S. steelmakers, and we are confident that current valuations will look like a bargain.
U.S. Steel Spot Prices Likely to Decline Further Into 2015
Domestic steel spot prices have declined materially since mid-2014, and hot-rolled coil prices recently fell below $580 per ton for the first time since mid-2013. Declining steel prices have been driven by rising import volumes and reduced cost support stemming from materially lower iron ore and metallurgical coal prices.
We expect steel prices to hover around $550 per ton over the course of 2015, as they currently sit only slightly above what we believe to be the per-unit production cost of the marginal producer. The high end of the industry cost curve is, for the most part, composed of Chinese steelmakers whose cost structures are highly leveraged to prevailing spot prices for seaborne iron ore and metallurgical coal. The lower half of the cost curve consists of steelmakers with varying degrees of self-sufficiency for iron ore and metallurgical coal, most of whom were historically able to secure these steelmaking raw materials at a cost well below prevailing spot prices.
Due to the steep declines in iron ore and met coal prices over the course of 2014, we think the upper half of the industry cost curve has flattened and the entire industry cost curve has pivoted downward.
Consistent with our forecast that lower iron ore and met coal prices are here to stay, we expect steel prices to increase roughly in line with inflation after 2015, remaining below their trailing five-year average of $665 per ton through 2018. Even so, we expect post-2015 U.S. steelmaking margins to exceed trailing five-year averages, given materially lower input costs, improved efficiency, and our expectation for improving capacity utilization rates.
We Expect Influential Trade Case on Cold-Rolled Steel to Be Filed in 2015
Given the wide gap between domestic and international steel prices compared with historical levels and the preponderance of high import volumes, numerous steel-related trade cases were filed with the Department of Commerce in 2014. The outcomes of the two most noteworthy trade cases filed in 2014 were, for the most part, disappointing for the U.S. steelmaking community. In September, the International Trade Administration's final determination to assess antidumping duties on Mexican rebar imports but not against Turkish rebar imports was a major surprise, effectively giving Turkish exporters the green light to continue shipping large volumes of rebar to U.S. purchasers at low prices.
A few months earlier, the ITA determined that South Korea and six other countries had been illegally dumping oil country tubular goods in the U.S. The antidumping duties applied to South Korea, however, ranged from only 9.89% to 15.75%, which was not high enough to discourage South Korean companies from exporting to the U.S.
As a result, OCTG import volumes have remained high and continue to account for roughly 50% of total domestic OCTG consumption. January license data points to an expected uptick in import volumes (151K metric tons), which are likely to retrace levels witnessed before the final determination of the OCTG trade case.
A trade case on welded line pipe, which was filed against South Korea and Turkey in October, should be resolved in mid-2015, and a very important trade case on cold-rolled and coated steel is expected to be filed soon against imports from China, India, South Korea, and Taiwan. It was widely believed that this case would be filed late last year but, given the major impact it could have on the landscape of the U.S. steel industry, petitioners have pushed it back in order to fine-tune their arguments. We expect the U.S. to consume roughly 110 Mt of steel in 2015, and flat-rolled steel will represent approximately 60% of this total. Given that cold-rolled and coated steel accounts for roughly half of all flat-rolled steel demand, the trade case could affect roughly one third of total domestic steel demand.
As of now, our forecasts for U.S. steelmakers do not include the impact of a potential trade case of this magnitude and, therefore, this possibility provides upside risk to the U.S. steelmaking space.
Increasing Construction Activity Will Support Steel Demand Growth
We expect the construction end market, which accounts for roughly 40% of total U.S. steel consumption, to grow faster than any other key end market for steel in 2015. Our outlook is supported by Architecture Billings Index readings that have exceeded 50 for eight consecutive months, signaling an expansionary environment for architectural design projects. This trend indicates that construction activity is likely to pick up in the warmer months of 2015. Based on a regression analysis between the ABI and actual U.S. construction spending, the ABI tends to lead construction activity by 9-12 months, although associated steel purchases would probably take place slightly sooner.
On a regional basis, the South and West have reported the highest ABI readings since August, although this reflects typical seasonality as cold weather prohibits large construction projects in the Midwest and Northeast. The magnitude of ABI readings in the South is particularly noteworthy, as they have far exceeded levels achieved at this time last year. This indicates that many more architectural firms in the region are now reporting "significant increases (5% or more)" in billings relative to late 2013. December ABI readings for all four regions sit above their comparable values at this time last year.
Within our coverage list, the most noteworthy beneficiaries of this near-term catalyst would be Commercial Metals, Gerdau (GGB), Nucor, and Steel Dynamics (STLD). Commercial Metals, in particular, is well positioned to enjoy growing shipment volumes in 2015 due to its geographic exposure to the U.S. Sun Belt and the concentration of its asset base in Florida, Texas, and California.
Although our expectations point to increased construction spending over the course of 2015, we didn't see much evidence of this trend taking hold as of late 2014. Per seasonally adjusted U.S. Census data, construction spending declined modestly from October to November but increased 2.4% in November relative to the same period last year. During 2014, residential construction spending actually declined while nonresidential grew at roughly a 4% clip.
Automotive Steel Demand Will Maintain Momentum
Automotive steel demand was the bright spot for the U.S. steelmaking community in 2014 as U.S. light-vehicle sales were strong. On a seasonally adjusted basis, U.S. light-vehicle sales registered at 16.8 million units in December, up from less than 16.0 million in December 2013.
Amid speculation that a growth rate of this magnitude would be unsustainable, falling oil prices could support further growth in the upcoming year as the value proposition of owning or leasing a car has become much more attractive. Additionally, lower oil prices could deter automakers from substituting aluminum for steel, as the fuel-efficiency gains driven by aluminum adoption could become less pressing. Automotive steel demand is likely to remain relatively strong. The Morningstar industrials team estimates that 2015 U.S. light-vehicle demand will increase roughly 3% from 2014, to about 17 million units. Desirable new models, an aging fleet of vehicles on the road, readily available credit, and higher usage (as measured by average miles driven) should have a favorable impact on demand.
If so, AK Steel is the clear beneficiary--roughly more than half of its sales are derived from the automotive end market. This is particularly true given AK Steel's July 2014 acquisition of Severstal's Dearborn, Michigan, production facility, which is a large supplier for Midwest auto manufacturing operations. U.S. Steel would also benefit greatly from strong automotive steel demand.
Energy End Market Will Detract Significantly From Steel Consumption Growth
A source of significant flat-steel demand growth for most of 2014, the energy market has swiftly changed course and is now the least attractive end market for steelmakers. Plummeting oil prices have already caused a rapid reduction in the U.S. oil and gas rig count. Accordingly, we've witnessed the widespread cancellation or suspension of new drilling projects that would simply not be profitable in the depressed oil price environment. Natural gas prices are holding up slightly better than oil, but have still declined to just below $3.00 per mmBTU.
The Morningstar energy team anticipates that exploration and production companies are likely to reduce capital expenditure budgets by roughly 20%, with some companies slashing their spending upward of 50% and Canadian companies decreasing spending levels roughly 15%. With 10% of all U.S. steel shipments sold into the energy market, a 20% capital expenditure decrease in 2015 would, in isolation, translate to a roughly 2% decline to U.S. steel shipment volumes for the year. Even so, we anticipate that total U.S. steel shipment volumes will grow in the low single digits thanks to improving construction activity, increased automotive production, and healthy demand for industrial goods.
Strong Industrial Demand Partially Offset by Lower Demand for U.S. Exports
Industrial steel demand for the manufacture of machinery and equipment depends on broader economic growth and demand for U.S. exports, which is driven largely by the value of the U.S. dollar. The Chicago Fed National Activity Index reached +0.73 in November 2014, its highest level in years. The CFNAI is a weighted average of 85 indicators of national economic activity that are drawn from four categories: production and income, employment data, personal consumption, and sales/orders/inventories. A zero value for the index indicates that the national economy is expanding at its historical trend rate of growth. A value above zero indicates above-average growth. The strong November result was largely driven by a sizable increase in production and income.
The Institute for Supply Management's Purchasing Managers Index also sheds some light on the well-being of industrial steel demand. The December PMI came in at 55.5, which signals an expansionary environment, although it amounts to a material decrease from October and November readings, which were 59.0 and 58.7, respectively.
Even so, a stronger U.S. dollar will prohibit the potential upside for industrial steel demand in the U.S. by reducing the relative attractiveness of export goods. The U.S. dollar appreciated materially versus the currencies of its top four export markets (Canada, Mexico, China, and Japan) in 2014, with a large share of the gains coming in the final quarter. These four markets accounted for roughly 45% of the U.S. total export value in 2014.
U.S. Steelmaker Valuations Imply Expectations for No Recovery
Low oil prices are causing a rapid reduction in the U.S. rig count, and as E&P companies slash their capital expenditure budgets, we are likely to observe a material negative impact to shipment volumes for U.S. flat-rolled steel producers. In the near term, disappointing volumes will probably be accompanied by even lower prices than prevailing levels just shy of $520 per ton. In the face of these substantial near-term headwinds, the U.S. flat-rolled steelmakers under our coverage (AK Steel, Nucor, Steel Dynamics, and U.S. Steel) have endured steep sell-offs in recent months.
We think a modest rebound for steel prices, strong end-market demand (excluding energy), and a stabilization of the U.S. rig count will support earnings growth and share price appreciation in the coming years. We don't anticipate outperformance this quarter or next, as the operating environment could very well get worse before it gets better. Regardless, we are confident that current U.S. steelmaker valuations will look like a bargain two or three years from now, as overly pessimistic expectations now appear to be baked into share prices. The fact that U.S. Steel is now trading below its book value per share reflects the degree to which price-implied growth expectations have soured.
Nucor Is Our Top Pick in the Steelmaking Space
Nucor remains our top steelmaker pick. In a new environment of low iron ore and steel prices, vertical integration loses its strategic appeal, and we strongly prefer companies that enjoy low iron unit conversion costs.
Along these lines, Nucor taps into locally sourced, low-cost natural gas to establish favorable unit costs relative to its peers. Now trading at what we believe to be a very attractive entry point, Nucor is one of the few steel companies we cover that operates with an economic moat. The company's low-cost position and low financial leverage should allow it to successfully navigate a period of lower cash flows through 2015 before material earnings growth kicks in thereafter.
The ramp-up of Nucor's direct-reduced iron project over the course of 2015 will pave the way for materially improved long-term earnings potential, and we expect its timing to dovetail nicely with an improving operating environment in 2016 and beyond. In recent months, the economics of Nucor's DRI project have become even more favorable, as iron ore prices and natural gas prices have plummeted. This will allow Nucor to supply high-quality iron units to its steel mills at very favorable unit costs, improving upon its already-enviable positioning on the industry cost curve for steelmaking.
Andrew Lane does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.