More Pain Ahead for U.S. Steelmakers
Even after their shares have traded down, we see little upside.
Although the shares of U.S. steelmakers have traded sharply lower in recent months, we see little upside and urge bargain hunters to seek greener pastures. In 2015, the group faced a perfect storm that included massive global overcapacity, weak demand, high import levels, low capacity utilization, and a deflationary price environment. For the most part, these headwinds remain and are likely to persist.
We maintain a cautious long-term outlook for the U.S. steelmakers we cover, a list that includes AK Steel (AKS), Commercial Metals (CMC), Nucor (NUE), Steel Dynamics (STLD), and U.S. Steel (X). None of these companies has an economic moat, in our opinion.
On an equal-weighted basis, the group is trading at an average 25% premium to our published fair value estimates. We highlight AK Steel and U.S. Steel, in particular, as stocks to avoid. For investors still seeking steel exposure, we view Commercial Metals and Nucor as the least unattractive options, as they are currently trading in 3-star territory and offer exposure to growing U.S. nonresidential construction activity.
The most pressing headwind facing the U.S. steelmaking industry is global overcapacity, largely driven by excess capacity in China. In an effort to ensure steel self-sufficiency, heavy Chinese investment fueled unprecedented steelmaking capacity growth over the past two decades. Now, however, with Chinese steel consumption having peaked in 2014, the country has emerged as a rapidly growing net exporter of steel. Chinese steel exports exceeded 100 million metric tons in 2015, increasing from only 29 million metric tons as recently as 2012. The country first moved into a net export position in 2006 after being a net importer for many years. We estimate that China currently has 300 million metric tons of overcapacity. This amounts to nearly 4 times the actual steel production in the United States in 2015, a staggering data point. We expect Chinese overcapacity to remain in place for many years to come, supporting continued growth in the country's steel export volumes.
On the demand front, U.S. steel consumption declined roughly 3% in 2015 from 2014 levels. Although this figure doesn't exactly jump off the page, it is concerning, given that we witnessed improving nonresidential construction activity and strong automotive demand during the year. Construction and automotive account for roughly 40% and 25%, respectively, of total U.S. steel demand. Lower consumption was driven by extremely weak demand from the energy, machinery, and equipment end markets. We expect weak demand to remain in place over the near term, and we are particularly cautious about faltering demand from the automotive end market, which is probably nearing cyclical peak production levels.
Steel demand was anemic not just in the U.S. but globally, too, with modest declines in 2015. The combination of overcapacity abroad and a strong U.S. dollar (which makes imports more attractive on a relative cost basis) sustained elevated import volumes, as imports took share from U.S. steelmakers. Accordingly, U.S. steel production fell to 79 million metric tons in 2015, an 11% decline from 2014, even though demand fell only 3%. Total import volumes fell 7% in 2015 after rising 36% the previous year. Imports currently account for 26% of total consumption, a notable decline from 34% in January 2015. We expect the U.S. import share of consumption to decline slightly further in 2016 because of stricter trade policies stemming from three major steel trade cases filed last summer.
We anticipate that elevated import volumes will continue to weigh on U.S. steelmaking capacity utilization. Utilization is currently 71%, in line with the 2015 average but far below the 85% that is typical in a midcycle operating environment. Although we expect utilization rates to rise very gradually with improving demand, it is unlikely that industrywide utilization rates in the U.S. will exceed 80% at any point in 2016.
With utilization rates remaining low, global oversupply reigning supreme, and falling unit costs shifting the global cost curve lower, a deflationary price environment for steel took hold in 2015. U.S. hot-rolled coil prices declined 35% over the course of the year, roughly in line with the decline of benchmark product prices in other key steel-consuming regions. U.S. hot-rolled coil prices bottomed out at $355 per short ton in early December but have since recovered to $400. Although prices might rally further in the very near term ahead of key trade case determinations, we see little additional upside. In a lower-for-longer price environment, we expect U.S. hot-rolled coil prices to hover around $450 per ton, in real terms, through 2020. Our forecast sits nearly 30% below the trailing five-year average of $630 per ton and on the low end of consensus expectations.
Although a number of trade cases have been filed in recent years amid elevated import volumes, they have done little to improve the operating environment for U.S. steelmakers. We are of the opinion that the potential impact of trade case filings is frequently overstated. Typically, reducing trade inflows from a particular country or group of countries causes import volumes to pick up from other countries in what we refer to as the whack-a-mole phenomenon. However, the potential for favorable outcomes from the three high-profile trade cases filed in mid-2015 (hot-rolled, cold-rolled, and corrosion-resistant steels) could provide a modest boost for U.S. steel prices given the product types and trade partners in question. U.S. hot-rolled coil prices typically trade at an average spread of $100 per ton above world export prices through the business cycle, as this spread accounts for storage and transportation costs. However, the potential for incremental protectionism stemming from the outcomes of these trade cases could support a wider spread, perhaps as high as $200 per ton if the rulings are favorable for the petitioners. In our view, this represents the only potential near-term upside catalyst for the U.S. steelmaking community. However, this development certainly wouldn't represent a panacea for the pressing challenges that would otherwise remain in place.
We see little upside across the U.S. steelmaking space. Under our base-case scenario, in which U.S. steelmakers get mild pricing relief from trade cases but other key headwinds remain, minimill operators Commercial Metals, Nucor, and Steel Dynamics should remain profitable and hold up best. In this case, we see considerable downside for AK Steel and U.S. Steel. Largely because of their very high financial leverage, we assign these two companies an Extreme fair value uncertainty rating. They also offer less attractive end-market exposure than their peers.
Andrew Lane does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.