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Avoid the Steel Trap

Fundamentals indicate trouble ahead for U.S. steelmakers.

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U.S. steelmaker stocks have rallied sharply after a painful 2015 and are now pricing in much better times ahead. Given the impact of skyrocketing steel prices, the perception of improved supply discipline in China, and protectionist trade cases, the consensus narrative now argues that the worst is over. We strongly disagree and see more pain ahead for U.S. steelmakers. Barring a significant improvement in demand, we are hard-pressed to buy into the thesis that elevated steel prices are sustainable. We contend that the peak has already been realized and that prices will move materially lower by the end of 2016. Based on our outlook, every U.S. steelmaker we cover is trading above fair value. In particular, we urge investors to avoid highly leveraged blast furnace operators, as their future cash flows are most sensitive to falling steel prices. We see the most considerable downside for  AK Steel (AKS),  U.S. Steel (X), and  ArcelorMittal (MT).

The year-to-date rally in U.S. steel prices is a direct result of three key factors: Trade cases have reduced import volumes, Chinese stimulus drove a steel demand shock, and the Chinese central government has advertised increased supply discipline. U.S. trade cases have had a clear impact on steel trade flows. In China, however, we expect stimulus effects to prove fleeting and promises of supply discipline to go unfulfilled. Rather than signaling a recovery after prices plummeted 35% in 2015, we argue that sharply higher steel prices represent a brief upcycle amid a prevailing downdraft. Additionally, steel demand both globally and in the United States remains soft, and we see no signs of a sustainable improvement.

U.S. Steel Prices Have Moved Well Above Marginal Cost of Production
We expect nominal prices for hot-rolled coil, or HRC, in the U.S. to decline sharply from current levels, ultimately settling near 2015 lows in a midcycle environment. Our below-consensus steel price forecast is the key driver of our bearish outlook for U.S. steelmakers.

To forecast steel prices, we employ a cost benchmarking approach that aims to estimate the steelmaking unit costs of the marginal producer of steel. Our annual steel price forecasts employ our price forecasts for iron ore, metallurgical coal, and ferrous scrap prices, each of which sits below current levels and general consensus.

Historically, U.S. HRC prices have closely tracked our estimated unit costs for the marginal producer of steel. The current $250 per metric ton spread between U.S. HRC prices and our estimate of marginal cost is far wider than any such spread we've witnessed in recent history. Bulls argue that recent countervailing and anti-dumping duties are a game changer, having altered the playing field in the favor of U.S. steelmakers. This would conceivably sustain U.S. steel prices at a steep premium to world export prices.

Bears argue that recent trade cases will ultimately have no impact whatsoever on U.S. steel prices over the long term and that they will fall all the way back to marginal cost. We side more closely with the bears, although we still believe that recent trade case outcomes will continue to support prices at a modest premium to marginal cost. Our base case for U.S. HRC prices assumes that they will reflect an ongoing $50 premium to our estimate of marginal cost, ultimately settling just below $400 per metric ton (nominal). Prices were this low just five months ago in February 2016. Forecasting that U.S. HRC prices will maintain a multiyear premium to marginal cost might appear aggressive, as we haven't observed any such premium in recent years. However, even though we assume a $50/mt premium in our base case through 2020, we still expect midcycle prices to decline over 30% (nominal) from current levels.

When U.S. steel prices move above marginal cost, rising import volumes have historically served as the primary catalyst that brings them back down to earth. The view that recent trade case actions will sustain U.S. steel prices well above marginal cost implicitly assumes that import volumes from targeted countries of export won't be fully replaced by import volumes from other countries. U.S. steelmakers would have you believe that they will be able to capture a large portion of the forgone market share stemming from trade sanctions. If so, this could sustain an elevated price premium to marginal cost. Instead, we contend that U.S. steelmakers will capture only a small portion of the forgone market share because other countries will competitively bid prices back down.

In recent weeks, U.S. HRC prices continued to move higher even though world export prices began to decline. By mid-July, they sat $260/mt above world export prices. Typically, U.S. HRC prices trade closer to a $100/mt premium. The last time U.S. HRC prices moved more than $200/mt above world export prices for an extended period (mid-2013 to late 2014), import volumes skyrocketed as purchasers took advantage of the price discrepancy by eschewing U.S.-produced steel in exchange for cheaper foreign material. This quickly drove U.S. steel prices lower as U.S. HRC prices subsequently endured one of the largest and steepest declines in history.

Along these lines, the effectiveness of trade cases in boxing out import volumes will be critical in determining the trajectory of steel prices in the U.S. Although trade sanctions have eliminated some of the largest exporters of hot-rolled coil, cold-rolled coil, and corrosion-resistant steel from the U.S. market, we expect rising imports from other countries to pick up the slack, driving U.S. steel prices lower.

Still in the Midst of a Long-Run Downdraft in Commodity Prices
Taking a more global perspective, we've witnessed a multidecade decline in broader metals and minerals prices. When we look at the World Bank Metals and Minerals Price Index (which is largely derived from prevailing copper, aluminum, and iron ore prices) since 1960, three investment boom periods are evident, with the China investment boom clearly the most impactful in terms of magnitude and duration. Although many argue that commodity prices have stabilized or are likely to rise, we see further downside for each of these commodities in addition to steel. Given ongoing weak global demand for steel, a lack of supply discipline in China, and our outlook for declining steelmaking raw material prices, we don't expect the recent steel price rally to stick.

China's Investment Boom Has Sustained Prices Above Long-Run Trend

Vertical Integration Determines Sensitivity to Falling Steel Prices

In a deflationary price environment for steel and steelmaking raw materials, the ownership of mining assets (whether iron ore or met coal) typically leads to margin contraction. For example, U.S. Steel mines all of its iron ore needs. This means that its iron ore unit costs remain relatively stagnant when steel prices and seaborne iron ore prices fluctuate. Therefore, for U.S. Steel, lower steel prices can have a dramatic downward impact on margins. In this same scenario, consider a coastal Chinese blast furnace operator that imports all of its iron ore needs via the seaborne market. For this business, the negative impact of a deflationary steel price environment would be partially offset by input cost relief in the form of cheaper raw materials.

Vertical integration for minimills, however, has a very different impact when steel and steelmaking prices decline. Even when a minimill operator owns scrap assets, as  Nucor (NUE),  Steel Dynamics (STLD), and  Commercial Metals (CMC) do, they still pay prevailing market prices for the scrap that they purchase and melt. Therefore, even though margins still tend to contract modestly when steel prices fall, much of the impact of lower steel prices is offset by the benefits of cheaper scrap, given that steel and scrap prices tend to move in the same direction. The difference between steel and scrap prices is far more stable through the business cycle than margins for a vertically integrated blast furnace operator.

For this reason, Nucor, Steel Dynamics, and Commercial Metals each remained profitable amid challenging market conditions in 2015. U.S. Steel, AK Steel, and ArcelorMittal, each of which is fully or partially self-sufficient in iron ore, reported losses. Given our outlook for sharply lower steel prices, we maintain a negative outlook for shares of these last three companies. However, even for the minimill operators we cover, we expect steel price declines to outpace declines in ferrous scrap, driving margin contraction between now and the next midcycle environment.

The 'China Problem' Isn't Going Away
The most pressing headwind facing the global steelmaking industry is the combination of weak global steel demand and massive steelmaking overcapacity in China. We are unlikely to boost our long-term outlook for steel prices and industrywide profitability unless this dynamic improves.

Although Chinese steel demand has been resilient so far this year as the central government has reopened its stimulus playbook, weak demand will persist in the long run. Therefore, the "China problem" can only be addressed via a supply-side response in the form of large-scale capacity cuts. The Chinese government has publicly laid out lofty targets for capacity cuts, but we think they are unlikely to be fully achieved and will ultimately have a very limited impact. As production levels remain elevated relative to the country's steel needs, we expect China's net exports of steel to rise further. This will cap upside for global steel prices and pressure margins for U.S. steelmakers even if trade cases divert large volumes of Chinese exports from landing directly on U.S. shores. Indeed, only a few months after a series of announcements from China that steel capacity would be cut aggressively, China's daily crude steel production soared to an all-time high in June. China produced 69.47 million metric tons of steel in June 2016, up 1.7% from June 2015.

To support GDP as China's economic growth model gradually shifts from an investment-led to a consumption-led model, the Chinese government has again turned to stimulus measures. But we view stimulus-led fixed-asset investment growth as unsustainable, as China's stimulus packages are driving lower returns with each iteration. This is in part because more and more stimulus proceeds are being used to service debt than to finance high-return investment projects.

China's stimulus measures since late 2015 have driven what we believe to be a speculative price bubble across various steel products. Chinese HRC prices rallied 80% from December 2015 to May 2016, while Chinese rebar prices rose 68%. We view China's stimulus as the critical reason that global steel prices moved well above the marginal cost of production. Over time, even if the Chinese government maintains its stimulus measures, they are likely to have diminishing returns on steel demand and future price shocks will be less likely.

Massive Chinese Overcapacity Remains
At the close of 2015, we estimated that China had roughly 300 million metric tons per year of excess steelmaking capacity in place. This represents nearly 30% of the country's 1.1 billion metric tons of total capacity. Put in perspective, China's excess capacity equates to nearly 4 times actual steel production in the U.S. in 2015. The resilience of loss-making capacity in China reflects the heavy involvement of local governments eager to support employment, GDP, and tax revenue rather than optimize profitability.

In early 2016, China's central government announced that the country would slash steelmaking capacity by 100-150 million metric tons between 2016 and 2020, eliminating as many as 400,000 jobs. More recently, the chairman of the National Development and Reform Commission said China would eliminate up to 45 million metric tons of steelmaking capacity in 2016, causing 180,000 steelmakers to lose their jobs and require relocation. Also, 280 million mtpy of coal capacity is slated to come off line, resulting in the elimination of 700,000 coal jobs. It's important to note that these targets specify only capacity cuts rather than production cuts. This means that, even if these targets are achieved, much of it would likely come from nonoperating capacity with only a portion of the cuts addressing currently operating capacity. Therefore, the impact on actual steel and coal production would be smaller than these headline figures would seem to imply.

Additionally, we're skeptical regarding follow-through. The central government’s plan to cut steelmaking capacity runs counter to the incentives of the local governments ultimately responsible for executing the plan. In recent years, similar government policies that targeted steel capacity cuts proved to be less than effective. The central government has attempted to encourage mill closures via more stringent environmental fines, but its efforts have been frequently stymied by the imposition of equal and opposite subsidies from local governments. Our skepticism about capacity cuts is also heightened by the fact that new capacity is still coming on line in many areas.

The challenges facing China's steel industry will only worsen if, as we expect, domestic steel consumption contracts by roughly 70 million metric tons over the next decade. Even if China were to cut 100 million mtpy of capacity by 2020 and add no new capacity, our forecast still leaves the country with more than 200 million metric tons of excess capacity. Even the full achievement of China's lofty capacity reduction targets won't resolve the key headwind facing the global steel industry.

Exports Remain Elevated and Consumption Still Overestimated
China became a net exporter of steel in 2006 and is now the largest global net exporter by a considerable margin. Since 2006, when China's net export position amounted to only 28 million metric tons of steel, the country's net steel exports have increased at an astonishing 13.9% annual rate to 101 million metric tons in 2015.

We anticipate further net export growth through 2025, albeit at a much slower rate. We forecast that China will reach 132 million metric tons by 2025, implying a 2.7% compound annual growth rate. This would mean that net exports' share of production in China will rise from just 13% in 2015 to 17% by 2025. In June, Chinese finished steel exports reached 10.9 million metric tons, a 23% increase from the same period last year. Our expectation that Chinese steel exports will remain elevated implies significant displacement of steel production in other countries.

Our outlook contrasts with the consensus view that production cuts in China will drive lower net exports. Instead, we argue that production levels won't necessarily track falling steel consumption. Although we expect China's steel consumption to decline roughly 7% between now and 2020, we expect production volumes to remain relatively stagnant, ultimately settling around 770 million mtpy.

After surging nearly fourfold from 2002 to 2013 on the back of a debt-fueled investment boom, China's steel demand is now normalizing. Steel consumption has already declined 8% from the 2013 peak of 765 million metric tons, having reached 704 million metric tons in 2015. Most have abandoned the once widely held view that China had many years to go before it would hit peak steel demand.

However, consensus continues to underestimate how far demand is likely to fall as China's construction boom goes bust. In contrast to many analysts who expect demand to stabilize around 700 million metric tons, we believe the worst is yet to come. We expect China's steel demand to fall to 650 million metric tons by 2020 and 630 million by 2025.

We expect weak fixed-asset investment to drive falling steel consumption, as the construction end market accounts for roughly 60% of China's steel demand. In turn, faltering construction activity will also weigh on machinery-related steel demand, which accounts for another 20% of the country's steel demand. Tailwinds from the smaller consumer-oriented automobile and appliance end markets won't be enough to offset headwinds in the larger construction market.

Impact of Protectionist Trade Cases Is Overstated
We expect the recent trade cases on hot-rolled coil, cold-rolled coil, and corrosion-resistant steel imports to provide modest benefits for U.S. steelmakers. In our view, U.S. steel companies will be successful in capturing some of market share forgone by targeted countries. This has allowed for higher shipment volume growth relative to levels observed in recent years. Regardless, we contend that the perceived impact of the trade cases has still been overstated. Although the three major trade cases filed in the summer of 2015 targeted key exporters of high-volume product types, we expect total imports to decline less than 10% in 2016. Phrased differently, shares of U.S. steelmakers have now priced in a significantly improved competitive landscape that we don’t expect them to realize.

A key assumption we make is that U.S. firms will capture only a relatively small portion of market share forgone by exporters targeted by recent trade cases. Instead, other steel-exporting countries will continue to step up in place of those that have been blocked out of the market by trade sanctions. There are simply too many countries that export steel to the U.S. for trade sanctions levied against just a few to justify current elevated prices. When a big player is boxed out of the market, a number of smaller exporters typically step in. Additionally, in some instances, trade sanctions inspire market entry for steel-exporting countries that didn't previously ship any material to the U.S.

We've also noticed that the enactment of any import duties stemming from countries targeted by trade cases tend to be perceived as a clear positive for the U.S. steel industry. However, in our view, the imposition of very small import duties can have no impact or even an adverse impact on volumes from a specific country.

U.S. Steel's Complaint Unlikely to Be a Game Changer
In May, the International Trade Commission announced that it would investigate a complaint filed by U.S. Steel that contends that 40 Chinese steelmakers conspired to fix prices, steal trade secrets, and circumvent trade duties by false labeling. The filing seeks the exclusion of all unfairly traded Chinese products from the U.S. market.

In our view, the complaint is unlikely to be a game changer for U.S. steelmakers. Trade case filings have already boxed out Chinese exports of many steel product types to the U.S. In June 2015, China exported 174,000 metric tons of steel to the U.S., accounting for just over 6% of total U.S. imports. In June 2016, preliminary license data indicates that Chinese steel exports to the U.S. had fallen to 55,000 metric tons, less than 2% of total U.S. imports. Based on this data, drawn steel wire, standard steel pipe, and stainless products accounted for a combined 59% of total import volumes from China in June. None of these product types, however, currently sits in the top five most imported steel product types by volume. This reflects the degree to which Chinese material has already been chased out of the U.S. steel market.

In early July, the ITC suspended the Section 337 petition, believing that it should instead by investigated by the U.S. Commerce Department. However, Shanghai-based Baosteel is also seeking to extend the timeline of the investigation in order to provide a more comprehensive defense against U.S. Steel's allegations. Therefore, it is unlikely that the proceedings will have any noticeable near-term impact on the steel market.

One outcome that could prove us wrong rests on the possibility that the Commerce Department determines that large swaths of steel exports from China are being labeled with false certificates of origin from other countries. Ultimately, the responsibility for assuring legitimate certificates of origin of imported goods lies with the importer. If Chinese exporters are proved to have been illegally routing material through other countries to the U.S., the Section 337 filing could materially reduce import volumes from countries other than China. Although such violations might be difficult to prove, this is an aspect of the investigation that could have a positive impact on the competitive positioning of U.S. steelmakers.

It would be short-sighted to consider the potential impact of recent trade cases without considering U.S. production volumes over a longer historical time horizon. Indeed, China's emergence as the world's dominant steel producer has driven the U.S. production share far lower. The U.S. global steel production share has declined from roughly 15% in 1980 to only 5% in 2015. Over the same period, U.S. steel production in absolute terms has been relatively flat.

It is fair to claim that elevated steel import volumes have weighed on U.S. production volumes over the past couple of years. However, it has been many years since U.S. steelmakers enjoyed an extended period of rising production volumes. Although China's emergence as a net steel exporter 10 years ago has had a clear negative impact on U.S. production volumes, the China story has been a double-edge sword. China's previous role as a massive net importer of steel was a key driver of a period of consistently rising U.S. production volumes during 1991-2000. Regardless, China was essentially a nonfactor when U.S. steel production peaked in 1973 at 137,000 metric tons. For perspective, U.S. steel production of 79,000 metric tons in 2015 accounted for only 58% of 1973 production levels.

Steel Market Fundamentals Remain Downright Ugly
Higher steel prices have not been accompanied by improving steel demand, and we see no evidence of meaningful supply discipline on a global scale. This brings the sustainability of the steel price rally into question.

Steel consumption per capita in the U.S. has been falling for decades. After oscillating around 450 kilograms per capita from roughly 1950 to 1975, it has steadily declined in recent decades as U.S. GDP has been driven increasingly by consumption-led growth rather than more steel-intensive fixed-asset investment-led growth.

2015, when steel prices decreased 35%, actually represented above-trend steel consumption, due primarily to strong demand from the automotive end market. Considering that aluminum and carbon fiber threaten to take at least some market share from steel in the auto arena, we view a material uptick in steel consumption as unlikely. We remain concerned about the prospects for rising steel demand from the U.S.’ two chief steel-consuming end markets, construction (42% of demand) and automotive (27% of demand).

Although nonresidential construction spending has steadily improved in recent years, growth has slowed considerably over the trailing 12 months. May nonresidential construction spending was up only 1.2% year on year, a substantial deceleration from a 9.7% compound average growth rate from May 2013 to May 2015. Our outlook for 4% nominal growth annually over the next decade trails the consensus view for high-single-digit nominal growth. Therefore, although we expect spending growth to rise in the coming years, we argue that overly optimistic expectations are likely priced into the valuations of U.S. steelmaker stocks.

The Architectural Billings Index provides a useful proxy for future nonresidential construction spending and, therefore, steel demand for construction applications. The ABI is a monthly survey for which readings above 50 indicate expansion and readings below 50 signal contraction regarding "work on the boards" architectural projects. Readings typically lead actual construction activity by 9-12 months. The ABI remained above 50 all but one month in 2015, and although we have observed growth in 2016, it has been very modest. In 2016, ABI readings have remained slightly above 50 each month since January, although we note a decline to 52.6 in June from 55.6 in the same period last year.

This instills concern that although near-term nonresidential construction spending growth should remain positive, it will probably remain sluggish in the coming months. Over a longer time horizon, ongoing low-single-digit nonresidential spending growth would prove not only far lower than consensus expectations imply but also lower than our own bearish outlook. This trend represents a clear downside risk to share prices for U.S. steelmakers with exposure to long product types.

Steel demand from the automotive end market has been a clear bright spot for overall U.S. steel consumption. North American car and light-truck production, which grew at a 1.4% compound annual rate over 1951-2015, has grown 12.4% annually since bottoming out in 2009 and 4.5% annually over the past three years. The Morningstar industrials team argues that the North American car and truck market is at or near a cyclical peak. We anticipate a 1.7% annual decline through 2020 from 2015 levels--a troubling proposition for steel demand, given its large consumption share in the U.S.

Steel demand from both the machinery and equipment (9% of U.S. steel demand) and energy (7%) end markets remains soft, largely due to the impact of ongoing low energy prices. Combined with construction and automotive, these four end markets account for 85% of U.S. steel demand, but none of them inspires optimism about the prospect of materially improved steel consumption in the coming years.

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