U.S. Steel and Aluminum Makers Would Gain From Commerce Proposals

On Feb. 16, the Department of Commerce released two lengthy reports providing recommendations resulting from its investigations related to Section 232 of the Trade Expansion Act of 1962. These suggest heavy tariffs or quotas on steel and aluminum imports to the United States. The recommended remedies were calculated to achieve an 80% capacity utilization rate for each industry. President Donald Trump now has 90 days to review the proposals and determine the appropriate course of action. Effectively, Trump has been provided a menu of options to address each industry, which includes a global quota, a global tariff, or individual tariffs on a subset of countries. All potential tariffs and quotas would be in addition to the plethora of antidumping and countervailing duties that are already in place.

If the Department of Commerce’s recommendations are enacted, they will be met with significant opposition. Within the U.S., companies that consume high volumes of steel and aluminum will continue to object, as their steel and aluminum input costs are likely to rise. Outside the U.S., countries that export large volumes of steel and aluminum to the U.S. will object that this unilateral action breaches international trade obligations as established under the World Trade Organization. A series of appeals to the WTO would probably follow. Many argue that this aggressive action might spur an all-out trade war, as targeted countries might retaliate with trade sanctions of their own on U.S. export products. Given that the recommendations have been made under the guise of protecting U.S. national security (the nature of a Section 232 investigation), widely believed to be a loophole that facilitates protectionism, U.S. trade partners are likely to cry foul. Regardless, we think it’s highly likely that Trump will follow through on some form of these recommendations.

For steel imports, the Department of Commerce suggests a global quota of 63% of 2017 import volumes on a go-forward basis, limiting imports to 22.7 million metric tons. Alternatively, it recommends a 24% import tariff on all steel imports. The third option includes targeted, country-specific tariffs of 53% for Brazil, South Korea, Russia, Turkey, India, Vietnam, China, Thailand, South Africa, Egypt, Malaysia, and Costa Rica.

For aluminum imports, the Department of Commerce suggests a global quota of 86.7% of 2017 import volumes on a go-forward basis, limiting imports to 4.4 million metric tons. Alternatively, it recommends a 7.7% import tariff on aluminum imports. The third option includes targeted, country-specific tariffs of 23.6% for China, Hong Kong, Russia, Venezuela, and Vietnam.

The targeted solutions for either industry would still limit imports from all other countries to 100% of their 2017 import levels going forward--that is, no incremental volumes. Both reports leave room for exemptions for certain countries and exclusions for certain product types. Ultimately, any final version could include a combination of the various recommended measures.

Although it’s difficult to handicap the most likely outcome, we expect the Trump administration to enact tariffs targeting specific countries for both steel and aluminum imports. The potential target countries listed above are for the most part countries with which the U.S. already has icy trade relationships. This approach would rankle fewer trade partners and reduce the risk of widespread retaliation on the trade front versus the potential fallout from blanket tariffs or quotas.

For the steel and aluminum companies we cover, the impact of increased protectionism in the form of tariffs would expand the spread between U.S. metal prices and world export prices. Additionally, forgone import volumes would be replaced by higher volumes from U.S. producers. Accordingly, margin expansion would be supported by two main factors. First, metals margins would probably expand, with average selling prices rising more than raw material prices. Second, given the high capital intensity and fixed costs inherent to the steel and aluminum industries, higher capacity utilization would drive the benefits of operating leverage as production volumes rise.

The magnitudes of our fair value estimate adjustments are largely a function of the varying degrees of operating leverage, financial leverage, and raw material self-sufficiency for the U.S. steelmakers we cover. Our fair value estimates for

Assuming the targeted tariff program is enacted, we now expect U.S. steel prices to sustain a wider spread above world export prices. Our midcycle U.S. hot-rolled coil price forecast rises to $460 per short ton from $420, while our midcycle U.S. rebar price forecast rises to $500 per short ton from $430 (both above marginal cost).

Additionally, we’ve increased our shipment volume forecasts (to varying degrees) for each of these companies, as they will be able to capture market share forgone by targeted countries. This combination of factors, along with the benefits of operating leverage as capacity utilization rises, would boost industry margins above our prior forecasts.

Although the Section 232 investigation has long been discussed, we did not anticipate that the resulting recommendations would be as punitive as those announced by the Department of Commerce. First, even though steel import volumes remain well above historical levels, accounting for roughly 30% of U.S. steel consumption in 2017, U.S. steelmakers have for the most part delivered impressive profits over the past couple of years. Indeed, thanks to healthy demand and elevated prices, lower-cost U.S. steelmakers are now profiting at near-record levels.

Second, we expected that significant opposition to the Section 232 investigation from major steel-consuming industries would short-circuit the Trump administration’s desire for heavy sanctions. The recommended tariffs or import quotas are likely to drive steel prices still higher, weighing on the profitability of downstream buyers, which represent a much larger portion of the U.S. economy than the steelmakers themselves.

Finally, we viewed the potential risk of igniting an all-out trade war as yet another factor that might throw a wet blanket over the potential for highly punitive sanctions.

Regardless, the Department of Commerce willingly dismissed these considerations and laid out an aggressive menu of options from which the president will choose. Trump’s record of executive orders indicates that he won’t shy away from pursuing one of the suggested courses of action. If so, the potential implications of a disruption to U.S. economic growth and retaliation from U.S. trade partners are unclear.

What is crystal clear, however, is that this development is a major boon for U.S. steelmakers. We maintain a bearish outlook for global steel prices as a result of our below-consensus outlook for Chinese fixed-asset investment and our expectation that structural overcapacity will persist on a global scale. However, the proposed protection will help insulate the U.S. steel industry from a global downdraft over the medium term and likely drive heady profits even higher in the near term.

We also raised our fair value estimate for aluminum company

Much as with the steelmakers, assuming the targeted tariff program is enacted, we expect Alcoa to realize a modest boost to average selling prices, as the proposed tariffs will sustain prices above marginal cost for U.S. volumes. Additionally, we’ve increased our shipment volume forecasts, as Alcoa’s production volumes in the U.S. will be able to capture market share forgone by targeted countries. This combination of factors, along with the benefits of operating leverage as capacity utilization rises, would boost margins above our prior forecasts.

However, the Department of Commerce’s recommendations won’t ultimately prove transformational for Alcoa. First, the recommended tariff magnitude is relatively modest at 7.7% (for the blanket tariff solution). Historically, tariffs below the 10% threshold have had a limited impact on import volumes from the countries to which they are assigned. Second, Alcoa’s U.S. aluminum production contributes a small portion of companywide profits, particularly now that management has shut down a significant portion of the company’s asset base in the U.S.

Even at our updated fair value estimate, we still view Alcoa’s shares as overvalued. Over the long run, we expect decelerating fixed-asset investment growth in China and persistent global overcapacity to drive lower profits for the company.