***NOTES FROM 2010: New wave – the game starts to change

Things are looking up for the steel industry. But as mills emerge blinking from the dark days of recession, they face a different world.

Things are looking up for the steel industry. But as mills emerge blinking from the dark days of recession, they are facing a different world.

When the industry’s top execs met at the Hotel Okura in Tokyo for the World Steel Association’s (worldsteel’s) annual meeting, most were optimistic.

Based on worldsteel’s most recent projections, they had good reason.

In its short-term outlook, worldsteel revised its demand expectations upward, reporting that consumer demand had already started to exceed expectations.

“The rate of growth in our industry is above what we expected thanks to a faster recovery in the developed world and faster-than-expected recovery in India and emerging economies,” Techint Group ceo and vice chairman of worldsteel, Paolo Rocca, said.

“This suggests a steady and stable recovery, and our current forecast does not foresee a double-dip recession as feared by some,” Ternium ceo Daniel Novegil said.

Paolo Rocca and Daniel Novegil

But there is still good reason for steelmakers to be cautious; Worldsteel’s figures were not so overwhelmingly positive that the industry can completely exorcise concern.

The rate of Chinese growth is slowing — Beijing’s efforts to cool the real estate market are to blame. And, with an increased focus on capacity concentration, it is likely Chinese crude steel output growth will fall as well.

Absolute decoupling is unlikely, if not impossible. But China’s influence on the world steel market will become less critical.

This is the difficult truth that lies beneath worldsteel’s projections. Demand might be recovering, but it will have a very different face once it returns to normal.

“The road ahead will remain rocky,” ArcelorMittal chairman and ceo Lakshmi Mittal told AMM’s Steel Success Strategies Conference in New York, June.

“Even if demand reaches pre-crisis levels in 2010, it will have a very different geographical profile,” he said.

Lakshmi Mittal

This presents problems for established steelmakers.

“Steel demand in the developed economies will still be below the pre-crisis level in 2011,” Novegil said in Tokyo. “So far, the recovery has been mainly driven by the inventory cycle and government stimulus packages, whose effects are now fading out.”

“But whether consumer and corporate spending will now pick up and continue the recovery momentum is yet to be seen,” he added. “Recent economic indicators are sending mixed signs, and developments during the remaining part of this year and early next year must be watched carefully.”

It’s not just down to supply and demand – there are other problems as well. For example, the weak dollar has played havoc with international trade.

President of European steel industry lobby and ceo of Austrian steelmaker Voestalpine Wolfgang Eder believes that Europe’s steel industry will be in trouble if the euro rises above $1.45. It nearly got there in early November.

With demand at home still pretty low, Europe’s mills will find it hard to withstand another serious downturn.

Some would argue they are still gripped by the last.

BF No.3 at Nippon Steel’s Kimitsu steelworks

Home to 28 blast furnaces, including several of the world’s largest, Japan’s steel sector is under serious pressure as well.

The strength of the Yen doesn’t cause that much pain directly to steelmakers — the impact of appreciation on steel exports is offset by mills’ raw materials import costs. But their main customers in the manufacturing sector have been forced to shift their operations overseas.

Now mills like Nippon Steel and JFE Steel are being forced to follow and this isn’t easy.

“It’s very simple for the assembly business and automobile manufacturers to move their plants, but it’s hard for the steel industry to move facilities outside of Japan,” JFE Steel president and ceo Eiji Hayashida told MB.

“Companies are building new plants in the rest of Asia and other countries, so we will increase our exports to these transplants,” he said. “That’s the way we are running the business — the domestic market is shrinking. In order to cover that, we have to export more.”

So the problems associated with being more export dependent aren’t going to disappear quickly.

“The crisis [lies within] the world we will have to live for some time,” Alexei Mordashov, ceo of Russia’s largest producer Severstal, told delegates at Metal Bulletin’s Russian Steel Summit in Moscow.

Alexei Mordashov

Whether or not the apparent upturn in steel demand and economic indicators means the industry is really recovering remains to be seen. But it’s obvious that steelmakers in Western Europe, North America and other developed regions won’t be able to shift back to operating at pre-crisis levels on pre-crisis terms.

That’s the real “new normal” — competing on a cost per tonne basis is a competition that has no winners. At least not any more.

“Steel price volatility has been exactly in line with volatility in steel equities,” Renaissance Capital’s Rob Edwards said at the SSS conference in New York. “Uncertainty in steel pricing flows through relatively low valuations from the steel industry itself.”

Spiro Youakim of Lazard & Co is on the same page.

“Equity valuations have declined considerably from their highs at the start of the spring — most no longer reflect the fundamental values of the corresponding companies,” he said. “Companies with sustainable operating margins have been awarded higher multiples than their peers.”

“We feel this characteristic will remain a defining feature of our industry for some time to come,” he added.

In reality, there are some serious structural problems in the world of steel. This year, these issues have become worse.

“The overwhelming dynamic affecting the pace and level of our industry’s return to profitability today is the raw materials industry,” US Steel ceo and chairman John Surma said in June.

John Surma

In 2010 annually-agreed benchmark contracts for iron ore all but disappeared. The new era has heralded shorter contract terms, index-linked pricing and variations in the way deals are sealed from company to company.

Steelmakers aren’t happy about that.

“Chinese iron ore production hasn’t kept pace with steel production [which] has resulted in 2009 being a record year for iron ore imports,” Mittal said. “As a result, spot prices have rocketed and miners have taken the opportunity to move to quarterly prices.”

“This brings greater volatility and more speculation [and] it will therefore be more difficult for steelmakers to offer long-term prices to their customers,” he said.

It’s not just about sustainable pricing, steelmakers say. The concentration of the seaborne iron ore market — which boils down to just three main producers — means the steel industry isn’t equipped to negotiate pricing efficiently.

“Our industry is claiming progressively less of the value created by steel,” Surma said. “Steel is becoming a medium for mines to reap the value of our resources.”

“If we expect to provide raw materials suppliers with a reasonable market and steel-consuming sectors with a decent profit from using our product, we need to recapture our position in this value chain,” he added.

That will be hard. And, in the meantime, some steelmakers might be heading down a dangerous path.

Earlier this year, ThyssenKrupp said it planned to introduce a raw materials surcharge, shifting customers it previously offered annual or even longer-term contracts onto the new system.

ArcelorMittal and Salzgitter seemed certain to do the same. But the outcry from these key steel consumers was severe.

Consumer demand for manufactured goods still isn’t great, while investment in construction and infrastructure development, another key consumer of steel, is still far from the norm.

Mills can just pass on more volatile iron ore pricing but doing so undermines their position in the supply chain and, ultimately, could encourage the substitution of steel with other materials in some applications.

“I am concerned about the cost of steel,” JFE’s Hayashida told MB. “As a basic material, the advantage of steel is its strength, its formability, and also its cost.”

Eiji Hayashida

Substitution is bad news for the steel sector and bad news for the wider economy as well.

“Manufacturing is where wealth is created [and] it drives research,” Surma said. “Steel is essential to sustaining our global infrastructure.”
Investors are already favoring steelmaking companies with raw materials resources.

Private equity in particular is targeting companies that are looking to bring new mining capacity on stream.

But this isn’t a complete answer: just look at Russia.

Russia’s steelmaking sector is already highly consolidated. It’s dominated by a number of massive groups, including Evraz, which produced 15.28 million tonnes of crude steel in 2009.

Novolipetsk Steel (NLMK) produced 10.61 million tonnes, while Magnitogorsk Iron & Steel (MMK) and Mechel produced 9.61 million tonnes and 5.49 million tonnes respectively.

Pretty much all of them have significant raw materials assets and several are self-sufficient.

But their costs are rising. Even though the country has extensive oil and gas reserves, energy prices are climbing. Fast. Last year, Russian energy prices rose to European levels. They’ll keep rising next year.

Energy isn’t the only cost. Labour costs are on the up and inflation is a serious problem. And there are currency problems for Russian companies as well — even if the trade flow rebalances, 50% of Russian steel will still be exported.

As bulk steelmakers, Russian companies are among the best in the world. But bulk steelmaking is not the place to be. Quality, services and innovation are now much more important. And there is still a long way to go.

“It’s not just about convincing the people at the top, they are all onside already,” a leading industry consultant told MB. “Even when the decisions are made, they are often sabotaged lower down. “

“Changing the mindset is very difficult,” he added. “It might be impossible.”

That’s why MB launched the Stockholm Selection. Earlier this year, MB started case-studying the companies that have the right idea. They have been doing impressive things — not just because they make business sense when demand is low, but because they’ve had the foresight to invest ahead of the crisis.

“Good-to-great companies [have] a culture that says ‘prepare for the bad times during the good times, and prepare for the good times during the bad times,’ ” Dan DiMicco, Nucor ceo said.

Right on; and we’ve already published the first of the selection.

JFE Steel got it right by making savvy investments overseas when domestic demand started to fall. But there are others as well.

Stay tuned for more in the new year.