A new era for steel drivers, implications and risks

Colin Hamilton*

Published by Maney Publishing (c) IOM Communications Ltd

In the not too distant past, steel producers would have been happy to receive around $250 for a tonne of hot rolled coil. Now, with prices having peaked around four times this level, it is obvious that the entire cost make-up of the steel industry has undergone a signicant structural shift. This paper will examine the fundamental reasons behind the steel price surge, together with implications, opportunities and risks for the steel industry going forward.

What has happened to steel prices?

As recently as 2001, we saw numerous high-prole steel companies le for bankruptcy amid poor market fundamentals and failed restructuring. Steel, as with most heavy industries, was not seen as an attractive business to be in and investment dried up. Yet, only seven years on, and despite the current economic climate, 2008 invested capital and earnings levels were at record highs. Indeed, Lakshmi Mittal recently epitomised the underlying industry feeling in declaring We have succeeded in transforming ourselves into a protable and sustainable industry.1 It is important to understand the changes which have fuelled this revolution and how these will continue to shape the industry going forward, starting with steel prices. Figure 1 shows the CRU steel price index (CRUspi, a weighted average of steel prices in Europe, Asia and North America) from 2000 to September 2008.2 There are various succinct factors contributing to this systematic shift.

such sustained strong growth. Demand levels have soared in the 20022007 period, as witnessed by Fig. 2, with crude steel production growth rates topping 5% every year as the supply side strives to respond to this explosion.3 Table 1 breaks this growth down on a regional basis, and it is easy to see where the key demand centres have been.4 China, with its huge, upwardly mobile population has witnessed vast development perpetuated by mass urbanisation, as workers from the inland provinces move to the eastern cities in order to nd better-paid employment. This has led to rapid demand from the infrastructure and residential sectors, in order to provide both housing and

transport for the rising population and also to service a growing middle class, who desire steel-intensive luxury items such as cars and washing machines. Although the year-on-year rate of Chinese demand has slowed to 3% through 2008, this is now from a huge base resulting in an extra 150 million tonnes of steel production per anrum since 2005.5 Whilst China accounts for by far the majority of steel production growth (70%) in recent times, it is by no means alone. Other rapidly developing nations, such as Brazil and Russia, have also demonstrated considerable growth as they climb the infrastructure hump evident as GDP/capita rises from a low base. Furthermore, India, with its one

1 The evolution of steel prices 20002008

The boom in demand

To start with, the prime driver for the steel industry has never witnessed
*Senior Steel Consultant, Steelmaking and Raw Materials, CRU Analysis, London email colin.hamilton@crugroup.com

2 Demand for at steel products 20022007

2009 Institute of Materials, Minerals and Mining Published by Maney on behalf of the Institute DOI 10.1179/174328109X439261

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billion plus population, has yet to push on with steel-intensive development. When this takes place, a second wave of demand will be signalled necessitating further investment in steel production. Together, it is the demands of these rapidly developing nations which has started to help luffer the steel industry against the full impact of Western economic cycles.

The raw material price storm

Demand for steel has of course ltered upstream into greater requirement for raw materials, with markets for iron ore, metallurgical coal and ferrous scrap under pressure like never before. In terms of iron ore, the average annual growth rate in seaborne trade from 19762002 was 2.4%.6 In the period 20022007, this soared to 10.8% average annual growth. With Chinas steel production surge, its demand could no longer be met by domestic mine output. Furthermore, the iron content of Chinese ores has been continually falling making their extraction and use ever more costly. As a result, imports of iron ore into Chinese ports have surged with Chinese mills now negotiating the annual contract price with Brazilian and Australian suppliers. In turn, the iron ore majors have used their dominant, consolidated position to push through six consecutive years of price increases. These rises relate not only to the global iron ore shortage, but are also underpinned by drastic increases in mining capital costs, necessitating high prices in order to guarantee investments. Metallurgical coal and coke seaborne demand has also risen sharply in order to meet increased blast furnace production, though to a lesser extent than iron ore due to Chinas relative self-sufciency and increased use of pulverised coal injection. Indeed, after doubling in 2005, metallurgical coal contract rates actually fell in the 2006
Table 1 Regional year-on-year 20022008, % Asia, Africa, Middle East 2002 2003 2004 2005 2006 2007 2008(est) 20022008(est) 22 2 2 3 3 4 3 19

3 Index of steelmaking raw material prices 20022008

and 2007 contract negotiations. However, through 2007 the market tightness became evident through a soaring spot price, not helped by infrastructural constraints at the Australian coal ports. The situation was further exacerbated by mine ooding in Queensland, which effectively removed 810Mt of potential supply from the market. The result was a hard metallurgical coal benchmark price of $300/t in 2008, compared to $47/t in 2003.7 Furthermore, recent years have seen China emerge as a net importer of coking coal, and the Chinese domestic price has risen to, in effect, match the international price, which will bolster contract talks going forward. The rapid rises in seaborne trade of ore and coal, plus other commodities such as grain, has seen huge pressure applied to the dry bulk freight market. Port delays have risen, and timecharter rates hit new peaks in 2008. This has added further to the raw material price surge for integrated producers, as most purchases of coal and ore are made on a free on board basis, with the customer bearing the freight cost. The rapid rise in steel production has also had a profound effect on the ferrous scrap market. Until recently, the electric arc furnace share of steel production was rising, as scrap was plentiful and capital costs not

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prohibitive. However, although the majority of additional Chinese production is via basic oxygen furnaces, in other fast-growing regions such as the Middle East and South East Asia the smaller-scale electric arc furnace route still rules. Pressure on the scrap market rst became evident in 2004, with a 5075% year-on-year change in benchmark prices over 2003.8 Added to that, Russia and Ukrainian scrap supply started to slow as more and more was utilised in domestic production. With the current steel production surge likely to take 825 years to come back as scrap material, fundamentals in this market will be tight for the short-medium term, as reected in current prices. Figure 3 shows an indexed summary of key steelmaking raw material prices over the period 20022008.9

At long last, a corporate approach

Another signicant change in the steel industry from the start of the decade is the adoption of a corporate mindset. This has been a crucial step in the endeavour to ensure a sustainable future for the sector, in terms of attracting investment and managing growth correctly. Production targets and sales targets are no longer the staple key indicators of company performance; moreover, production facilities are now more attuned to the market than ever. Gone is the era of produce, produce, produce with the market situation as an afterthought. Corporate decisions are now made on the basis of how much shareholder value they will add, and how they will affect the EBITDA margin. A prime example is the late 2008 utilisation rate cuts, where all steel

changes in crude steel production growth South America 2 8 3 3 3 2 4 26 North America 22 2 2 2 2 1 1 9

China 18 16 15 25 22 17 9 161

CIS 0 13 4 21 1 4 3 26

Europe 22 1 0 1 0 2 1 6

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majors rapidly reacted to plummeting demand by taking production ofine in an attempt to balance the market. This has had wide-ranging implications, most notably in terms of industry consolidation. With the steel industry suddenly cash-rich, this has fuelled a raft of merger and acquisition activity as companies seek to create corporate value. The Chinese sector has lagged behind in this eld to some respect, but with the emergence of the Hebei Steel Group of companies in early 2008 it seems as though the last bastion is falling. These larger groups have much greater ability to react to the market in a proactive way without causing such dramatic price shocks as seen historically. For example, a company operating fty blast furnaces nds it easier to link production levels to market demand than one operating a single furnace. Overall, this should have the effect of reducing price volatility in the long term, allowing sustainable growth in the steel sector rather than cycles of boom and bust.

What does the future hold?

Having considered the events currently driving the steel industry, it is important to assess the effects they have brought about and the potential long-term implications. While the future remains unclear, particularly given the uncertain nancial climate, one thing is for certain; the steel industry of the future will be a fundamentally different entity to that of the past. The sector is continuing to experience a rapid and dramatic revolution in terms of its structure and signicance.

underpinned by a high mining cost for both the hard, prevalent taconite ore and metallurgical coal.10 However, the steel companies in the main chose not to divest these assets and as a direct result are reaping the rewards now when international prices for these materials are well above historical norms, albeit tempered to a certain extent by the rapid increases in mining capital costs. These mills have stolen a competitive march on their Asian and European counterparts and moved well down the industry cost curve. However, the risk prevails that as both international contract benchmarks and freight rates fall in 2009 then the competitive advantage is lost. A similar situation exists for scrapbased mini-mills, whereby any country with a scrap surplus it at competitive advantage. The global scrap market price is governed by the key import regions of Turkey and South East Asia, and any domestic prices are is essence a function of the freight rates to these points. This again has benetted North American producers, whose domestic price is dampened by the vast oceans between their countries and the key import regions, and overcomes any labour and supply cost disadvantages faced.

The new era of steel pricing

In light of the vastly increased prices paid for raw materials and energy products, and the growing philosophy of margin protection, it seems certain that we are entering into a new era of sustained, higher steel prices. Indeed, even with the dramatic fall in demand resulting from the glotal ecomimic crisis, most steel products have fallen to only 2006 or 2007 levels at the trough of the price cycle. Furthermore, despite ongoing worries over the global economic environment and lack of available funds from lenders, the rapid demand growth of developing countries points to a strong future for steel. Furthermore, although the tight fundamentals present in raw material and freight markets have eased in the medium term, energy cost pressures will underpin prices going forward such that they will never return to levels seen in the early 2000s. The application of value-based management techniques to the steel sector also bodes well for steel prices, in that the importance of the value chain itself has now been recognised. As with any chain, it is only as strong as its weakest link. Companies now strive

to ensure each process within that chain makes enough money for it to survive in a downturn, abetted by upstream integration to control the process ow. Provided there are no signicant changes to trade ows and corporate approach, and the industry ensures transparency of the value chain, margins over raw materials and therefore prices should be maintained at historically high levels for the foreseeable future. Any industry which makes money, particularly in a sustainable fashion, is always going to attract the interest of the nancial sector. In minor metals such as cobalt and vanadium, nancial speculation has driven prices to never seen levels of both price and price volatility. So far, the steel industry has been generally immune from such inltration and price manipulation. The new fashion for steel futures contracts may change this, a move that is both a risk and opportunity for the steel industry. These contracts offer producers and end users another tool to manage their price risk, however producers worry that the nancial trading involved could undermine the work they have carried out to reduce market volatility. Whatever the outcome, these contracts are here to stay and will become a key market indicator going forward.

The potential coke crisis

One section of the value chain that presents a huge upside price risk to steel manufacturers going forward is the supply of merchant coke. With the historical closure of many domestic metallurgical coal mines due to cost and environmental pressures, many producers have ended up coke short when trying to respond to high levels of demand. While nowhere near as large as the seaborne market for coal or iron ore, the trade in merchant coke has been growing, reaching 35.7 Mt in 2007.11 Moreover, this market has become overreliant on a ow of coke out of China, where recent year-on-year growth rates in coke production have been in the 1520% range.12 There are several factors inuencing Chinese coke supply to the merchant market. Firstly, as an energy product, export levels are capped by the Chinese government. Furthermore, in light of booming domestic demand, an export tax has been applied to metallurgical coke. This has increased from 5% to 40% over the 20072008 period.13 Coke production costs in

Those that have and those that have not

Given the inuence of raw materials on costs of production in 2008, it is unsurprising to nd that steel producers with captive raw material sources are faring much better in terms of production costs (and hence margins) than those reliant on imports. This situation has partially been driven by high freight rates, but more so by the increased gap between mining costs and international market price. Although this gap will likely decrease through 2009, those with upstream assets still nd themselves in a strong position. A prime example of this is North American integrated facilities, who until recently, were among the highest cost producers globally. This high cost was

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material supply at a distinct advantage. There are also risks and opportunities for the steel industry going forward, with the trend towards steel futures, continued demand from developing countries and a future shortage of key raw material inputs, factors which are at the forefront of current strategic planning.

References
1. L. N. Mittal, Keynote presentation, Proc. Steel Success Strategies XIII conf. New York, 2008. 2. CRU Steel Price Index, September 2008. 3. World steel in figures 2008, International Iron & Steel Institute, 2008. 4. Crude steel statistics, International Iron & Steel Institute, 2008. 5. Crude Steel Quarterly, CRU Analysis, February 2009. 6. H. OMalley: Current condition and future outlook for the steel market, Proc. 3rd Annual Iron Ore Insights Conf., October 2008. 7. Coal Manual, The TEX report, 2008 8. The Metallics Market Service, CRU Analysis, 2008. 9. C. Baker: Outlook for raw materials where next for iron ore, coal and scrap?, Proc.11th Central and Eastern European Steel Conf., 2008. 10. J. J. Poveromo: Outlook for blast furnace ironmaking, India Coke Summit, 2007. 11. Global Trade Information Services 12. The outlook for metallurgical coke, CRU Analysis, 2008. 13. National Bureau of Statistics for China.

4 Chinese coke production and realisation costs, export basis

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China have also soared, as demonstrated by Fig. 4, as the price of domestic coking coal soared in 2008.12 Tight market fundamentals have resulted in these costs being passed directly onto the customer, whether domestic or abroad. While for several years the steel industry has coped with the necessity of trade from China without substantial effect on the cost structure, given the price surge in 2008 both for coal and coke and future cutbacks in Chinese export volumes, there is now the likelihood of signicant pressure on the merchant market. Coke buyers must now seek alternative supplies (who tend to match the Chinese export price), pay the increased costs or constrain hot metal production. All options suggest higher production costs in the blast furnace, and given that coke battery expansions are expensive and slow to progress due to the strict environmental regulations, this situation is likely to persist in the medium term. While the steel

production slump of 20082009 has dampend merchant coke demand and the need for battery expansions, the resulting lack of investment may indeed exacerlate the situation in stronger demand condition.

Conclusions
From this analysis, it is evident that the recent evolution of the steel industry has been founded on a unique set of circumstances. Raw material price hikes, shareholder inuence, booming demand, capital investment needs and value chain transparency have all contributed to a new growth era for steel, different to any seen previously. While the current economic crisis and resultant fall in steel demand is hitting the sector trend, fundamentally the industry is in better shape to manage economic cycles than in the past. As with any period of dynamic change, there have been winners and losers, with those having captive raw

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