Moscow, Russia
February 19, 2008
Presented by: David Phelps, President, American Institute for International Steel
THE US STEEL MARKET IN 2008
I want to thank the Adam Smith Institute for the opportunity to speak to this important conference today about the US steel market. I am proud to represent the members of the American Institute for International Steel. AIIS is the only US-based steel trade association that promotes real free trade in steel – something Adam Smith himself I am sure would approve of. AIIS represents North American steel importers and exporters, distributors, processors, port authorities, stevedoring firms, customs brokers, freight forwarders, ocean carriers, railroads, trucking firms and one steel producer and a bank. In short, everyone in the steel supply chain in our market.
CLOUDS DARKEN THE MACRO OUTLOOK
Unsettled financial markets in the United States cast a great deal of uncertainty over the course the economy will take in 2008. Problems in the housing market have spread to the banking and other financial sectors. Loans are harder to get, business expansion has slowed and there is less talk of mergers and acquisitions. Interestingly at the same time last year we were having the same discussion and for the same reasons. While the general economy rebounded from a weak first quarter in the second and third quarters, the steel market stumbled along in inventory reduction mode for the entire year.
In the US, consumer spending accounts for 70% of GDP and has already been negatively affected by shrinking home values, reduced access to loans and accelerating inflation. It remains to be seen whether the US government’s bail-out measures for the housing market will be adequate to restore some degree of normalcy.
GDP in 2007 fluctuated wildly -- 0.6% growth in the first quarter, 3.8% growth in the second quarter, 4.9% growth in the third quarter, and 0.6% in the fourth quarter. During 2007, unemployment also remained low, 4.6-4.7% for most of the year, until it jumped to 5% at the end of the year. These levels of unemployment are historically low. Job creation remained robust throughout the year until the end. The consensus for GDP growth in 2008 is around 2%, but of course, predictions this early in the year are notoriously inaccurate.
2007 for manufacturing followed a record year in 2006, with output reaching new highs, profitability at record levels and spurred by high growth rates in productivity. Employment in manufacturing continued its long term downward trend due to the improvements in productivity. In the US, we hear a lot from the protectionists about the end of manufacturing in the US, but the data simply tell another story, although 2008 is likely to be more of a challenge than either 2006 or 2007.
Nevertheless, the US economy has been in tight situations before and always proved to be sufficiently flexible and resourceful to work its way out eventually.
All along and so far in 2008, US steel producers have maintained that the economy is doing alright and steel demand is good -- one of the reasons they advance to justify the unusually large price increases they have announced in the last few months. They also point to the sharp rise in the cost of steelmaking inputs such as iron ore, coke, ferroalloys, etc. So far, the market is accepting the higher prices because inventories are depleted and consumers have little choice in the short run. Some mills have placed consumers on allocation too. As I’ll discuss in a moment, the price increases announced by US producers for the first quarter of this year are truly impressive if not frightening.
SUPPLY SIDE CONSIDERATIONS
The steel producers’ pricing actions have been encouraged by developments occurring inside and outside the US economy. Within the US, service centers and steel users need to rebuild inventories to the levels geared to the normal long-term GDP growth rate of 3.0-3.3% per annum. But what if in the current year the economy should continue to limp along at the 0.6% annual rate to which it slowed in the fourth quarter of last year? In that case, service centers and steel users will not see a need to replenish inventories to that of previous years when, according to Table 1, actual steel consumption hovered around 115Mt (million metric tonnes). Should macroeconomic headwinds turn out as strong as some economists predict, inventory adjustment will feed less tonnage to the domestic mills than they expect.
Foremost among the external factors the industry expects to strengthen demand for its products is reduced competition from imported steel. The causes are the declining international value of the dollar as well as rapid economic expansion and rising or higher steel prices abroad. Sharply rising ocean freight rates also boosted the landed prices of imports last year and by the end of the year, made importing steel into the US a real challenge. Steel imports from China in particular have fallen, probably as a consequence of higher Chinese export taxes, trade cases filed by US steel producers, freight rates, US Government pressure on the Chinese Government, and a fierce anti-China lobbying campaign financed by US steel producer associations and of course, the unions.
Reduced import competition not only means more shipments by US steelmakers. It also explains the ease with which the dominant US steelmakers have managed to raise home-market prices. Given their high degree of concentration —three firms controlling over 70% of output in most product lines—they have learned to match their combined sales volume to fluctuating demand, thereby stabilizing prices and profit margins even in an unsteady environment. [The presence of importers, who do not play by the same oligopolistic rules, detract from this objective.] But in the US market, imports are needed to keep our factories operating; the US industry simply cannot make enough steel to satisfy domestic demand. Therefore, there will come a point where US consumers will have to purchase imports, possibly at higher prices than domestic, or domestic industry prices will rise sufficiently to encourage imports again to fill the gap.
WILL US STEEL DEMAND PROVE SUSTAINABLE?
Following this brief overview of the principal forces acting on the supply side of the US steel market, let me now focus on the demand side. US steel producers generally harbor a more optimistic view of the future than many steel users. Producers have good reasons in early 2008 to be optimistic. Prices are rising, order books filling and some producers are moving to allocation for some products.
First, demand for US-made steel in Canada and Mexico has remained strong. Steel consumers in Mexico and Canada include many American transplant manufacturers operating in Canada and Mexico or their parts suppliers. Therefore they prefer to use steel of standardized grade and quality made for their US operations. This explains why more than 85% of US steel exports are destined for our NAFTA partners in Mexico and Canada. And exports have been strong to these markets.
The US is running a positive trade balance with both Canada and Mexico in terms of finished steel mill products. Steel trade with these countries therefore does not help to narrow the US steel market’s 30-35Mt supply gap. In fact, if NAFTA were viewed as a single country, its combined steel trade balance with the rest of the world would register an even larger supply deficit than the US by itself.
The American Iron and Steel Institute (AISI) publishes data on “shipments by market classification.” Unfortunately, these data have their limits because they leave unidentified the final users of over half of all US shipments – such as shipments to distributors, processors, and “non-classified” buyers.
The Durable Goods Sector
By the end of 2007, transportation equipment, excluding aircraft, was the largest steel-using activity in this sector. It experienced a 3.3% contraction of shipments during 2007 and a 4.2% reduction in new orders. These numbers reflect data showing a drop in car and light truck sales from 16.5 million units in 2006 to around 16.0 million in 2007. We estimate a further decline to 15.0 million units in 2008.
“Machinery,” ranking next in expenditures, enjoyed a very slight increase in both shipments and new orders. The same was true for “Fabricated Metal Products,” while “Electrical Equipment, Appliances, and Components” saw a sizable 6.1% increase in shipments and a 3.6% increase in new orders.
Shipments by the entire manufacturing sector, which includes the above-mentioned activities, rose by 1.9% last year and its new orders by 1.7%. These numbers do not support the often-heard contention that US manufacturing is in free fall as a result of unfair foreign trade practices and massive outsourcing of manufacturing jobs to low-wage countries. Instead, they are evidence that US manufacturing exports are sufficiently robust to overcome or at least ameliorate a sharp drop in domestic demand.
Nonresidential Construction (Private and Public)
Despite efforts to promote the building of steel residences in the US, it is non-residential investment that accounts for most of the steel used in construction. The nonresidential sector includes expenditures on hotels, schools, energy (or power) plants, pipelines, manufacturing facilities and infrastructure renewal investments.
Infrastructure upkeep and expansion--expenditures on “transportation,” “highway and street,” “sewage and waste disposal,” and “water supply”--topped the expenditure list and for the most part still did well by year’s end. Investment in such facilities has generally suffered from neglect in the United States. As a result of highly publicized collapsing bridges and accidents caused by poorly maintained roads, political pressure for larger investments has increased. Should there be increased federal government expenditures it would be welcome news for US steelmakers. In most instances they would be beneficiaries of the “Buy American” clause, which essentially rules out the use of foreign-made steel for public projects.
Expenditures on educational facilities, the second largest category, grew at a rapid 17% annual rate. They sustained this rate throughout the year and can be expected to continue throughout 2008.
The third largest (mostly private) category was a combination of “office” and “lodging.” Lodging-- hotels and motels--was the smaller of the two but had the largest growth rate in this sector, 67%. As regards offices and hotels, given their high current occupancy rates, construction is likely to continue robust through much of 2008 although by year’s end a general economic slowdown would leave a negative mark on these activities as well.
“Commercial” construction, next in absolute expenditures, registered a growth rate of slightly under 10% in 2007. There is a chance that this rate will slow down because the sharp drop in new home construction will eventually lead to delays in the building or completion of shopping centers, movie theaters, and the like.
Spending on energy-related construction not only grew at the second-highest rate in the list, its growth accelerated toward the end of the year. That leads us to foresee continued expansion through 2008. The industry comprises a wide range of activities, including drilling for oil and natural gas, the construction of additional pipelines for their transportation, and new developments like ethanol production, storage and distribution, wind turbines and other oil-substitution technologies, all of which will boost the demand for steel. Pipeline construction is the strongest of the category as some pipe and tube used for drilling is reportedly soft at this time due to high levels of inventory, especially the lower end OCTG products.
Spending on manufacturing construction was more moderate in size, with a growth rate slightly above 10%. Because its growth accelerated toward the end of the year, we infer that it will continue well into 2008.
During the short term, probably until August or September this year, the US economy probably carries enough momentum to sustain the pace of these activities. Current conditions for the domestic industry certainly support the positive view, at least for the short to medium term. We harbor some concern, however, that toward the end of the year the continuing financial turmoil and weaker consumer spending will act as disincentives to commercial investment in manufacturing and construction. The likely result would be a pronounced weakness of steel consumption during the final quarter of 2008 that may carry over into the first quarter or even the first half of 2009.
PRICE INCREASES
Although some steel producers have recently admitted that markets might be a little on the soft side, they plan to go ahead with their announced monthly price increases. Their chief objective, as they also admit, is to maintain their profit margins. They have not expressed concern whether this might squeeze the margins of steel users to the point of putting their viability at risk. Because imported steel has likewise seen steep price increases, it no longer represents a realistic alternative source to many US steel users, at least at this time. In fact, prices in some foreign markets are now sufficiently high that US producers, instead of stabilizing their margins via output reductions, have instead exported the surpluses to non-NAFTA markets. Obviously, strong markets overseas and the weak dollar make the conditions for their exports favorable.
As has become typical of the US steel industry, the dominant firms announced uniform price increases almost in lockstep in recent months. Prices of hotrolled coils were raised $27/T in January 2008, which was followed by a $40 increase for February. However, the announcements for March showed a differential, with Nucor asking for another $80, the other major companies $50. In early February, one mill announced a further increase of $30 per net ton – to $700 per net ton – for April deliveries. Another mill announced in early February that it will not open its books to non-contact customers for that month. The all-important auto contract negotiations in the US suggest more price increases for that important market, with the mills demanding another 20% increase over 2007 and the auto companies trying to keep the increase to 10%.
Table 1 shows the prices resulting from these announcements per metric ton for both flat and non-flat steel mill products in addition to the prevailing SBB Steel Index numbers for different periods. Graph 1 displays the course of US prices for major flatrolled sheet categories, whereas graph 2 compares US prices of hotrolled coils with those in Europe and Japan.
RISING COSTS OF STEELMAKING INPUTS
Major steelmaking inputs have become more costly in recent months. How much this will drive up the average cost of finished steel in the US cannot easily be determined. In the first place, the single most costly input for most integrated mills, iron ore, has not yet gone through the annual price negotiation. Secondly, while plenty of information is available for spot prices of other resources, not enough is known about cost changes related to company-controlled operations and about resources purchased under multiyear contracts.
Iron Ore Customarily the three dominant iron ore producers face representatives of a leading steel industry, probably the Japanese this year. It has been reported, that at a preliminary meeting the sellers demanded a 70% price increase, the buyers conceded 30%. For European or Japanese steel companies, which depend heavily on seaborne ores, these numbers would be equivalent to a cost increase, per ton of steel product, of respectively $65 and $29. Encouraged by very high spot prices obtained by Indian ore sellers in China, the three big miners may insist on a 50% rise.
For US steelmakers, the effect is more difficult to assess, because firms buy pellets on long-term contract from Cleveland Cliffs, while others have either captive mines or maintain very close relations with domestic suppliers. There is no reason why the cost of captive mines should rise much faster than the general inflation rate, certainly not by great leaps as in the international market. Nevertheless, the US mills are likely to use global price movements to explain their need for higher prices to American steel users, all the more so since they import 11Mt of iron ore from the international market, mostly from Canada and Brazil.
Scrap and Pig Iron Fifty nine percent of the steel produced in the US is by the electric furnace process rather than in oxygen converters. It is therefore not surprising that the industry consumes more scrap than iron ore. Additionally, nearly 10Mt of pig iron and DRI are imported, the pig iron mostly by minimills, the DRI by both minimills and integrated producers. Both scrap and pig iron prices experienced very large increases since December 2007. Shredded scrap rose from $294 to 384/T, No 1 bushelling from $316 to $399/T, and No 1 heavy melt from$264 to $324. Pig iron imported from Brazil moved from $350 in December to $420fob by the end of January. In early February, there was a small pull back in the price of scrap, but whether that is the beginning of a trend cannot be known at this point.
Ocean Freights: Ocean freights soared into the stratosphere last year, declined and then rose again recently. There are signs that rates could moderate again.
CONCLUSION
The US steel market must import steel to make up for the shortage of domestically produced products, whether semifinished or finished. With inventories at low levels at the beginning of the year, rapid fire price increases by domestic mills, increasing discussions regarding some mills being booked out and moving to allocation for some products, something has to give. Early in 2008 we are beginning to hear of some import business being concluded at higher prices than domestic (re-bar as a case in point) and we would not be surprised if that trend spreads in the near to medium term until domestic prices catch up or surpass import price offerings. With all the question marks for the year mentioned above, one item seems most important, underlying demand. If recessionary forces take hold in the US, customers will have little reason to buy either domestic or imported steel products and inventory rebuilding and demand may stall. We hope more for a repeat of our experience in 2007, when the first quarter GDP data came out, pundits predicted a recession that year too – and for the same general economic reasons, housing etc. They were wrong as GDP rebounded in the second quarter to 3.8% and the third to 4.9%. While underlying demand in the economy fooled the pundits in 2007, we are hopeful that this year, export activities and a still resilient consumer will keep the economy moving forward in 2008.
We will soon know. Thank you for the opportunity to speak to this conference again, and I look forward to any questions you may have.
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