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The world’s most produced metal faces a slowdown, so now looks like a good time for caution

by Timon Day

After the hectic pace of the past five years, when steel production rose by around 10% a year, a slowdown is inevitable. In anticipation of this deceleration, the market has aggressively marked down shares in the world’s leading steel firms, and also companies that provide their raw materials such as the big mining companies.

UK investors might like to take a contrarian punt on structural steel group Severfield-Rowen (SFR) where business from the government and utility firms is holding up well and a price/earnings ratio (PE) of 5.6 looks to price in a lot of bad news. But a more cautious approach seems appropriate on mining and the global steel firms with secondary listings in London, despite their single-digit prospective PEs, until the prospects for the global economy in 2009 become a lot clearer.

Rise in production

Output of steel dwarfs that of all other metals and demand for it is a good guide to the state of the mining industry and global economic growth.

MEPS, a UK-based provider of data on worldwide steel prices, output and consumption, forecasts a 5.6% increase in global crude steel production to 1,420 million tonnes in 2008. An 8% rise in Chinese demand from 489 million tonnes to 527 million tonnes leads the way, with fellow BRIC nations Brazil, Russia and India not far behind. MEPS expects steel production to rise a further 5% in 2009 and 2010 and ease slightly to 4% growth in 2011.

Despite this increase in demand, MEPS Managing director Peter Fish does expect steel prices to weaken slightly over the next nine months, although by not much more than 10%. More iron ore mines are coming onstream, easing a raw material bottleneck, but the expectation is prices will remain robust so long as the countries producing the most steel continue to use it internally and not export it.

Rival US steel information service World Steel Dynamics (WSD) is more bearish. WSD forecasts by the end of this year the industry ‘may be on the verge of a supply/demand disaster due to rising steel output and stagnating demand’. This is more in tune with August’s downbeat outlook statement from Finnish steel company Outokumpu, which predicted a drop in stainless steel prices of ?100-?150 per tonne in the third quarter, down from ?1,300 per tonne in the second because of weak demand from the construction industry.

If WSD is correct this could mean a sharp decline in steel prices by around 35% for hot-rolled band products, with a fall in scrap metal prices leading the way. Nor does WSD expect a sharp price recovery during 2009 as governments around the world grapple with rising budget deficits and restrain their economic growth to curb inflation. At least the consultancy is more enthusiastic about 2010, reckoning prices will rebound. After that there will be good solid years of growth, with steel-makers having ‘pricing power’.

If the uncertain prospects for 2009 are one problem for steel investors, the lack of indigenous UK players is another. Corus, formerly known as British Steel, was snapped up by Indian rival Tata Steel for £6.7 billion in January 2007, although Tata is reported to be considering whether to list on the London Stock Exchange (LSE).

The world’s biggest steel magnate does at least live in London. Following a string of acquisitions, Lakshmi Mittal’s Luxembourg-listed Arcelor-Mittal is the world’s number-one steel firm, with a 25% market share and 320,000 staff across more than 60 countries.

Russian steel-makers have also made big waves, following the acquisition of 10% of the US steel industry and heavy investment in new plant over the past three years. Both Severstal (SVST) and Evraz (EZZ), which is controlled by Chelsea football club owner Roman Abramovich, have secondary listings in London. Russia’s largest steel producer, Novolipetsk Steel (NLMK) is also listed in London via a Global Depositary Receipt (GDR).

Lakshmi Mittal has argued the round of consolidation seen in the past three years means ‘the volatile years of boom and bust have been relegated to the past’. Investors clearly remain unconvinced. Novolipetsk’s shares have plunged from a 2008 peak of $56 to $37, while Arcelor-Mittal’s stock has fallen by a quarter from its highs and Severstal’s by a third.

End of the good times

This price action suggests the market fears the boom times may be over for steel firms, as construction activity and automotive production plunge in the West and the BRIC nations struggle to decouple from the slowdown. The Reserve Bank of India has just cut its 2008 GDP growth forecast, while rumours of an economic stimulus package in China continue to swirl.

It is not just steel-makers whose shares have been hit hard: the miners that supply them with vital raw materials have suffered too, as BHP Billiton (BLT), Rio Tinto (RIO) and Xstrata (XTA) are all off by more than a third from their year’s high.

China may still hold the key to both the steel and mining sectors. If GDP growth can be maintained at the 10%-plus level, the sectors should hold up relatively well, although it is still unclear whether this would be enough to compensate for any hard landing in the West.

Broker Blue Oar (BLUE) says ‘given that even a slowdown in the Chinese market would see real GDP growth still above 6% and in excess of what western economies have achieved for many decades, the long-term demand story looks intact.’ Blue Oar argues leading iron ore producer BHP Billiton is too cheap on a PE of just 8 for the year to June 2009, and also highlights the attractions of Anglo American (AAL) on 7.5.

Yet as Shares (28 August) has pointed out, these multiples are based on aggressive earnings growth forecasts for 2009 – forecasts which could prove optimistic unless metals prices recover and quickly. After all, zinc prices peaked in 2006, nickel and uranium in 2007 and this year has seen prices in lead, copper, platinum and aluminium peak and fall by at least 10% since February, April, May and July of this year respectively.

Shock and ore

It will be years if not decades before mining companies such as Rio Tinto secure a price rise to match the 96.5% hike in iron ore supplied to Chinese steel-makers, chalked up in June.

Iron ore producers can at least take encouragement from how bullish the steel firms remain. Severstal lifted crude steel output by 10% from its first quarter to its second quarter at 5.3 million tonnes, with production of rolled products ahead 13%. Novolipetsk grew its first-half net profits by 48% to $913 million on sales up 50% at $3.5 billion. Like its peers, it is also throwing off massive amounts of cash, which can be used for acquisitions and plant modernisation. Ms Galina Aglyamova, Novolipetsk’s chief financial officer, did warn the global economic outlook is uncertain but remained optimistic, saying: ‘However the developing world continues to outperform and Russia in particular is expected to grow significantly, with growth driven by commercial and residential construction and the machinery sector, coupled with the government investment programmes for infrastructure development.’ She sees steel prices stabilising in the third quarter and softening in the fourth.

Arcelor-Mittal enjoyed a 31% rise in sales in the first half to $68 billion, with net income ahead 65% at $8.2 billion. The group’s extraordinary expansion, both geographically and vertically, into buying coal mining companies among other things, shows no sign of abating. Lakshmi Mittal has acquired coal assets in Australia, America and Africa to ensure raw material self sufficiency and further his plans to corner the steel market.

Yet not everyone buys into Mittal’s strategy. ‘Quite how a notoriously cyclical 19th century technology has been transformed into a 21st century growth business eludes us,’ says Nick Stevenson of equity strategy think-tank Mirabaud Securities. ‘The mere fact that Mr. Mittal has made a fortune by cornering a quarter of the global market does not provide conclusive proof that “this time, things are different”. After all, Aristotle Onassis probably dominated the global tanker industry to the same extent in the 1960s and made a fortune that makes Mr Mittal’s look modest by comparison, but even he wasn’t able to prevent the collapse of the industry in the 1970s,’ he concludes.