Steel: An inferno of unprofitability; The world’s overcapacity in steelmaking is getting worse, and profits are evaporating

Steel: An inferno of unprofitability; The world’s overcapacity in steelmaking is getting worse, and profits are evaporating

Jul 6th 2013 |From the print edition

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THE importance of steel is in no doubt. It is the material from which much of the modern world is made, from skyscrapers to washing machines. Governments everywhere regard a strong steelmaking business as a sign of economic virility, and thus hover anxiously over their domestic producers. A French minister recently threatened to nationalise ArcelorMittal’s Florange plant if it pursued plans to cut jobs and close two blast furnaces. Despite a weak world economy, global production of steel rose by 1.2% last year to a record 1.55 billion tonnes.Yet importance does not always translate into financial success. Steelmaking scrapes by on microscopic margins that make even airlines look like paragons of profitability. This is most apparent in Europe, whose steelmakers are the most beleaguered. Yet China, where the industry is booming—it has enjoyed almost all of the global production growth in the past decade—faces many of the same problems.

The most pressing concern is an old one: overcapacity. In Europe especially, the drive to build lots of vast steelworks in the post-war reconstruction effort continued into the booming 1960s, only for demand to hit a wall in the oil shocks of the 1970s. Too little was done to adjust capacity to the meagre growth rates that followed. The financial crisis delivered the latest blow. Around half of steel output is used in construction, an industry that took a heavy battering. Steel consumption in Europe, at around 145m tonnes in 2012, is nearly 30% below its pre-crisis level and demand is still falling.

A declining domestic market is far from Europe’s only ill. Labour costs are sky-high (only Japan’s are greater). Feisty unions and fussy governments make closing steel plants a difficult, expensive and lengthy process. And energy, two-fifths of steelmakers’ operating costs, is pricey. Wolfgang Eder, president of Eurofer, a steel-industry body, and boss of Voestalpine, Austria’s biggest steelmaker, reckons that the continent’s unused capacity is 50m tonnes.

American steelmakers, though they are struggling to compete with Latin American rivals, have it a bit better. Signs that the economy is recovering, cheap energy from shale gas and a resurgent motor industry are all bringing good cheer to steel firms. Jefferies, a bank, reckons America’s steel consumption will grow by 2.8% this year.

In Europe, despite some efforts to manage capacity by idling facilities, there is little chance of the big closures required. No firm wants to be first to shut plants and let competitors reap the benefit. And deals struck when times were good still haunt steelmakers. ArcelorMittal, which became the world’s biggest steelmaker in a huge merger in 2006, agreed to maintain jobs and production to persuade European governments to wave the deal through. Now it will be a struggle to break these promises.

Adding to the pressure on steelmakers’ profitability is China’s growing capacity, which is denting steel prices around the world. After a decade of rapid expansion, Chinese firms are now responsible for half of global production. Although the government seems determined to cover the entire country with steel and concrete in its drive for growth, the steelmakers have expanded so rapidly that they now suffer from massive overcapacity. Yet more is being added: Jefferies reckons that another 105m tonnes of new capacity is under construction or planned.

China’s stated aim of reining back steelmakers and consolidating state-run firms has happened “mostly on paper”, according to Philipp Englin of World Steel Dynamics, a consultancy. The central government wants cheap steel, so it is unwilling to take radical steps to curtail overcapacity. Meanwhile local governments are encouraging more steel mills to set up shop. They are a vital source of direct and indirect employment, and tax revenues. To these enterprises, profits are unimportant.

Since China itself will have little need for this unprofitable steel, it will inevitably add to the country’s exports, further depressing world prices. Chinese exports are likely to be 30m-50m tonnes in each of the next few years—a small share of the country’s total production of almost 750m tonnes, but an amount that now exceeds the tonnage sold abroad by longer-established exporters such as Japan, South Korea, Ukraine and Russia.

The expansion of Chinese steelmaking has pushed up the cost of the industry’s main raw material, iron ore, squeezing margins further (see chart,). The supply of ore is dominated by four big mining firms, which supply 70% of all the ore traded by sea around the world. Until 2010 ore prices were fixed in annual negotiations between big steelmakers and the four miners. Now the steelmakers have to pay at, or close to, spot-market prices, and these have proved volatile. The futures market is still underdeveloped, with puny volumes and thin liquidity, so hedging is hard. This has made the struggle for profits only more arduous.

Iron ore is a sellers’ market but steelmaking, since there has been little global consolidation, is a buyers’ one. ArcelorMittal, way out in front of any rival, has only 6% of the world market, and 60 firms produce 5m tonnes or more, says Nicholas Walters of the World Steel Association. Buyers, such as carmakers, are bigger and more powerful, and thus can negotiate hard. These pressures have made the steel industry a mere “conversion business”, making wafer-thin profits, at best, by transforming ore into metal, laments Colin Hamilton of Macquarie, a bank.

China’s continuing economic growth offers the prospect of its excess capacity eventually being used up, if the central government can somehow restrain local authorities’ zeal for new plants. Europe’s outlook is gloomier. Its firms face an unwelcome choice between abrupt closures and death by a thousand cuts. Although the world still needs plenty of steel it doesn’t need as much as steelmakers are able to supply.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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