Chinese Steel: Perspective on Price Weakness

Dynamics affecting steel prices are more complex than they look.

Since the second quarter of 2011, Chinese steel prices have declined precipitously, with both domestic long (rebar) and flat (HRC) steel prices falling approximately 42%1 from their peaks in 2011. Many analysts believe that the collapse in steel prices has been due to high expectations and a weakening Chinese economy. However, we think that Chinese steel prices are misunderstood and that other forces are actually at play.

No Steel Consumption ‘Collapse’

China steel consumption and price trends have clearly been on very different paths over the last decade. Since 2003, steel consumption has nearly tripled while prices have moved sideways. Even as the impact of Chinese stimulus wore off in 2011, steel consumption continued to grow a further 12% between 2011 and 2013. In our view, growth is likely to continue at a steady pace, given the continuous process of urbanization and growing consumption.

Contrasting Fortunes of Steel Consumption and Prices

Sources: Bloomberg, CEIC, Morgan Stanley Research.

Cost Drivers of Steel Deserve a Closer Look

If weak demand has not caused the decline in steel prices, what about input costs? The biggest cost drivers in steel production are iron ore and coking coal. Over the past seven years, prices of steel and its main raw materials have displayed a strong correlation.

High Correlations among Steel, Iron Ore and Coal Prices

Sources: Bloomberg, Deutsche Bank.

Absent other factors, we believe this trend suggests that either downstream steel demand is affecting upstream coal/iron ore prices or vice versa. We tend to think it's the latter—and that lower input prices (and resulting lower steel costs) are in fact supporting demand, for two reasons:

    1. Chinese steel mills’ utilization rates of 72%–80% over the past five years have not significantly differed from the global average,2 suggesting that there isn’t extraordinary weakness in Chinese demand.
    2. Chinese steel producers negotiate and set prices on a monthly basis with their customers. The relatively stable gross margins of the steel mills suggest they have been able to pass through cost increases to their customers successfully.

Moreover, we believe that input prices are likely to remain moderate relative to the post-financial crisis peak three years ago. Coal and iron ore have not experienced supply shocks like those of 2011, when floods in Queensland, Australia, impacted coal output and Indian regulatory changes hampered domestic coal and iron ore production. The resulting ramp-up of coal and iron ore production in the Asia Pacific region led to not just to subsequent oversupply in these raw materials but also to lower cost curves, as mining companies improved operational efficiency and economies of scale as volumes expanded. More recently, China’s central government announced infrastructure spending plans for railways and roads. But it is likely that China’s domestic steel supply will respond quickly, neutralizing potential benefits of a pick-up in infrastructure-led demand.

Steel Mill Gross Margins Have Not Suffered from Lower Prices

Sources: Bloomberg, Deutsche Bank. HRC is hot-rolled steel.

Seeking the Right ‘Takeaway’

Focusing on the impact of these trends on the Chinese steel industry, we can see that Chinese steel mill gross margins are a lot more resilient than most analysts realize. There are indeed steel mills that are losing money at today’s prices, but they are typically inefficient at the operating level—burdened by excess labor, old and inefficient plants, and high environmental and compliance costs, among other issues. In a competitive market, such plants can be expected to close down as consolidation takes place.

To us, blaming the fall in steel prices on declining Chinese demand and a worsening economy would be a mistake. Rather than focusing on headline prices, we think it makes more sense to look at gross margins and consumption trends to determine the real state of the Chinese steel sector. Overall, we hold a neutral view towards the sector. Absent any major fiscal stimulus and/or economic growth surprises/shocks, we think the outlook for demand and supply will likely remain on a stable growth trajectory. While the current property market weakness may pose some concern about demand for commoditized long steel products, we are finding what we consider attractive opportunities in some specialized flat steel producers—in particular, white goods and auto sheet producers. Domestically, China continues to have a limited supply of such products.

Clearly, supply/demand dynamics for Chinese steel have major implications, not just for the domestic industry and the Chinese economy, but for steel and iron ore prices worldwide—as China accounted for about half of global steel production last year. We believe that looking beneath the surface to identify the causes of pricing shifts provides insights in identifying opportunities, even in a sector with a relatively poor broad outlook like Chinese steel, should allow investors to get ahead of trends going forward.

1As of May 30, 2014
2According to Worldsteel Association, China’s utilization rate in 2013 was 72% vs global average of 74%

This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. This material is not intended as a formal research report and should not be relied upon as a basis for making an investment decision. The firm, its employees and advisory clients may hold positions of companies within any sectors discussed. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of this material and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Neuberger Berman products and services may not be available in all jurisdictions or to all client types. This material may include estimates, outlooks, projections and other "forward-looking statements." Due to a variety of factors, actual events may differ significantly from those presented. Investing entails risks, including possible loss of principal. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results.

This material has been issued for use by the following entities; in the U.S. and Canada by Neuberger Berman LLC, a U.S. registered investment advisor and broker-dealer and member FINRA/SIPC; in Europe, Latin America and the Middle East by Neuberger Berman Europe Limited, which is authorised and regulated by the UK Financial Conduct Authority and is registered in England and Wales, Lansdowne House, 57 Berkeley Square, London, W1J 6ER, and is also regulated by the Dubai Financial Services Authority as a Representative Office; in Australia by Neuberger Berman Australia Pty Ltd (ACN 146 033 801, AFS Licence No. 391401), which is licensed and regulated by the Australian Securities and Investments Commission to deal in, and to provide financial product advice for, certain financial products to wholesale clients; in Hong Kong by Neuberger Berman Asia Limited, which is licensed and regulated by the Hong Kong Securities and Futures Commission; in Singapore by Neuberger Berman Singapore Pte. Limited (Company No. 200821844K), which currently carries out the regulated activity of fund management under the Securities and Futures Act (Chapter 289) (“SFA”) and operates as an Exempt Financial Adviser under section 23(1)(d) of the Financial Advisers Act (Chapter 110) (“FAA”) of Singapore. Under the FAA, NB Singapore is exempted from Sections 25, 27 and 36 of the FAA, where its financial advisory service is provided to an accredited or expert investor (as defined in Section 4A of the SFA); in Taiwan to specific professional investors or financial institutions for internal use only by Neuberger Berman Taiwan Limited, which is licensed and regulated by the Financial Services Commission (“FSC”) and a separate entity and independently operated business, with FSC operating license no.:(102) FSC SICE no.011, and address at: 10F, No. 1, Songzhi Road, Taipei, Telephone number: (02) 87268280; and in Japan and Korea by Neuberger Berman East Asia Limited, which is authorized and regulated by the Financial Services Agency of Japan and the Financial Services Commission of Republic of Korea, respectively (please visit for additional disclosure items required under the Financial Instruments and Exchange Act of Japan). Except for the foregoing, this material is not intended for use or distribution within or aimed at the residents of any other country or jurisdiction. This document is not an advertisement and is not intended for public use or additional distribution in the following jurisdictions: Brunei, Thailand, Malaysia and China.

The “Neuberger Berman” name and logo are registered service marks of Neuberger Berman Group LLC.