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:
- 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.
- 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%
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