Soaring Steel Makes Winners and Losers

The price surge magnifies the disparity between steelmakers with their own raw materials and those dependent on world markets for them

Recently the prices of several key steelmaking raw materials have gone through the roof. Since the end of 2003, the price of iron ore has soared 321%, and it's up 65% just in the last year. Coking coal is up a staggering 582% since 2003 and triple what it was in 2007. And scrap steel has climbed 237%, doubling since last year.

These price increases have put severe pressure on the entire steel supply chain, particularly the downstream portion, as steelmakers, service centers, and customers fight over who will be forced to bear the brunt of the increases—much like in the game of musical chairs where the objective is to avoid being left without a seat when the music stops.

As a consequence of increased input prices, hot rolled band, the key steel industry product, is now being quoted at $1,000 per metric ton, which is a price barrier that has never before been crossed. Raw materials surcharges are being declared by steelmakers on what seems like a daily basis and passed along to increasingly alarmed customers. Some of these customers, particularly in the construction business (which accounts for about one-third of steel usage in the U.S. and about one-half in Asia), are choking on the price increases, as certain projects are being rendered uneconomical.

When Will the Disparity End?

The other result of the price surge is that, as never before, there is a great and increasing disparity between the haves—those steelmakers that are fully integrated and self-sufficient from a raw materials perspective—and the have-nots—those that depend on the world markets for their raw materials.

Who will be the winners and losers in this battle? The clearest potential winners, at least in the short term, will be the upstream raw materials producers. They have the products everyone needs. That's why they can push through these enormous price increases. The big question for them, however, is how long the supply/demand disparity will last. Some industry analysts believe the supply/demand imbalance in iron ore will continue until 2012-15, when additional capacity is projected to come online, while others believe the gap will close much sooner, perhaps as early as 2008.

Other potential winners will be the fully integrated steelmakers, those companies that are self-sufficient in raw materials. These include many of the Russian, Ukrainian, and other Eastern European steelmakers, such as Severstal (CHMF.RTS) and Metinvest, and to a somewhat lesser extent US Steel (X) and ArcelorMittal (MT), the industry leader.

Market Power Will Be Key

The potential losers among steelmakers will be those that are not self-sufficient in raw materials and are dependent on the world markets. The major companies in this category are the Chinese, Japanese, and South Koreans. Indeed, there are many more steelmakers overall that are not self-sufficient than are. The big question facing these have-nots is how will they remain competitive when their costs are increasingly out of line with those of the haves.

Other potential losers will be those downstream companies left without a chair when the music stops. At some point, someone in the chain will have to absorb the price increases. This could include service centers, processors, and customers. Of course, large customers will surely try to say no, and push the price increases back upstream. Market power will be the key.

Another Option: Sell Out Now

The have-nots must focus on upstream opportunities. Raw materials generally are becoming scarcer and more expensive. Under these circumstances, it is important that steelmakers own and control their own inputs. This is a sea change from the industry circumstances until a decade or so ago, when raw materials were plentiful and pricing was stable. Indeed, during this earlier era, many integrated steelmakers divested their raw materials assets to focus their attention on steelmaking.

Since there are no formal futures instruments that have-not steelmakers can use to hedge their exposure to the market, their choices are to continue buying raw materials on the open market, acquire raw materials companies, or hedge through noncontrolling investments in raw materials companies. Of course, one additional option is to sell out now, when steel, metals, and mining companies are still trading at all-time high valuations.

The best way for downstream companies to weather the raw materials storm may be to store nuts for the winter by raising more equity. In times of volatility, nothing is more comforting than having a cash cushion.

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