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What is the backbone of modern industry? What holds society together, yet never is seen? What do we all need but never talk about? What do we use every day yet hardly ever buy it as an ordinary consumer?

Steel - The Backbone of Modern Society

Steel is very useful. It can be used to build cars, railroads, trains, bridges, airports, appliances, and other essential things society needs to function. It is strong, sturdy, and now it is very cheap. In March 2011, hot rolled steel coil was $881 per tonne (1000 kg). One year later, it was $734 per tonne. For hot rolled steel plate, in March 2011 it was $963 per tonne. One year later, it was $858 per tonne. Why does this matter? Well if you are looking to build a bridge or a building now may be the time. But as this trend continues, steel producers will become even less profitable.

Why the Drop?

In order to know why steel prices dropped, you simply have to look at why it rose in the first place. From 2000 to 2005, steel demand increased 6% due to India and China building out their infrastructure. This increase in demand led to an increase in steel prices, which spurred more investment in steel plants. This led to China's crude steel production growing from 494.9 million tonnes in 2007 to 683.3 million tonnes in 2011. India's has also grown from 53.5 million tonnes in 2007 to 72.2 million tonnes in 2011. As a whole, global steel production has grown from 1,351.3 million tonnes to 1,490.1 million tonnes (stats from the World Steel Association) from 2007 to 2011. What really is interesting is how fast steel production recovered, from 2009 to 2011 global steel production grew from 1,219.7 million tonnes to 1,490.1 million tonnes.

But, China's steel demand has been rapidly slowing down, with the World Steel Association predicting global steel demand to only grow 3.6% in 2012, much less than the 5.6% growth in 2011. This was made in April, so that number is probably going to come in less than expected. They see global demand for steel coming in at 1,420 million tonnes in 2012. That leaves a 70 million tonnes surplus if production levels stay at their 2011 levels, which they won't. This July steel production grew by 2% year over year. If the trend continues, there most likely will be a surplus of steel for a while.

 

As you can see from this graph, steel production has skyrocketed over the past decade. Even with the dip from the 2008-2009 crash, it is still double what it was in 2000 (data from World Steel Association, graph from Wikipedia). Global demand for steel, especially in China and India, has slowed down considerably, which has sent prices much lower as the surplus grows. Plus Nomura analysts Matthew Cross and Ivan Lee have stated that through their research China can keep urbanizing at its current rate and not need to increase its steel consumption. That is bad news for steel producers.

Who Gets Hurt

AK Steel Holding Corp (NYSE: AKS) and United States Steel Corp (NYSE: X) are two major US steel producers who are currently getting hit hard due to cheap imports and low steel prices. Year to date, US Steel Corp's stock price has fallen from $26.50 to $20, and AK Steel Corp's has fallen from $8.26 to $5.23. UBS also pointed this out, downgrading AKS to a sell from neutral citing "longer-term issues remain and we view AKS as having the most downside risk in an environment with weaker pricing." Any steel producer operating in this environment is getting hit hard. In its latest earnings, US Steel reported earnings of 69 cents a share. Next quarter, analysts are expecting a meager 3 cents a share profit. In AK's latest earnings, they reported a profit of 10 cents a share. Next quarter, that is expected to come in at a loss of 19 cents a share. Sad. These are two companies you don't want to own if this weakness continues. If you had to pick one of these as a turnaround play, pick US Steel, as it trades at 1.1 book and is projected to remain profitable, while AKS trades at 2.50 book and is slated to lose money. But, there is an even better way to play a turnaround in steel pricing and global growth in general.

A Diamond in the Rough?

In the steel industry, everyone is hurting. But, has a great value play emerged? ArcelorMittal (NYSE: MT) pays out a 5% dividend and trades at 0.41 book value. So clearly investors are expecting a lot of weakness in ArcelorMittal, but has that already been priced in? Arcelor is way off its year high, coming down from $23 to $15. While I don't think China's economy will have an H2 pickup that Chinese government officials are predicting, and it looks like India's economy will continue to experience weakness because it doesn't look like it will undergo any pro-growth reforms anytime soon, ArcelorMittal still offers a great dividend and is trading well below the value of its assets. If a smart investor buys in on this weakness and waits several years, nice gains could be had. This company still has some downside risk, there should be support at the $13 area.

Other Players

Two other players who get hurt from this are the iron ore producers. Vale SA (NYSE: VALE) is the world's largest iron ore producer, and iron is a primary component in steel production. If prices remain low and steel consumption doesn't pick up, Vale will see its margins and profits compressed. Vale's stock is far off its year high of $26, down to $16 now, and has fallen 12% YTD. Iron ore pricing is very weak right now, and has fallen below $100 per tonne for the first time since 2009. Another mining giant BHP Billiton Limited (NYSE: BHP) is also getting hurt from weak iron ore pricing for lackluster steel demand. It is also getting hurt from weak demand for metals in general. BHP's CEO Marius Kloppers expects long-term weakness in both demand and pricing going forward while China's economy slows down. While lower input costs are very beneficial to these steel producers, iron prices fall and rise in tandem with steel prices. 

Final Thoughts

It seems for the time being that China and India's economies will continue to slow down and steel demand will continue to be depressed. With depressed demand comes depressed pricing, and unless these emerging markets start growing faster or if production is curbed, this will continue for some time. This means the steel manufacturers are going to keep being hit hard by weak pricing. With this week pricing, you shouldn't be a buyer of steel makers, as there are no gains to be made. What you should do is steer clear of this area for a while, especially AKS. But, if you can time a bottom correctly, then ArcelorMittal is a great value play, and will reward long-term shareholders greatly with both dividends and capital appreciation. Bullish on MT in the long term, bearish AKS and X and the rest of the steel industry as a whole over the next 12 months.