Steel Giants’ Fate Tied to Oil Prices in 2013

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The steel industry’s titan ArcelorMittal (NYSE: MT) has decided to write down the goodwill of its European operations by $4.3 billion due to the "weaker macroeconomic and market environment” of the continent. The effect of this non-cash impairment charge will be reflected in the fourth quarter’s results due on February 6. The demand for steel in Europe has dropped by 8% this year and 29% overall since 2007. This weak level of demand, coming from high unemployment and drastic cuts in public and private expenditures, is expected to persist over the medium term – 12 to 24 months. The Euro-zone has not registered any growth in the previous four quarters, having contracted in the previous two.   And Q4’s results are not expected when all is calculated to be much better. The Eurocoin indicator, one of the earliest estimates showing GDP growth in the euro zone area, has been negative for all of Q4 -- -0.29% for October and November, and -0.27% for December.

On the other hand, while demand for steel is down in Europe, it has climbed by 8% in the U.S. in 2012.  But these are not the drivers of the global steel economy, China is and since China’s output has been falling for the past year it has depressed the industry as inventories have backed up across the sector.  With China actively stimulating infrastructure spending that trend is changing.

In its third quarterly results, ArcelorMittal reported an 18.5% drop in sales from Q3-2011 to $19.7 billion year over year, resulting in a net loss of $709 million.  This swung net profit from $0.43 per share to a loss of $0.46. Excluding one-off items, A-M still lost $0.31 per share, far worse than projections. The prices of iron-ore have continued their decline from last year falling from their peak of $187 in Feb-2011 to bottoming at $99.47 in Sep-2012.  Globally these lower iron ore prices will shift global demand to markets previously unable to compete with the Chinese for it. 

A-M shipped 12.7% more iron ore through the first nine months of the year, but at far lower prices. Couple that with a 2.2% decrease in steel shipments over the same period and its bottom line suffered horrendous damage.  The fundamental news does not get that much better for 2013-14.  If global demand picks up due to the unprecedented central bank interventions of the past four months from the E.C.B., the Fed, the Bank of Japan, and the PBoC it will only spark a rise in energy costs which will have to be absorbed by iron and steel producers at all levels of their business.  There may be a quarter or two of improved margins as forward hedging locks in relatively lower prices but then the current problems will reassert themselves. 

The proof is in the following table which compares A-M’s operating margin with the price of the US Brent Crude ETF (NYSEMKT: BNO). It assumes a 6 month forward hedge on oil deliveries by A-M so that the price of BNO quoted is the price paid for the oil used during the reported quarter, i.e. for Q3 2011, the price of BNO in the table is the average monthly close for the three months of Q1 2011.  The Pearson Statistic is the correlation coefficient of the relationship.  The closer to 1 or -1 the Pearson Statistic is the stronger the correlation between the variables.  It’s pretty obvious that A-M’s margins are strongly correlated to energy prices.

<table> <tbody> <tr> <td> <p><strong>NYSE:MT</strong></p> </td> <td> <p><strong>Q3 2011</strong></p> </td> <td> <p><strong>Q4 2011</strong></p> </td> <td> <p><strong>Q1 2012</strong></p> </td> <td> <p><strong>Q2 2012</strong></p> </td> <td> <p><strong>Q3 2012</strong></p> </td> </tr> <tr> <td> <p><strong>%Op Margin</strong></p> </td> <td> <p>5.2%</p> </td> <td> <p>2.2%</p> </td> <td> <p>3.7%</p> </td> <td> <p>5.7%</p> </td> <td> <p>0.9%</p> </td> </tr> <tr> <td> <p><strong>AMEX:BNO </strong></p> </td> <td> <p>73.05</p> </td> <td> <p>78.67</p> </td> <td> <p>74.05</p> </td> <td> <p>75.36</p> </td> <td> <p>83.14</p> </td> </tr> <tr> <td> <p><strong>Pearson Stat</strong></p> </td> <td> <p>-0.874</p> </td> <td> </td> <td> </td> <td> </td> <td> </td> </tr> </tbody> </table>

Looking at rival US Steel (NYSE: X) we see similar results but because of the relatively cheaper energy prices of domestically produced oil and natural gas, the hit to their bottom line has been muted.  Operating margins for US Steel have been, on average, higher over the past 5 quarters since the Brent/WTI spread has blown out to more than $20 per barrel and U.S. Natural Gas prices have plummeted.  So, while US Steel reported a drop in sales and earnings it didn’t report a quarterly loss in Q3, overall, the company has lost money in the first nine months. Although its quarterly profits doubled to $44 million that it came on the back of an income tax benefit of $27 million whereas in the same quarter last year, it recorded income tax charges of $33 million. Excluding the effect of income tax, the company’s profit before tax -- year over year -- dropped by 69% to $17 million.  But it is still a mild profit. US Steel’s sales for the first nine months have seen a modest drop of 1.5% to $14.8 billion but it has gone from making a profit of $158 million to a loss of $74 million in that period. The company’s total steel shipments have fallen by 2.34% to 16.4 million tons.

I did a similar analysis for US Steel but substituted the United States Oil Fund ETF (NYSEMKT: USO) as a proxy for WTI Crude.  The results were similar but the correlation was weaker.

<table> <tbody> <tr> <td> <p><strong>NYSE:X</strong></p> </td> <td> <p><strong>Q3 2011</strong></p> </td> <td> <p><strong>Q4 2011</strong></p> </td> <td> <p><strong>Q1 2012</strong></p> </td> <td> <p><strong>Q2 2012</strong></p> </td> <td> <p><strong>Q3 2012</strong></p> </td> </tr> <tr> <td> <p><strong>% Op Margin</strong></p> </td> <td> <p>10.3%</p> </td> <td> <p>3.6%</p> </td> <td> <p>10.6%</p> </td> <td> <p>10.8%</p> </td> <td> <p>7.3%</p> </td> </tr> <tr> <td> <p><strong>AMEX:USO</strong></p> </td> <td> <p>40.13</p> </td> <td> <p>40.96</p> </td> <td> <p>34.14</p> </td> <td> <p>37.54</p> </td> <td> <p>39.32</p> </td> </tr> <tr> <td> <p><strong>Pearson Stat</strong></p> </td> <td> <p>-0.640</p> </td> <td> </td> <td> </td> <td> </td> <td> </td> </tr> </tbody> </table>

The Chinese slowdown, Euro-zone debt crisis and an oversupply in the industry will continue to create problems for steel manufacturers in the medium term.  The World Steel Association believes that steel consumption has risen by 2.1% this year, significantly lower than 6.2% in 2011. US Steel’s total operating income is going to drop from $171 million in the previous quarter to breaking even.

With the Federal Reserve openly inviting inflation for 2013-14 the spread between U.S. and International energy costs will tighten to a degree – the WTI/Brent spread will drop and the price of U.S. Natural Gas will rise —which will be good news for U.S. steel producer exports as emerging market currencies will buy more at the margin rather than from China.  I would look for a medium-term, but short-lived rebound in U.S. Steel because of this effect.  Both companies will see improved margins in Q4 because of the huge drop in oil prices during Q2 but I am expecting oil to rise on inflation expectations in 2013, regardless of increased U.S. production.  For Arcelor-Mittal the structurally stronger Euro will plague its short-term profitability but in the long run will create a net positive effect on its overall business as oil will be relatively cheaper.

The shares of both US Steel and MT have been down 9.85% and 3.96% in 2012 whereas Market Vectors Steel ETF (NYSEMKT: SLX) has been up 2.39% over the same period. SLX includes all the top publicly traded steel producers of the world and gives exposure to emerging markets where steel demand is far stronger, now benefitting nicely from lower prices and stronger currencies.  The ETF gives highest weightage to Rio Tinto – 13.58% – while MT and US Steel have 7.04% and 3.74% representation.  This weighting also diversifies the ETF to a larger extent.

China’s manufacturing PMI has now started showing signs of improvement so demand there is going to rise – according to Australia’s Bureau of Resources and Energy Economics, by 4% to 668 million tons.  2013 will be a mixed bag based on the interplay of rising demand and higher energy prices. 

PeterPham8 has no position in any stocks mentioned. The Motley Fool owns shares of ArcelorMittal. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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