Global demand remains weak due to an uncertain economy, putting pressure on the profit margins of steel makers

Posco, a South Korea-based company, Asia’s third-biggest steelmaker and the world’s fourth-biggest steel producer by 2011 output according to rankings by the World Steel Association, cut its 2012 sales forecast for the third time this year after quarterly profit missed analyst estimates due to a poor demand and decline in prices. Standard & Poor’s Ratings Services (S&P) also cut Posco’s rating. S&P expects Posco to encounter continued tough steel industry conditions in the region over the next 12 to 18 months as a result of slowing demand amid significant overcapacity.
 

Macroeconomic uncertainties make it unlikely that the global slowdown in demand for steel will turn around quickly. The recovery is expected to be delayed as the global economy remains gloomy due to fiscal crisis in advanced economies.
 

This is the case with other companies of the same sector in India, as well. The steel industry’s profitability, which had risen sharply from FY04, is on its way down, according to a recent report from Credit Suisse. In the past eight years, there has been a remarkable surge in mining as well as smelting operating profits, but pressures have emerged on both smelting and mining profits, and are likely to continue going forward. There has been a remarkable surge in iron ore and coking coal prices, which seems to be unwinding now. The slowdown in the Chinese economy and the debt crisis in Europe have restrained the demand growth and profit margins have declined.
 

As per the Credit Suisse report, over the past years the dramatic increase in profitability was due to cheap raw materials, either through direct ownership (e.g., SAIL and Tata Steel), or just geographical proximity aided by tariff barriers (most Indian steel makers). For Indian firms smelting margins were weak despite import duty protection, and Free Trade Agreement (FTA)-related imports have now brought domestic prices closer to international benchmarks, says the report. Indian steel equities are down, but are not cheap and with rising leverage below the operating line, run the risk of book value erosion.
 

“In the last four years, however, steelmaking margins, or smelting margins have come down sharply, hurt by the erosion of end-demand, and the lagged commissioning of capacity increases planned during the period of shortage. Over the past few months, as iron ore and coking coal prices have crashed, there are fears anew about the impact on the steel industry of the Chinese economy moving away from investment, and towards consumption.,” says the report.
 

The sheer scale and growth of Chinese steel demand was the root cause of the remarkable rise in iron ore and coking coal prices over the past five to six years. This is because supply takes a while to come up. The premium of steel prices in India over global prices has started to erode so much so that even without the import duty impact, Indian prices are barely higher than global prices. This has a structural implication on steel company profitability in India.
 

The report mentions that the Chinese steel production is unlikely to fall from current levels and growth is likely to be slow going forward, as it has been for the past few quarters. Further, the pressure on utilisation keeps rising because of steady commissioning of new capacity. In the past few years Chinese regulators have reacted to surging exports by raising barriers, the agenda being to keep steel prices low so steel-using industries (e.g., heavy machinery, ship-building) could become more competitive globally. This time, however, the need to maintain high utilisations may supersede such concerns.
 

Worryingly, domestic oversupply concerns are still real and can only further hurt local profitability. The reset on Chinese demand growth expectations have hurt raw material prices, and the continuing capacity growth is creating an overhang on already weak smelting margins. Despite some of the highest steel prices globally, smelting margins for Indian firms have been disappointing.
 

Steel creates its own demand, this combined with the fact that given its permanence, especially in its use in heavy infrastructure/real estate, there can be long periods of ‘digestion’ of steel use, causing a demand downturn. From a pricing perspective, there is a non-linear impact—when regions with a concentration of raw materials start to see a surge in economic activity, costs start to go up (currency, wages, other operating costs), pushing up the cost curve sharply. When this reverses, the cost curve deflates as rapidly.
 

Credit Suisse expects that in early years the decline in per-capita steel use globally going forward may not be steep, but even a flattening of demand could have a disastrous effect on both smelting and mining margins of steelmakers.