The Steel Industry Worldwide and Regionally: Assessment of Developments and Outlook

Transcription

1 Sector & Industry Studies Series Issue I, July 2007 The Steel Industry Worldwide and Regionally: Assessment of Developments and Outlook Economics & Strategy Division

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3 Foreword This series is intended to provide analyses and viewpoints regarding industries and economic sectors important to the region. GIC has a recognized record in direct and project investment in the GCC economies which gives a perspective on the various industries and economic sectors. We hope that this series provides interested readers with balanced and well-rounded views on the industries and sectors under review. The first study deals with the steel industry in international and regional contexts. Although GIC is an interested party in this business as investor, it is the role of the Economics and Strategy Division in the Corporation to provide an objective and balanced view regarding the prospects of the steel industry. We hope the readers will find the study informative and useful. As always, we welcome comments and suggestions. Soliman M. Demir, Ph. D. Head of Economics & Strategy

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5 Contents 1. Executive Summary Introduction Steel Products Summary Global Market Analysis Supply and Demand Implications for Global Steel Prices The Current Stance Industry Structure Industry Challenges Cost Structure Analysis Regional Steel Market Analysis in the Middle East Supply and Demand Key Regional Countries Prospects for GCC Countries The Steel Industry: Key Concerns Conclusions References... 46

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7 Executive Summary The short-term outlook for the market of steel products appears positive with global demand for steel continuing to grow. It is estimated that growth in demand for 2006 was 10 percent but is expected to slow to around 6 percent in This growth rate exceeds the 5.7 percent annual growth rate of global steel demand during However, steel consumption growth rates have differed greatly across regions where North America recorded the highest growth rate of nearly 15 percent, followed by CIS 1 with 13.5 percent, then China by nearly 11 percent. Global steel production has also experienced marked growth in 2005 and 2006 with 8.8 percent growth rate in Emerging markets such as those of Brazil, Russia, India, and China, the so-called BRICs, were the key producers. China and India, in particular, were expanding production more prominently and both accounted for nearly 45 percent of the world s steel output in The American Iron and Steel Institute (AISI) argues that steel companies in these countries, with government assistance, have planned steel projects that would add 278mt of capacity by 2008 whereas marketbased producers in the NAFTA region are expected to add only 3.3mt of raw steel capacity by China s share of the world steel output increased by 33.8 percent in 2006 while Asian countries as a whole-excluding China- have accounted for 20 percent of world total in The Asia region-including China- accounted for 53.8 percent of the world crude steel production in 2006 compared to one-third in In 2004, global steel prices increased sharply and rapidly which made the industry more profitable despite increases of 71.5% in world prices of iron ore in 2005, and higher transportation costs. This marked increase in iron ore prices, while helping ore producers to enjoy exceptional profits, placed upward pressure on the cost structure of steel producers. 1 CIS: Confederation of Independent States (member countries of the previous Soviet Union). 7

8 Although global steel prices recovered during the first half of 2006, after declining in 2005, they remained soft in China and are likely to remain so until China succeeds in its effort to consolidate steel production in fewer companies. Over the medium term, the steel industry is likely to face several issues that would affect steel trade flows. These issues include exchange rate changes, China s rapid production and consumption growth, tight supply of raw materials and industry consolidation. A weaker dollar is likely to raise costs of imports in USD terms and reduce trade in steel products. As China becomes a net exporter, the mt ton p.a. steel producers are likely to be the marginal ones who disappear while the 30 mt ton plus producers survive as a result of greater market consolidation over the medium to long term. However, niche producers of high value-added products that are designed to meet special demand growth in their immediate region, could be the exception to this global picture. The driving force behind recent acquisitions in the steel business is to reduce the steel price volatility implied in the cyclical nature of the steel industry. Incentives for greater consolidation in the global steel industry became more apparent when Mittal Co., acquired Arcelor to create the world s biggest steel company in terms of production and dollar sales. This deal together with other deals such as Tata-Corus are likely to change the industry s competitive pattern and encourage more consolidation which enables companies to enjoy healthy balance sheets and easier access to capital markets. Consolidation would give steel companies the edge to gain size and produce higher value-added products with higher margins vis-à-vis the excess supply of China s lower-margin products. 8

9 As for the Middle East, and in particular the GCC countries, steel production was not sufficient to satisfy the apparent steel demand which grew at 9 percent in 2006 and is expected to see a similar increase in As a consequence, GCC countries have become net importers of finished and semi-finished steel, especially billets, slab, and HR coils. GCC average per capita consumption is relatively high compared to other regions such as Asia and CIS but lower than the EU and the US. Currently, GCC countries are conducting negotiations to sign possible Free Trade Agreements (FTA) with China and India. Such agreements are likely to induce more imports of finished steel products to the GCC market from China; hence the ability of the GCC countries to provide duty protection would disappear following entry into free trade agreements. However, importing semi-finished products such as billet then rolling it in the GCC region will be more attractive to GCC businesses than importing finished products. We conclude the study with an assessment of the prospects for the steel industry in the GCC region. GCC producers, in order to flourish, would have to become more efficient and flexible (e.g., consolidate!). In the final analysis the region will be subject to the globalization forces impacting producers in both developed and developing countries. The effect of globalization will be more muted in the short to medium term, since the competitive advantage the region enjoys in energy will reduce the fierce effects of the globalization forces. In the long run, however, only efficiency, higher productivity, and market flexibility will be the ingredients for success of regional steel producers. 9

10 2. Introduction The cycle has shifted gear in the world economy. Growth peaked in 2004 and early 2005 but now is moderating. Although the slight shift in the growth cycle of the world economy is likely to reduce demand for hard commodities such as base metals, the global steel markets for most products continue to be oversupplied. A strong merger trend, however, is leading to a rationing of production to protect prices. Prices of raw materials such as oil, iron ore, and coil continued to be high as their supply remained tight. On the other hand, global trade was growing at an estimated 9 percent in 2006, after sluggish demand in OECD countries caused deceleration in growth in 2005 to 6.6 percent from 10.7 percent gains in Emerging Asia and transition economies of Eastern Europe were the key drivers of global trade and are likely to enjoy the fastest rates of export growth. China s economy has grown by around 10 percent p.a. on average during , while India s economy grew by more than 8 percent p.a. on average during that period driven mainly by trade growth. As a result, China has managed to sustain a trade surplus of $177.5bn, which contributed to its accumulated foreign reserves of $1028.8bn by the end of India, on the other hand, has managed to accumulate foreign reserves of $161.8bn though it had a trade deficit of $51.7bn during that year. The process of integrating these two booming economies into the world economy in a sustainable way without them facing trade barriers will likely be a challenge. China s growing trade and current account surplus is creating a backlash in the major importing countries, particularly the US. The Economist noted that 2 the performance of corporations in a given country has been viewed 2 The Economist, February 25, 2006, page

11 recently as invariant to macroeconomic conditions of that country. The reason is that big firms in G7 economies are becoming more international, where the share of corporate profits earned outside the domestic economy is getting higher. Globalization has given firms access to cheap labor abroad and the tendency to shift more production offshore has helped in keeping domestic wages relatively stable. It is estimated that the world s 40 biggest multinational companies employ, on average, 55 percent of their workforce in foreign countries and earn 59 percent of their revenues abroad. This trend, as we will see in the study, is helping in internationalizing production, breaking geographic barriers and is making the steel industry more global than it has ever been. There are implications for this trend as to how it affects prices, consolidation, regional development and trade. These implications will become evident in various parts of this study. 3. Steel Products Summary Table (1): Low Value-Added Ingots and semis Slabs Billets Blooms Sections and Rails Hot rolled wide strips & platesw Deformed reinforcing bars Other HR bars & flats High Value-Added HR/CR narrow strips & silicon sheets Galvanized coated sheets Welded tubes Cold drawn wire in coil CR sheets and coils Steel tubes, seamless Forged bars & cold finished bars HR rod in coil 4. Global Market Analysis 4.1 Supply and Demand Manufacturing oriented economies are usually more sensitive to business cycles than service 11

12 oriented economies because cyclical changes tend to amplify a given industry acceleration/ deceleration. Obvious changes in demand may lead to significant price changes. Industries like base metals and raw materials are examples of more volatile and highly cyclical markets i.e., any supply or demand disturbance could prompt sharp changes in prices. Earnings of firms operating in such industries tend to be cyclical as well which induces integration among these firms to reduce the risk of cyclicality. This is apparent in the steel industry where steel companies look for vertical integration to seize the iron ore they need and secure their supply chain by signing long-term supply contracts with mining companies as a hedge against price volatility. A recent study 3 notes that, viewed from a historical perspective, the steel and iron ore industries remain as cyclical and fundamental to countries like China and India in the 21 st Century as they were in the early stages of industrialization in Europe and North America in the 19 th Century and the postwar reconstruction of However, the study contends that the demographic factor has impacted steel demand substantially when considering China and India, with a population of over one billion each, embarking upon a rapid program of industrialization and urbanization. The study expects that demand for steel will grow at a greater magnitude; therefore, the world appears to have entered into a long cycle of higher demand for steel products than before. There will be periods of faster growth in demand followed by short periods of slower growth but the growth in global steel demand is unlikely to reverse back as it did in the early 1990s. The study argues that since 1970s, the steel industry has undergone nearly five historic cycles, from peak to trough, driven by technology advancements, globalization, and macroeconomic structural change. During the most recent cycle, , the US steel industry has seen 44 producers file for bankruptcy protection, which represented 20 percent of all steel companies, 3 Metal Bulletin, November 2005, page

13 including the second largest producer, Bethlehem Steel. By 2004, the 14 smallest companies were shut down while the remaining companies were either consolidated or liquidated. Such market consolidation was motivated by better prospects of realizing profits made jointly with offshore partners like Mittal and Severstal. At the same time, the industry strived to raise needed capital to improve efficiency and to meet the rising costs of health care and energy. The US economy grew by 3.5 percent in 2005, driven mainly by consumer spending, while the Chinese economy grew by around 10 percent. The US steel imports rose by 36 percent in 2005 to reach 20 mt and the share of manufacturing sector in the real GDP was only 14 percent in Whereas investment accounts for nearly half of China s GDP, exports accounted for almost 40 percent of GDP, compared to less than 20 and 25 percent for the US and Europe respectively. This contrast between the US and China has implications for the steel industry. Real Business Cycle (RBC) models have been revived recently when the world economy experienced a positive supply shock due to productivity gains from information technology and the re-emergence of China and India. This supply shock, as The Economist 4 argues, has reduced prices of many goods even though demand was growing and trade was flourishing. Fluctuations in global steel prices over short periods of time have increased markedly by more than 80 percent in 2004 while the world economy grew at 5.3 percent in 2004 and 4.9 percent in 2005 and again by 5.4 percent in The slowdown in 2005 was attributed mainly to slower growth in the US, Japan, and the EU. While steel prices have recovered during the first half of 2006, after declining through much of 2005, they started to contract during the second half of the year due to oversupply in China and higher inventories in some other markets. China grew by 10.7 percent in 2006, and was able to export up to 50 mt of steel during the year, 4 The Economist, May 6, 2006, page

14 signaling an excess supply in the global steel market of Chinese steel products. Domestically, steel overproduction is a threat because excess capacity, especially when it is state financed, tends to impose deflationary pressure on the domestic general price level. To avoid this, the Chinese government has focused on consolidating production (supply rationalization) and on encouraging consumer spending as a driving force for growth. China shall also reduce subsidies and other export rebates to steel producing companies. It is noteworthy that the recently approved 5-year plan implies a shift in focus from investment to consumption, especially by households. Chart 1: World Crude Steel Production Millions EU25 USA China Japan Middle East Source: Global crude steel production has increased by 8.8 percent in 2006, to reach a total of 1.24bn tons and is expected to increase by 5.4 percent in 2007 to reach 1.31bn tons. The operating rate, on average, has increased from 76.1 percent in 2000 to 85.3 percent in 2005 for the world crude steel, which is equivalent to 33.5 percent increase in production from 2000 to This rendered the steel industry more profitable for many years with average operating margin reaching nearly 16 percent in 2004 compared to a modest 7 percent in Emerging markets such as those of 5 We do not have hard data on margins in 2005 and 2006 but we estimate a slowing down in 2005 (commensurate with softening of prices during that year) and a slight recovery in

15 Brazil, Russia, India, and China, have played an important role in the steel market and helped driving up world prices of Iron Ore. China and India were expanding more prominently and both account for nearly 45 percent of the world s steel output in China crude steel production rose by 20 percent from 349.4mt in 2005 to reach 418.8mt in 2006 while total steel production capacity reached 462mt which was 10 percent more than production. Total investment in the iron and steel sector increased by 17 percent from nearly $28.2bn in 2005 to $33bn in The growth helped China s iron and steel sector to achieve profit of $22bn in 2006, an increase of 24 percent over The Asia region-including China-accounted for 53.8 percent of the world crude steel production in 2006 compared to one-third in Chart 2: World Crude Steel Consumption Millions EU25 USA China Japan Middle East Source: On the demand side, global steel consumption has increased by nearly 10 percent from 998mt in 2005 to 1.1bnt in 2006 and IISI 6 predicts that global demand would be 5.8 percent higher in 2007 after growing at annual rate of 5.7 percent during China was the driving force behind that growth in demand followed by Asia Pacific then South America and Eastern Europe. 6 International Iron and Steel Institute, 15

16 China s steel consumption has reached 398.1mt in 2006 accounting for 36 percent of global steel consumption compared to 13.5 percent in Domestic consumption rose by around 20 percent a year during compared to a 1.6 percent during 1990s. However, steel consumption per person in China and India, which is 250kg and 35kg respectively, is relatively low compared to 600kg in Singapore, and 399kg in the EU and the US. To curb the imbalance between supply and demand, Asian countries have taken steps to cut their production of steel. In China, some 7 propose that domestic steel makers need to cut their production by 5 percent to avoid falling prices and the consequent widespread losses that many companies would incur. The government intends to consolidate the domestic steel industry around six large steel makers producing higher value-added products. These companies would be encouraged to restructure or even take over small-scale producers that tend to have outdated equipments, poor infrastructure, and higher operating costs. The motive is to screen initially the 66 biggest iron and steel producers out of nearly more than 800 steel enterprises. These big companies have earned combined profits of $13bn in 2006 compared to $9.5bn in 2005 with annual increase of 36.8 percent while the steel sector s total profits have increased from $15.7bn in 2005 to $22bn in However, the proposed 5 percent output reduction is likely to cause bankruptcy among the small-sized steel makers, of which 14 have already reported losses. Also market share of China s ten biggest steel makers fell slightly from 34 percent of 349mt in 2005 to 33 percent of 418.8mt in 2006 though their combined production increased from 117.5mt in 2005 to 138.4mt in This indicates that the consolidation is becoming more urgent. The government may exert strict control on new project approvals and stop any major capacity expansion as well. To help rationalize the supply side, the Chinese regulators have devised a 7 The Chinese Association for Iron and steel. 16

17 five-year plan to ease the current excess and slow the demand for iron ore. By 2007, the plan will reduce 55mt of steel making capacity focusing on outdated blast furnaces producing pig iron. By 2010, the plan is expected to shift production capacity of nearly 100mt of iron ore, pig iron, and raw cast iron to producing crude steel. Also the plan emphasizes improving technology, capital investment and environment protection measures. This move encouraged more product differentiation and highlighted the need to replace the abundant lower value-added products in the Chinese market by higher value-added products, which are in short supply in view of the growing demand for such products. These products include cold-rolled steel plates, cold-rolled silicon steel sheets, zinc-plated steel plates and steel pipes used in automobiles and appliances. The plan to cut steel production may signal downward pressure on surging international iron ore prices as China s demand for iron ore slows. China became a net steel exporter of 30.4mt by the end of 2006, and this excess supply of steel from China in global markets is likely to affect steel prices. However, the magnitude of price fall will depend on how far steel producers are responsive to the production cut plan. In 2006, China exported 40mt of finished steel products and over 9.2mt of semi-finished products. Its import of both finished and semi-finished products were 17.5mt and 1.3mt respectively. China s steel exports are likely to fall by 10mt or more than 20 percent in 2007 as a result of government policies and a growing trend towards protectionism, according to China Iron & Steel Association (CISA) officials Implications for Global Steel Prices Cost pressures on the steel sector would persist as iron ore contract prices, normally less than the spot price, have increased markedly by 71.5 percent in 2005, which helped mining groups enjoy 8 South and East Asia Iron and Steel Institute, February

18 extraordinary profits. As a result, much of these profits have been assigned for investment in expanding old mines and developing new ones. If prices continue to increase, the Chinese steel companies will suffer losses and would have to cut iron ore procurement. However, increasing supply of iron ore from traditional suppliers such as India, Australia, Brazil, and also the Ukraine may offset this upward trend in prices. Indeed, when the global market cycle slows, there is a possibility of a glut. China s iron ore imports have increased by 18.7 percent from 275mt in 2005 to 326.3mt in While China accounted for 40 percent of 687.5mt worth of global iron ore trade volume in 2005, it is expected to account for 51 percent of 895mt worth of global iron ore trade volume by 2010 according to Iron and Steel Statistics Bureau 9. Steel supply has been reduced recently in the US and the EU by 5.8 and 3.6 respectively. This reduction, however, is likely to be offset by higher supply from China, especially to markets such as NAFTA and the EU. In 2006, the US was the top steel importer with 40.4mt, followed by EU25 with 38mt. China was the top steel exporter with 49.2mt, followed by Japan with 34.2 mt, and Russia with 31mt. After declining in 2005, global steel prices recovered during the first half of 2006, although they remained soft in China and are likely to remain so unless China succeeds in its effort to consolidate supply in its domestic steel market through tight fiscal measures and the elimination of export rebates. Government spending is crucial because export rebates and subsidies, in China and the OECD, are distorting the market for steel prices. 9 March

19 Chart 3: Steel Price Forecast (USS/Ton) Source: In the EU and the US, average prices were falling because lower prices of imports from Asian markets were inducing relative prices of steel to level off. The escalation in costs of raw materials and in steel prices in 2004 led to a surge in inventory building in early 2005 in the EU and the US to hedge against future price increases. But the supply of steel, mainly hot rolled sheets, has increased markedly from China during 2005 and 2006 and prices have declined afterwards. Such prices are likely to move upward as demand increases and supply is rationed. However for cold rolled, supply remained tight as it fell short of demand during

20 Chart 4: Iron Ore Contract Prices (US$ Cents/dry metric ton unit) Source: CVRD, Wall Street Journal, US Steel and other steel producers. Chart 5 : Flat-Rolled Products Transaction Prices $/Ton Hot Rolled Cold Rolled Galvanized Source: Peter Morici Manufacturing and Steel Prices paper presented at the National Press Club, Washington, D.C. on 15 February The chart shows that steel and iron ore prices in dollars per ton, have been very volatile, especially in Price volatility in general has been common in the world market but global steel prices, in particular, have risen at a greater magnitude. In particular, the higher costs of health care and 20

21 pension obligations in the US have constituted cost-push factors in the price increase. In the most recent edition of The Economist Intelligence Unit, Global Outlook (May 2007), the EIU forecasts steel prices as follows (US$ per ton): 2007: $574, 2008: $435, 2009: $425, 2010: $500 and 2011: $ The Current Stance 5.1 Industry Structure Global steel industry is fragmented and only percent of global steel production is concentrated in a few large steel companies. For example, in the EU a few large firms have a combined market share of 75 percent whereas the remaining 25 percent of market share is scattered across many small producers. World regions, however, differ with respect to their degree of fragmentation. The steel industry is undergoing a period of structural change, through mergers and acquisitions, to consolidate mining and steel assets into a small number of holding companies. The incentive came as big steel companies managed to sustain good profits and enjoy relatively healthier balance sheets boosted by higher steel prices in the last few years. Other drivers of global consolidation include: easier access to international capital markets and the reduction in barriers that existed on cross-border transactions. 21

22 Chart 6: Biggest Steel Producers in 2004 vs mmt in 2004 $bn in mmt in Mittal Arcelor Nippon Steel JFE POSCO Shanghai Baosteel US Steel 0 Arcelo Nippon /Mittal Steel JFE POSCO Baosteel Tata Shandong US Steel /Corus Source: A recent example of global consolidation is the acquisition of Arcelor by Mittal for $32.2bn which aims at increasing market share of the merged entity across continents by achieving economies of scale. The merger of Mittal Steel of India, the biggest with total production of more than 60mt, and Arcelor of Europe, the second biggest company with total production close to 50mt, accelerated the move towards global consolidation that began earlier. Mittal took over International Steel Group (ISG) of the US in 2004 and has taken control of Krivorozstahl of Ukraine. In Europe, the merger of Arbed, Acerelia, and Usinor formed Arcelor, which later boosted its Latin American interests by acquiring Dofasco as well. Mittal has shown interest in buying minority stakes in Chinese companies and recently bought 37 percent of a steel pipe maker in China. Nippon Steel and Posco, Asia s two biggest steel makers, agreed on a five-year tie-up in 2000, which was extended in Tata, an Indian steel company, has recently acquired the UK s Corus Group for $12.2bn to create the world s sixth largest steel producer 10. US Steel, the largest integrated steel producer in the US, initiated talks in 2006 to acquire AK Steel, the third largest US based steel maker. The merger would create a steel producer with global production capacity approaching 30mtpy, placing it among the top ten largest in the world. In 10 The Economist, February 3,

23 May 2007, Arcelor Mittal showed interest in the AK Steel company and may offer about $4.5bn for the company according to the Financial Times website 11. However, such overseas possible acquisition would be subject to US regulatory review and there is a tendency for US authorities to resist foreign takeovers, especially in sensitive sectors. The above chart 12 shows that the biggest producers are located in Asian countries, mainly India, China, Japan, and Korea. Their combined production of 287mt accounted for nearly 23 percent of global steel production in The world s five biggest steel makers produced 19 percent of global output in 2006 up from 14 percent in Mittal-Arcelor is the biggest steel producer in the world with more than 100mtpy as well as global operations with subsidiaries and plants across four continents. However, the expansion of the Chinese market continued to be a major driving force behind the steel business, as the number of Chinese companies listed in the top fifty-five steel companies worldwide has reached fifteen. The top fifteen steel producers in the world have a combined production of 435mt of crude steel, accounting for 35 percent of world steel production in 2006, which stood at nearly 1.24bnt. The biggest 7 crude steel producers have combined total sales of $186.4bn out of nearly $500bn that the global sector generated in These companies benefit from relatively cheap labor and are located in growing steel markets as well as close to mines of raw materials. Recent steel merger activities are driven mainly by the desire of steel companies to strengthen their negotiating power with suppliers of raw materials ( i.e., iron ore) Mittal, for example, has large capital stock in areas where iron ore mines exist in Australia, Brazil, Ukraine, and Russia. It has purchased mines worldwide that have so far satisfied 82 percent of its iron needs. The company intends to be self sufficient in iron by creating its own mining in Liberia, Bosnia, Mexico, and Kazakhstan, or through acquisition of The Economist, February 4,

24 Ukrainian mines. Its mines in Liberia will produce 10mtpy, while mines in Bosnia, Mexico, and Kazakhstan will produce each 2.5mtpy by Mittal also acquired mines in Ukraine with capacity to produce 11mtpy by The merger between Mittal and Arcelor does not represent a threat to market competition since Mittal-Arcelor has aggregate steel production of around 100mtpy, representing 10 percent market share. However, one would expect that 10-20mt producers are likely to be the marginal producers to disappear as a result of market consolidation. The attempt of Canadian subsidiary of Mittal Steel Company to acquire Canadian Stelco was an attempt to penetrate the NAFTA market in late Russia s biggest steel maker, Evraz agreed to buy Oregon Steel Mills, a US company, for $2.3bn in order to boost its crude steel processing capabilities in North America and Europe for making higher value products such as rail tracks and oil pipes 13. Major Chinese steel makers Shougang Group and Tangshan Iron& Steel have agreed to coordinate their raw material purchases and steel sales, in what could be another step towards an eventual merger that would create one of world s largest producers. Mittal and Posco are each planning to build multi-billion dollar steel plants in eastern India. Also a Russian steel company is considering an Indian partner to build a 10 mty steel plant in the Indian state of Orissa to capitalize on the potential availability of iron ore. All these examples reinforce the trend towards consolidation in the steel business. 5.2 Industry Challenges There are many factors that affect the current outlook for global steel growth and prices. These factors can be either exogenous or endogenous, depending on whether one can control them or 13 November 20,

25 not. For example, tax differentials and trade barriers as exogenous factors have contributed to the rising costs of the global steel industry and caused reduction in competitiveness. In the USA, direct taxes are placed on capital and labor whereas in Europe indirect taxes such as VAT are common. According to the WTO rules, the rebate of direct taxes on exports are not permitted, whereas the same rules do permit rebate of indirect taxes on consumption. This means that the U.S. steel companies would be worse off compared to their counterparts in Europe. Russia and Ukraine impose tax on their Ferrous Scrap while India and USA follow Anti-Dumping measures in an attempt to combat the huge increase in their steel imports. China maintains tax rebates on certain products as part of its policy for export quotas. Overvalued dollar exchange rates in 2005 coupled with higher costs of health care have helped to reduce the competitiveness of the US steel industry. Endogenous factors such as firm size, product differentiation and innovation also represent challenges to the steel industry. Maintaining an undervalued currency of major steel exporters such as China, Brazil, South Korea, and Japan vs. US Dollar have promoted their exports and forced US producers to cut production. In January 1993, China devalued the Yuan from 5.7 to 8.7 per dollar and kept the Yuan pegged at nearly 8.3 per dollar until it revalued the Yuan again in July 2005 by only 2 percent. The effect on the Chinese economy of the earlier devaluation of the Yuan resulted in encouraging FDI and boosted investments in China. Whereas the minor 2 percent revaluation of the Yuan in 2005 has done nothing to cool the investment boom or reduce FDI inflows. The Entry / Exit Barriers are crucial since major steel markets such as the US and the EU usually impose import tariffs and quotas as barriers to their markets, especially when they view the Yuan as drastically undervalued against the dollar and the Euro. Moreover, they have the tendency to resist foreign acquisition of domestic firms. On the otherhand, countries like Australia, Brazil, 25

26 and Ukraine have enjoyed easier regulation, abundant raw materials, and cheaper cost of labor, therefore, US and EU steel companies have acquired factories and invested in these countries. This helps in providing US and EU companies with raw materials from the ore and mining interests they own outside their boundaries. 6. Cost Structure Analysis Cost structure is relevant when it can be identified with different types of costs a given steel company is likely to incur. These costs include raw material, energy, transportations, operating costs, transaction costs, and social costs implied by the cost of negative externalities 14. The analysis should include exchange rate variability and terms of trade since steel is a tradable commodity and the industry is cyclical. The extent to which natural resources, like gas and oil are abundant and the seasonality of its use are relevant in analyzing the cost structure as well. For example prices of natural gas in cold climate countries tend to be higher in winter than in summer as the increase in demand for heating purposes reduces the amount available for the metal industry. Seeking alternative fuel supplies such as coal, diesel, or oil and the environmental concerns inherent in the use of these other sources of energy also matter. The global steel industry has a relatively homogeneous cost structure across steel companies i.e., each company faces declining marginal costs and rising fixed costs. Also, the highest portion of a given steel company s cost structure is raw material costs, followed by energy, transportation, then labor costs. The industry enjoys relatively free entry (no real entry barriers), but higher cost of exit. The free entry condition is likely to make profit margins thinner due to the high probability of new entrants. In the late 1980s, some of the US steel companies were forced to 14 Negative externalities imply costs that are imposed by society and its laws and regulations (e.g., imposed health, insurance and environmental costs, social pensions, national security, etc.). 26

27 exit through liquidation of assets after suffering severe financial problems. The demand curve for steel is relatively flat i.e., no single firm can dictate market prices, for example, by reducing production to raise prices. As global demand showed signs of weakness during that period (1980s), the industry cut output yet prices were not very responsive and continued sliding. The world crude steel production has been growing at nearly 7 percent annually since 2002, and as a result, the world iron ore trade excluding the spot market sale has grown by 9.1 percent from 550mt in 2004 to 600mt in 2005 and is expected to reach 895mt by 2010, with a growth of 49.2 percent for the period. The spot market price of iron ore is higher with a premium of nearly $20 over the contract price which is negotiated annually. Benchmark iron ore prices increased by 19.1 percent in 2006 and is predicted to grow moderately by 9.5 percent in 2007 to reach 83.4 US Cents/dry metric ton unit. These modest rises, after the marked jump of 71.6 percent in 2005, were due to falling freight rates, high spot market prices, and the appreciation of domestic currencies against the US dollar. A weaker dollar tends to raise costs in dollar terms and improves US exports but is likely to push up the cost of importing iron ore denominated in dollars. The historic rise in 2005 was justified by strong demand from China while iron ore supply remained tight. This rise may have acted to encourage companies to increase efficiency and labor productivity as well as to increase incentives among steel producers to acquire mining companies to control input costs. An example was a bid by Mittal Steel and Tata Group for South African based company (Highveld) that has huge reserves of iron ore. Highveld mines its own ore and uses electricity rather than costly coking coal to process the iron ore and also makes hot metal in Electric Arc Furnace (EAF) rather than Blast Furnace. 27

28 In Russia, the biggest iron ore producer, with 45 percent market share, produces 39mt of iron ore and 6.3mt of crude steel. There is a growing tendency for steel companies to look for other possible substitutes and trade iron ore for billets, slabs and pig iron. Also, there is an incentive for companies to use conversion contracts of iron ore to pig iron and negotiate contract prices as a way to handle rising input costs. Soaring demand from China in 2005 prompted miners and energy producers such as BHP Billiton to spend $29.4bn expanding and building mines. On June 20, 2006, China s biggest buyer of iron ore, Baosteel Group, agreed to a 19 percent price increase for iron ore following extended negotiations with the world s three biggest mining companies, BHP Billiton, Rio Tinto and CVRD. As a consequence, share prices of both BHP Billiton and Rio Tinto gained 3.1 and 2.5 percent respectively following the agreement on June 21, On December 22, 2006, Baosteel agreed to another 9.5 percent price increase for iron ore following negotiations with CVRD, the largest iron ore producer in the world which controls nearly two thirds of the global iron ore trade. Consolidation and privatization of government owned companies are likely to make the industry less inclined to be oversupplied with low value-added products to maintain output quotas. This will reduce steel price volatility and increase long-term profitability. Product differentiation towards higher value-added products will improve a company s ability to survive. Steel makers outside Asia, where many plants are hindered by relatively high fixed costs as well as labor charges, are becoming more optimistic about their chances of survival. The reason is a partial shift towards higher value-added products, and in this respect, Mittal priced Arcelor s steel mills in France, Spain, and Belgium for their technological sophistication, which explains the high price offered by Mittal to acquire Arcelor. One may also surmize that chances for niche producers in the GCC region, specializing in high value added products (e.g., USCO), are better if they focus 15 June 21,

29 on meeting regional demand for such products, utilizing their competitive advantage in lower shipping costs, lower energy costs and relatively lower labor costs. In this regard, the US steel industry has a positive outlook implied by a price earnings ratio of 7.0 which is below market valuations of around 15 for the S&P 500 index. As their shares have gained momentum, US steel companies have initiated talks about the prospect for merger and acquisition as seen in the US Steel Corp talks to buy AK Steel Corporation. While S&P 500 has gained 6 percent for the year till May 2007, a comparable index of steel producers has increased by 39.1 percent during the same period 16. Stock yields of Nucor and the US Steel Corp have increased, on annualized basis, by 21.1 and 52 percent respectively for YTD till May 16, This came as a result of higher prices and rising demand in non-residential construction which in turn enabled both companies to reach a record ROE 17 of 38.6 and 36.6 percent respectively. In the long run, the industry is expected to benefit from synergy effects stemming from further consolidation, a lower cost structure, and a continuation of the decline in the US Dollar. The above analysis of the cost structure of the steel industry shows that the highest portions of a given steel company s cost structure are raw material costs, energy costs, and transportation costs. The steel industry has a positive fundamental outlook, which indicates an upward trend in share prices. Selling prices for metals have more than doubled since 2002 and share prices in the sector have nearly quadrupled over the same period. Yet raw material and energy costs have continued to rise for steel producers worldwide. The three biggest mining companies have greater negotiating power over the price of their iron ore. This along with higher energy and transportation costs, has led to the squeezing of profit margins for steel companies. A shift in ROE: return on average equity. 29

30 global demand would impact steel prices given the cyclical nature of the industry. In countries that have pegged exchange rate regimes to the US dollar, such as the GCC countries, where interest and exchange rates are tied to the US rates, prices of tradable goods would import global disturbances to domestic markets. 7. Regional Steel Market Analysis in the Middle East (ME) Supply and Demand Crude steel production in the Middle East is projected to increase markedly by nearly 70 percent from 15.4mt in 2006 to 26.1mt in Metal Bulletin Research (MBR), December 2006 issue, states that capacity expansion will reside mainly in Egypt, Saudi Arabia, and UAE. Egypt will have added capacity expansion of nearly 2mt, Saudi Arabia 5mt, and UAE 1.5mt by Also, finished steel products capacity will increase by 46.7 percent from 22.9mt in 2006 to 33.6mt in Main capacity increases include UAE by 3.1mt, Egypt by 2.5mt and Saudi Arabia by 1.9mt. For raw steel production, MBR argues that it is expected to reach 51.5mt and 62.9mt in 2007 and 2010 respectively. However, the bulletin contends that such steel production was not sufficient to satisfy the apparent steel demand growing at 9 percent in 2006 and a similar rate in This in turn has led the ME to become a net importer of semi-finished steel, mainly billet, slab, and HR coils in which billet and slab are intermediate materials used to produce long and flat products. The large increase in consumption of semis and flat products has been partly met by imports, which have risen from 6.4mt in 1997 to around 25mt in 2005 and is expected to reach 30mt in Middle East refers to: Bahrain, Egypt, Iran, Iraq, Jordan, Kuwait, Lebanon, Oman, Palestinian Authority, Qatar, Saudi Arabia, Sudan, Syria, Turkey, UAE and Yemen. MENA refers to all the above in addition to: Algeria, Libya, Morrocco and Tunisia. 30

31 Demand in the region is dominated by long products, most of which are used in construction. Long product output such as rebar will be the dominant form of steel production, although its share of output will be declining. Rebar output grew from 14.1mt in 1997 to 21.6mt in 2004 and is expected to reach 28.9mt in Although the Middle East has been one of the world s active regions for steel plant suppliers in recent years, its steel plants are mostly starting from a lower steel-making base especially in flat products. Total flat products production has increased from 9.9mt in 1997 to 18 mt in 2004 driven mainly by Turkey and Iran and to a lesser extent Saudi Arabia and Egypt. In the Middle East, most current investments are driven by growth in domestic demand emanating from a strong construction boom. Steel demand in the region is expected to increase from 70mt in 2007 to around 90mt in GCC steel demand will be in the range of mt during the same period. GCC countries especially Kuwait, UAE, Saudi Arabia and to a lesser extent Oman and Bahrain are net importers of products such as ingots and semis, steel tubes, seamless, hot rolled rod in coil, cold drawn wire in coil, welded tubes, and cast iron pipes. However, net imports are likely to fall back to 5.4mt by 2010 with the expected increase in domestic production. In flat products, Egypt will remain a net exporter while the net import requirements of Saudi Arabia will remain around 1mt. However, the growing consumption from the UAE, Iraq, and other smaller states in ME will cause overall imports to rise. In billet, the higher demand in the UAE, Syria and, Sudan will offset falling demand from Saudi Arabia. Most production in the region is from Direct Reduction Iron (DRI) which forms an important component of ME expansion, utilizing natural gas which is plentiful. Production of DRI had 31

32 increased from 8.3mt in 1997 to 13.7mt in 2004 and is likely to reach 28.6mt in 2010, boosted by major projects in Saudi Arabia, Iran, Qatar, Oman, Bahrain and the UAE. However, the increase in DRI will require importing more pellets, scrap, and iron ore for direct reduction plants. Table (2): Consumption of Iron ores, Pellets, and Scrap in the production of DRI in the Middle East ( ) in million tons Iron Ores Pellets Scrap Iron ore oxide pellets are reduced via a hydrocarbon gas, usually methane, to produce DRI which then may be converted into steel using an Electric Arc Furnace (EAF) 19. Pure DRI is the feed for around 60 percent of steel produced in MENA, with around 25 percent from scrap and 15 percent from blast furnace production. DRI output was estimated at around 10mt in 2006, according to HSBC report, and is expected to increase to 19.3mt by 2010 which will require more imports of both iron ore and scrap in the region. Arab Countries have DRI / EAF plants with total capacity of 8.75mt. Qatar and Saudi Arabia have started their production in 1978 and 1983 respectively with production capacity at 0.72mt and 3.65mt each, then Egypt with 2.92mt in 1986 and Libya with 1.46mt in Middle East iron ore imports have increased from 14.6mt in 1997 to 22.2mt in 2004 and are expected to reach 42.5mt by 2010, even with Iran planning to double its own iron ore production capacity to 25mtpy by Outside Iran, iron ore is only mined in Turkey and Egypt, and total output is 18.6mt. ME iron ore, however, is a low grade iron ore relative to Australian or Brazilian ore. The UAE, Saudi Arabia, Oman, Qatar, and Egypt take most of their imports in the form of pellet. Such imports reached 13mt in 2004 and are likely to reach 25mt in Bahrain imports iron 19 HSBC report on SABIC, April

33 ore fines as an input for the pellet plant, which are then re-exported. Pellet in Bahrain is produced by Gulf Industrial Investment Co. (GIIC) which is a subsidiary of Gulf Investment Corporation (GIC). Other countries that produce iron ore since 1979 include Mauritania, Algeria, and to a lesser extent Saudi Arabia which started producing in 1997 with 2.9mt capacity. Scrap generation in the ME is relatively low and stood at around 5mtpy over , but has since increased to 8mtpy due to rising steel prices, production, and consumption over the period. Scrap consumption in the ME was less than 12mtpy until 2000, excluding Turkey, and the region was a net exporter until Volumes of exports from Iraq, Israel, Kuwait, Lebanon, Sudan, Syria, the UAE and Yemen offset imports into Egypt, Jordan, and Qatar. As new capacity materializes, the region, excluding Turkey, will become a net importer of over 1mtpy due to rising demand from Egypt, Iran, and Saudi Arabia. Turkey is the biggest single importer of scrap in the world. The region is likely to become a net exporter of Hot Briquetted Iron (HBI) and Libya has been a regular supplier of HBI to Spain and Italy. Meanwhile Qasco in Qatar is a regular buyer of Venezuelan HBI to maintain its steel production but soon will become a net exporter once its new 1.5mtpy DRI plant starts operating in In Oman, Al-Ghaith plant of Hamil Steel which is due to start in 2007 will also be a small net exporter of HBI. The Sohar Industrial Port (SIP) Company, based in Oman, has signed a MoU with CVRD in November 2006, to conduct a feasibility study into setting up an iron ore pelletising plant worth $1bn 20. The proposal involves constructing a facility with an initial capacity to produce 7.5mt of pellets for DR annually with the potential to expand output to 22mt if the project is implemented. Production is supposed to 20 March