Sunday, July 6, 2008

Is the Buck Finally Stopping for Steel?

While steel has had an amazing run, my thesis is at some point prices reach a level customers balk. But that's been the thesis in crude oil too - and so far the voracious appetite by certain countries has offset the demand destruction in others. However, we have been warning of the first signs of demand falling [May 17: WSJ - Fast Rising Steel Prices Set Back Big Projects]

At some price point it no longer makes sense to build things, even for China (although they are forced to, to swallow up the masses of populace moving from the countryside to the cities). I have to say I've been amazed that the steel companies can continue to pass along all costs to their end customers but at some point this stops. The point seems to be closing in.

In the past week we are seeing increasing signs of stress - ArcelorMittal (MT) Says Half of Customers Rejected $250 Surcharge
  • ArcelorMittal, the world's largest steelmaker, said about half its U.S. customers refused to pay a $250-a-ton surcharge that was added in May to make up for soaring raw-material costs.
  • ArcelorMittal will seek higher prices from those that rejected the surcharge on fixed-price contract shipments in the next round of annual discussions, Lou Schorsch, head of the company's flat-rolled business in the Americas, said today in an interview in Chicago.
  • ``With about half the customers we've had some good dialogue and good resolution where we've made some adjustments,'' said Schorsch, who is responsible for about $21 billion of the steelmaker's business in the Americas. ``The other half have said, `We can't afford to eat it.'''
  • The company is trying to take advantage of soaring global demand to pass on higher costs for iron ore, the main ingredient in steel, and the energy to produce and ship the metal. U.S. steel prices rose to a record $1,052 a ton in June, 82 percent higher than a year ago, Purchasing Magazine said yesterday.
  • ArcelorMittal in April agreed to pay Brazil's Cia. Vale do Rio Doce, the world's largest iron-ore exporter, 87 percent more for the ingredient as rising demand from China pushed up prices. ArcelorMittal also may pay Cleveland-Cliffs Inc., North America's largest iron-ore producer, about 60 percent more this year. Costs for coke, scrap, energy and transportation also are rising.
  • Some steel mills may pressure reluctant customers to accept surcharges by threatening to reduce the amount of metal they will sell, Aldo Mazzaferro, an analyst at Goldman, Sachs & Co. in New York, said in a May 12 note to investors. Contracts usually specify the price for the steel rather than volume to be sold, he said.
And just today in the Wall Street Journal
  • Some automakers are refusing to pay surcharges on steel contracts they agreed to, the Wall Street Journal reported, citing Aditya Mittal, chief financial officer of ArcelorMittal.
  • Some of these automakers have threatened to challenge the surcharges in court, the Journal said, citing people familiar with the matter. The newspaper didn't identify any companies refusing to pay.
  • The resistance is one of the first strong signals to steelmakers that their hardest-hit customers have reached a tipping point and may not be able to withstand higher prices.
So we finally begin to reach the very interesting point of many cross currents. Is the demand in China so great for (insert any commodity here) that if European or US customers say no, then (insert commodity) producers can just take their product elsewhere and get ridiculous rates (and folks a 1 year increase of 82% in steel or 105% in crude oil *is* ridiculous - demand is not growing at that rate). Or will the curtain begin to fall and will producers of said commodities begin to be unable to pass along costs? I don't have the answers - some of these moves upward in price have gone far above my near term estimates - while I am a long term World of Shortages guy, demand is not increasing at triple digits year over year. But prices are for certain things. So the path ahead will be very interesting.

Now unlike Ken Heebner of CGM Funds I've taken a completely different tact in approaching the steel boom - I've placed our investments into the inputs - iron ore and metallurgical coal - while his money (since last quarter) is concentrated in the actual steel makers. From my end, if the steel makers finally reach a ceiling in price, their margins will get squeezed (and in theory their stocks should suffer, not their suppliers). Also much of the supplier product pricing is longer term in nature (1 year contracts) versus a much more fluid situation at the steel maker level. But one could make multiple arguements - (1) eventually the same pressure would travel downstream to their suppliers - i.e. steel maker says to iron ore producer we cannot charge our customer any more so we cannot pay a new higher price for iron ore.... causing prices to stagnate or fall for suppliers (very plausible) or (2) even if the suppliers can maintain high prices the stock market won't care and "throw the baby out with the bathwater" and punish the entire supply chain (also very plausible). I don't know how it will work out, but I've tried to think 3-4 steps ahead and try to position us for what I see as this eventuality. And hopefully the market does not devolve into situation 2. Frankly nothing can go straight up in price without causing cut backs. Cities and states simply cannot do projects at costs ABC, auto makers cannot build product at profit at costs ABC, refrigerator makers cannot make profit at costs ABC, etc. So the buck will stop - at what price we don't know. And how the individual components of the supply chain will be affected we also don't know.

With that said I do believe there is still quite a bit of upside surprise in 2009 and 2010 earnings in many of the suppliers to the steel industry even at current prices (i.e. if prices did not go one iota higher), and for U.S. Steelmakers they have the advantage of the ever limp US Peso so their pricing on the world market, will at least be "relatively" cheap (i.e. producers in stronger currency markets will see their demand falter first). But this speaks to the timing of investments - even the best thesis are going to have their ups and downs and speed bumps. The world does need steel to build it's infrastructure. But at what cost? Only federal governments can truly afford to build project after project at losses. Once again - many moving parts and we'll need to monitor it over the coming quarters and years.

I repeat it every week - inflation is a tax on all things, producers and consumers. If consumers cannot accept price increases - that means producers margins will buckle. While Wall Street tends to sneer at Main Street as inconsequential - corporate profits are the lifeblood of stock valuations. So if/when producers profit margins buckle that has a real impact on stock valuations. It's all connected in the end.

Long Cleveland Cliffs, Vale in fund; long Cleveland Cliffs in personal account

Note we use CVRD for the label for Vale since this is what it used to be known as.

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