Looking for a relatively safe bet in a volatile equities market? Some analysts think steel stocks might be worth a look.
Wall Street analysts are becoming more and more bullish on U.S. steel producers, either increasing their buy ratings or their earnings estimates with prices per ton climbing dramatically since October. The average price of one ton of steel jumped from $545 in December to $665 in February and is already being quoted as high as $800 for May orders.
Indeed, the Standard & Poor's Steel index was up nearly 4% year-to-date through mid-March, vs. a 12% decline in the S&P 500-stock index.
Some fund managers, too, are bulking up on more shares of companies such as U.S. Steel (X), Nucor (NUE), and Commercial Metals (CMC), whose gross margins are more than keeping pace with rising raw material costs due to price hikes.
That the industry is able to hike prices and boost its margins with the economy on the brink of recession seems counterintuitive, to say the least. What's wrong with this picture?
Nothing, say analysts. It's simply the law of supply and demand at work. The steel industry has structural capacity shortage in North America of about 30 million to 40 million tons a year. Imports from foreign steel producers are less likely to make up that shortfall, due to a weaker U.S. dollar and rising freight costs.
Inventories Aren't Climbing as Usual
Low-cost producers from Brazil, Russia, and India would typically be the most logical exporters, but there are multiple reasons why new capacity isn't being added there, from a scarcity of capital due to political risk in Brazil to government bureaucracy and local opposition in India.
Most steel imports are coming from China, which has excess production capacity, but those imports are down an estimated 50% in the past six months. Chinese producers, already burdened by freight costs that can reach more than $150 a ton, now have an added disincentive to export their steel—an export tax imposed by the government in December.
The drop in imports has given U.S. producers remarkable pricing power over the past several months, even in the face of accelerating weakness in demand, as automakers, construction companies, and other steel-consuming industries pull back amid economic contraction.
Falling inventory at suppliers and service centers, down to roughly 2.5 months' worth of supply from an average of 3.2 months over the past three years, have not only buoyed prices but have also extended lead times for steel mills' order books, to 12 from 3 weeks, says Aldo Mazzaferro, an analyst who covers steel stocks for Goldman Sachs (GS) Global Investment Research.
At this stage of the steel cycle, service center inventories would normally begin to climb, since service centers typically rebuild inventories when they drop below 2.7 months' worth of supply. Meanwhile, a more-than-40% hike in spot market prices would usually attract imports, which would then push service center inventories higher, analyst David Gagliano wrote in a Credit Suisse (CS) Equity Research report on Mar. 18. "But this isn't happening, and we are now heading into the seasonally strong second quarter demand period," he wrote.
Inventories at U.S. service centers could remain abnormally low for a prolonged period since global production is already operating near capacity, prices in other countries are still higher than in the U.S., and further depreciation in the dollar makes it even more expensive to ship steel to the U.S., the report said. Gagliano predicted the strong pricing will extend into 2009 and maybe beyond despite a weak end-demand in the U.S.