The growing strength of steel

Steel prices have been soaring, but will they continue to do so? Or are we about to see this industrial metal lose some of its shine?

Something very strange is going on, says the Daily Mail. All over Britain manhole covers are going missing. Last month 44 disappeared overnight in Surrey. And in February Cambridge County council announced the loss of 150. And it's not just in the UK. Shanghai has lost 1,826 covers this year, says The Daily Telegraph. What's going on?

The answer is simple. Manhole covers are made out of steel and the price of steel has soared over the last year. Between October last year and January of this year, the prices of various steel products rose 25-30% in the Far East and 55% in the US. And they have continued to rise. Indeed, a few weeks ago, Corus, the UK's largest steel producer, announced plans to increase prices by another 20% or so on top of the 18-20% price rises it has already introduced this year. Only a few years ago your average manhole cover was worth a mere £40. Today, the price of scrap metal has risen so high that they fetch £120. This is heady stuff for an industry that has seen prices fall for the last 20 years, says Alf Young in the Glasgow Herald. In the US alone, since 1997 40 steel companies have gone bankrupt. Yet today, "everyone who has anything to do with buying or selling steel or the raw materials that go in to it cannot currently talk about anything else. Prices are rapidly going right through the roof." In Western Europe hot roiled coil - the type of steel that is used to make domestic appliances and car panels - has gone from $270 a tonne in the middle of last year to $500. And traded coke prices have tripled since the end of 2001 (the costs of making steel include coal/coke, iron ore and shipping). The price of scrap rose by 30-50% in the second half of last year and the spot price of shipping iron ore and coal rocketed by 75% in the fourth quarter of 2003.

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This is all thanks to China's voracious appetite for steel, says Lloyds List. The country has been investing heavily in its own steel-producing facilities and is making record amounts of steel. Last year its production jumped 21.2% to a record 220.1 tonnes from 186 million tonnes in 2002. This was not only the first time that a country had produced more than 200 million tonnes of steel, it was also more than the combined output of the USA and Japan, the world's second and third-largest producers. But even that wasn't anywhere near enough for China "to satisfy the craving of its prodigious economic growth". Demand for finished steel products rose 22% to 257 million tonnes from 211 million in 2002. The result? China's steel imports rose from 26.9 million in 2002 to 39.5 million tonnes in 2003, "making it by far the largest steel-importing country in the world". And this disparity between supply and demand will "remain a big influence this year". According to the Iron and Steel Statistics Bureau, China's crude-steel production is set to rise by 20% this year to 265 million tonnes, but demand for steel will hit 290 million tonnes.

This all means there is a shortage of steel in the world, says CNNMoney.com. And it isn't going to end any time soon. Not only has there been a serious lack of capital investment in the steel industry over the last decade - meaning that supply cannot be increased fast - but there are few indicators that demand is going to fall off.

Not if the Chinese have anything to do with it, says Morgan Stanley. Demand from there will be driven by two things. The first is manufacturing outsourcing from the US, Japan and Europe, which will keep factories busy for years. The second is the need to build an infrastructure to facilitate the migration of the Chinese from the country to the cities. China's economy has grown by 7.3% compounded for the last 18 years and "we estimate that it will grow 7-7.5% over the next five".

And its per-capita income is approaching $1,000. When Japan, South Korea and Taiwan reached this level, their metal consumption grew at double-digit rates for at least the next decade. Developing economies need houses, pots, factories, transport and rail facilities. All these things are metal intensive to build: if the Chinese economy grows at 7% a year, expect metal consumption to grow at around 9-12%. In 1985 China consumed 5% of the world's metals. Today it is 20%. In five years' time it should be around 25-30%. This is a "secular super cycle". Expect it to be strong and long. This has all been excellent news for the steel companies, says BuinessWeek. Last year in the US, as a sub sector, they rose 57.4%. And according to S&P analyst Leo Larkin, the good days are far from over: during the rest of 2004 steel should continue to outperform. In 2003 steel-operating results did not improve as sharply higher raw material costs (iron ore, coal, scrap steel - used in the lowcost electric arc furnace method of production) outweighed the rises in sales and volume. But now pretty much every US steel producer has at least introduced a "surcharge" to offset the rising prices of raw materials. These should lift margins and mean real profits in 2004.

And if those surcharges fall, says Goldman Sachs, "we believe base prices will be raised to offset this". Given an environment of steel shortages in most markets and strong order rates as well as "the improving supply/demand balance" in steel, "no steel company in the world today needs to lower prices to attract business". So far for 2004 first-quarter earnings should be good and second-quarter and third-quarter results "quite a bit better".

And it is this sustainability that investors should be considering. As the good times look more and more likely to continue, so the p/e to be paid for the shares should rise.