Aluminum and Steel: Costs Pushing Prices, So Are We Investing or Gambling?

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

March 9th, 2017

Aluminum and Steel: Costs Pushing Prices, So Are We Investing or Gambling?

  • Aluminum and steel pricing in the US have risen meaningfully off the lows of last year – steel more so because of tariff protection and aluminum because of cost pressures in Asia.
    • Demand expectations for steel may be high; anticipating infrastructure spending in the US, but aluminum is likely closer to real shortages than steel, and aluminum stocks are cheaper.
    • However, as Exhibit 1 shows, steel outside the US is moving faster than aluminum today because of closures and cost pressures in China. US steel could benefit if import prices rise because of cost pressure.
  • Chinese capacity closures have set expectations for a better year in ’17 for both metals, albeit dependent on China discipline, but we see three distinct differences, which favor aluminum.
    • China has 55% of the global capacity for aluminum and exports are needed to meet global market demand. For steel China has enough capacity to supply 87% of the global market.
    • Separately, with the industrial slowdown in China and no stimulus yet in the US, global steel demand growth is slow today, but improving from declines in 2015/2016. Aluminum, on the other hand, continues to grow at 5+% per annum.
    • US steel pricing has had a boost from tariff adjustments – aluminum could also get one.
  • Chinese closures – steel is a polluter – aluminum much less so, but the power needed to run an aluminum plant comes from a coal fired power station, which is also a polluter.
    • While the rhetoric suggests that China is going to keep its focus on pollution control with closures in industries that are contributing the most – coal and steel – we would rather bet on the material with faster growth and the smaller theoretical global capacity overhang.

Exhibit 1

Source: Capital IQ and SSR Analysis

  • A US import tariff for aluminum? There is a case being made to the WTO from multiple countries regarding Chinese exports, and it is also possible that the US acts unilaterally.
    • The US is a large importer of aluminum and semi-finished aluminum parts (e.g. wheel rims) but has many local production facilities idled – CENX would be the major beneficiary of a US tariff, but it would also be good for AA, which might restart capacity.
    • AA is making money from better alumina prices and margins today rather than aluminum.
  • On the steel side, X, WOR and STLD share prices are anticipating a lot today – but stocks are moving on sentiment rather than fundamentals, and a reduction in imports or the framework of an infrastructure bill could still send the steel sector higher – we prefer ATI, CRS and NUE.
    • Other metal stocks – such as FCX and NEM also look more interesting than steel.

Overview

Despite the pullback of the last week, which we believe offers some interesting entry points, the world is growing increasingly more bullish on metals in general, in part due to the investment rhetoric in the US, but in the near-term mostly because prices are rising. Metal prices are not rising because of the rhetoric, they are rising because China production constraints are limiting supply in some cases, because raw material and other costs are rising in China and for aluminum everywhere, and specifically for steel in the US, because of more punitive tariff barriers on Chinese imports.

Aluminum

We have held the view for the last few years that aluminum has the fundamental drivers to be one of the fastest metals to fall back into supply/demand balance. So far we have been disappointed, in part because China has continued its export push, despite higher operating rates and higher local demand, and partly because a large speculative inventory draw-down, which was probably needed, has added to aluminum supply, in our view making the market appear more oversupplied than it is.

Today we have a couple of additional drivers of pricing, the first being costs; higher coal pricing is driving higher electricity costs in China but higher bauxite and caustic soda pricing is pushing up alumina prices also. Capacity closures in China, in line with what is happening in other heavy industries has so far only helped push pricing in line with costs. A more positive sign however, and perhaps a leading indicator of further pricing strength, is that we have a point of inflection in the speculative inventory chart, with inventories switching from becoming a supplier of aluminum to a consumer. Through the last 6-7 years, demand for Aluminum has consistently grown in excess of 5% per annum globally, but from a producer perspective it would have looked around 150 basis points lower for the last two years because of the liquidation of inventories. If inventories start to pick back up – Exhibit 2 – we could see above trend apparent demand growth and this could put further upward pressure on pricing.

Exhibit 2

Source: Bloomberg

Aluminum no longer has some of the relative price advantages it had a couple of years ago when it was at an all-time low versus steel and crude oil (which we used as a proxy for engineering plastics), but prices are not unattractive relative to history and prices for all competing products have an upward bias today. Aluminum has plenty of room to run here before we would be too concerned about demand substitution – Exhibit 3.

Exhibit 3

Source: Capital IQ and SSR Analysis

Steel – a tougher market to get excited about – but that may not stop the stocks from going up!

The big win for steel in the US in 2016 was the successful tariff move. This lifted prices during 2016 and created a margin for US producers for the first time in many years – Exhibit 4. Subsequently, prices in Asia have risen and the gap has closed with the US – Exhibit 5 – but this has more to do with rising costs in Asia, as coal prices have recovered. Coal prices remain very depressed in the US and consequently the US steel producers are not seeing the cost pressures that exist in Asia. Asia coal prices have fallen from their recent peak, but there is a scenario where US steel improves because either import prices rise (driven by costs) or imports slow – for the same reason.

While there have been well publicized plant closures in China both for steel and for coal, China’s steel surplus is huge and so far, prices are only really moving with costs and tariffs and do not suggest any real market tightness – nor are they likely to without substantial further cuts or an unprecedented step change in demand.

This is the big difference between steel and aluminum – steel (so far) does not have an interesting demand growth story. Steel demand is down in China with the slowdown in the industrial economy and real-estate investment, with growth coming only from the automotive sector and machinery. Demand growth is weak outside China everywhere except India and some much smaller emerging economies that do not move the needle. In the US steel capacity is operating at less than 75% – similar to global rates – Exhibit 6. The growth story in the US has been oil and gas drilling, but the industry has overbuilt drilling pipe capacity and even though we see rig counts rising in the US we also see well efficiencies increasing rapidly and it is unclear that there is a linear relationship between rig count and/or oil production and drilling pipe demand anymore. We are consuming steel to build natural gas and NGL pipelines and we expect this to continue.

For the US industry to get real pricing power we would need to see operating rates close to 90% (as seen in 2008) which, with close to 130 million tons of capacity requires additional annual demand of close to 20 million tons, or a significant change in the balance of trade (the US remains a significant net importer). With automotive likely peaking and other segments like energy and machinery stable – construction and defense will need to deliver that growth suggesting close to a 50% increase in demand in those two sectors. For perspective:

  • The Keystone pipeline is expected to consume less than 500,000 tons of steel, 1/40th of the annual demand growth we need.
  • Existing Interstate Highways contain less than 135 tons of steel per mile – to increase demand by 5 million tons (25% of the growth we need) we would need to build 37,000 miles of 6 lane freeways (we currently have less than 50,000 miles of Interstate Highways)!
    • Bridge work to accommodate new and expanded roads is a much larger consumer of steel.

 

Despite the tariffs against China, trade remains the major issue with steel as the US still imports around 30% of what it consumes, depressing local operating rates.

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Bloomberg and SSR Analysis

Fragmentation is the other major problem for steel (Exhibit 7), though the story is not much different for aluminum.

Exhibit 7

Source: Bloomberg and SSR Analysis

In conclusion, Steel is mostly a tariff and possibly a relative cost story in our view (already reflected in X’s share price) – Aluminum is a demand story with a possible tariff kicker – not reflected in CENX and AA’s share prices.

Steel Demand a Problem – Aluminum very Different

In Exhibits 8 and 9 we show supply/demand data for steel and aluminum – sourced from Bloomberg – only data through 2015 for steel, but it shows the China slowdown very clearly. In the aluminum chart, the above and below trend demand are in part impacted by the swings in inventory summarized in Exhibit 2. In both cases some of the demand versus production mismatches are the result of recycled metal use, which shows up in demand and does not show up in production.

The real take-aways from these chats are the continued strength in aluminum demand, despite the industrial production pull back in China, which has had a serious impact on steel demand and created a major capacity surplus in China – China has roughly 1.2 billion tons of steel capacity – which compares to 2015 global finished steel demand of 1.4 billion tons – at capacity China could supply 86% of the worlds need for steel – the equivalent number for aluminum is around 55%. The other major difference however is that the West has closed a lot of aluminum capacity in the face of Chinese competition. For steel, we have seen sovereign intervention to keep marginal steel businesses alive – the UK and France with government intervention and the US with tariffs. Global steel capacity is roughly 2.3 billion tons, resulting in a nominal global operating rate below 70%.

Exhibit 8

Source: Bloomberg and SSR Analysis

Exhibit 9

Source: Bloomberg and SSR Analysis

The Value Lies Outside Steel – Except ATI and CRS

Given the operating rate in the steel industry and the fact that earnings expectations are not that high today (Exhibit 10), it is very anticipatory for these stocks to be trading above normal value – Exhibit 11. We do not have reliable and consistent enough history for Century Aluminum to include the company in the analysis in Exhibits 11 and 12 (which shows skepticism for the group).

Exhibit 10

Source: Capital IQ and SSR Analysis

Exhibit 11

Source: Capital IQ and SSR Analysis

Exhibit 12

Source: Capital IQ and SSR Analysis

CENX does not look that attractive using our return on tangible capital (ROTC) analysis (Exhibit 13) as it sits well above the line – and while the company may have more direct leverage to any border tariff on aluminum or targeted US tariff against China, AA is the more obvious overall value play here.

Exhibit 13

Source: Capital IQ and SSR Analysis

©2017, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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