Steel In Oversupply?

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 – Small rise in global stainless steel production in 2012
 – Market may be over-estimating Chinese steel consumption
 – This will impact on steel producer earnings
 – Iron ore sector will also be affected

By Chris Shaw

A marginal increase in world stainless steel output is expected in 2012, industry consultant MEPS noting total production is forecast to reach 34 million tonnes. 

This would represent a modest increase on 2011's production of 33.7 million tonnes. MEPS notes developing markets including India continue to drive growth in production, while only the US and South Korea among traditional producers are expected to lift output relative to last year.

MEPS also notes the latest Chinese output figures show significant volumes of previously unreported stainless steel production, as the new figures indicate 2011 output was a minimum of 14.19 million tonnes. 

With major steelmakers in China having curbed production in recent months given slower domestic growth and weaker export demand, MEPS forecasts total Chinese stainless steel production of 14.2 million tonnes for 2012.

Looking on the pricing side, MEPS notes average transaction prices for all steel products under coverage have fallen recently across all markets. In Brazil the focus remains on supplying finished steel products to domestic consumers as export opportunities are scarce. As a result, steelmakers in this market are operating at 80% capacity at present.

Trading conditions remain difficult in Russia as consumption continues to disappoint, while MEPS notes Indian steelmakers also remain bearish on the outlook for domestic consumption in the September quarter. This reflects a deterioration in market sentiment and weak underlying demand growth.

Even in China business confidence has weakened and the associated uncertainty over the future direction of prices has impacted on bookings. MEPS notes market participants remain bearish over the general market trend, while the China Iron and Steel Association (CISA) has questioned the long-term sustainability of China's current crude steel production growth rate.

As Citi notes, the market at present expects China will produce more than one billion tonnes of steel by 2025. Given China accounts for 45% of world steel demand, any adjustment in the intensity of China's investment profile is likely to have a significant impact on the global steel industry.

Compared to consensus forecasts, Citi has adopted a more conservative view, estimating Chinese steel production of 820 million tonnes in 2020. But further analysis suggests even this forecast may be optimistic as production in 2020 could come in between 480-720 million tonnes. 

Even this lower level of output would create an unbalanced market if Citi's expectation Chinese steel consumption trends to maintenance levels in coming years is correct. This forecast is based on the view the steel consumption rates of recent years are unsustainable over the longer-term.

For Citi, this means at a global level between 4-15% of current steel capacity would need to close to bring global steel supply in line with demand. Given around 75% of Chinese capacity is operated by state-owned enterprises and so has a limited adherence to profit objectives, Citi suggests any requirement to reduce capacity could fall unevenly upon producers in the Western world.

This would likely eliminate pricing power for steelmakers, so pressuring margins. Yet at present Citi notes consensus forecasts continue to build in margin expansion and an earnings recovery for global steelmakers, leading the broker to suggest the industry faces a period of earnings downgrades that is not yet priced into equities.

Assuming global steel production in a range of 480-720 million tonnes in 2020, the potential impact on iron ore producers relative to current expectations could also be significant in Citi's view. At present Citi forecasts a long-term iron ore price of US$100 per tonne, but if demand side assumptions are wrong this forecast will also be incorrect.

As an example, Citi notes an iron ore price of US$80 per tonne assumes the loss of around 100 million tonnes of iron ore from the seaborne market, while a price of US$60 per tonne assumes the loss of around 300 million tonnes from this market.

This would translate into a significant impact on iron ore producers, Citi noting the average earnings multiple for iron ore producers would increase from a base case assumption of seven to nine times in FY13 at iron ore of US$100 per tonne to a multiple of 11 times at an iron ore price of US$80 per tonne and to a multiple of 15 times at a price of US$60 per tonne.

Base case forecasts for Citi stand at US$139 per tonne in 2012 and US$135 per tonne in 2013.

Citi suggests a number of small iron ore producers would become unprofitable at US$60 per tonne, while parts of Anglo and Vale would be unprofitable at US$60 per tonne for iron ore. BHP Billiton ((BHP)) would be a winner in that it offers a more diverse earnings base to offset weaker iron ore earnings, so it remains Citi's preferred play. At current levels Citi suggests Rio Tinto's ((RIO)) share price is already discounting a more severe outcome in the iron ore market than is considered likely to occur.

JP Morgan has also assessed the iron ore market given the view iron ore prices are being supported by high cost production. The expectation is growth from low-cost producers will at some point over the next five years exceed demand growth from China, meaning the cost curve for the industry will flatten as high cost production slows when prices fall.

As examples of planned increases to production, JP Morgan points out Vale expects to lift total capacity from around 310 million tonnes per year now to nearly 470 million tonnes by 2015, while Rio Tinto plans an increase in capacity to more than 350 million tonnes per year by 2015 from around 230 million tonnes now.

For JP Morgan this suggests, compared to current levels of US$120-$130 per tonne, that marginal costs will remain above US$120 per tonne until 2014, then fall to US$90 per tonne by 2017. But if West African supply growth is excluded, marginal costs should stay above US$100 per tonne beyond 2020. 

On its numbers, JP Morgan estimates low cost iron ore producers continue to have incentive to grow output at prices as low as US$90 per tonne. As an example, assuming such a price, JP Morgan suggests a standard project with capital intensity of US$200 per tonne and operating costs of US$25 per tonne plus freight and royalties could generate an internal rate of return of 12%.

This wold be incentive enough in JP Morgan's view for low cost producers to continue to invest in growth and displace high cost production. 

Applying this to Australian producers, JP Morgan continues to prefer Rio Tinto, Fortescue ((FMG)), Atlas Iron ((AGO)) and Grange Resources ((GRR)). For Rio Tinto the attraction is valuation, solid growth and a strong balance sheet, while Fortescue continues to offer scope for exceed the market's current production and cost estimates.

Grange is also one of the cheapest iron ore stocks under coverage in JP Morgan's view, while Atlas Iron trades at a substantial discount to net present value while offering solid growth options in coming years. 

JP Morgan rates all four stocks as Overweight, while among other stocks under coverage JP Morgan has Neutral ratings on Aquila Resources ((AQA)), BHP Billiton ((BHP)) and Mount Gibson ((MGX)) and an Underweight rating on Gindalbie Metals ((GBG)). 

Among the stocks rated as Overweight, Sentiment Indicator readings according to the FNArena database stand at 1.0 for Rio Tinto, 0.9 for Fortescue, 0.8 for Atlas and 0.5 for Grange. 

JP Morgan's iron ore price forecasts stand at US$137.80 per tonne this year, US$135 per tonne in 2013 and U$120 per tonne in 2014. Recent adjustments means these estimates are 7%, 10% and 4% lower than previous forecasts. 

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