On the upswing: has the domestic steel industry learned its lessons?

For anyone looking at the stock market throughout the past year, it may come as a surprise, but US Steel has been one of the big gainers. Throughout the past five years, Pittsburgh-based US Steel has posted a return of around 200 percent, far greater than Dell Computer, Microsoft and Cisco Systems, three of the high-tech darlings of the 1990s.

What gives? Has the steel industry--and not only the steel industry, but the integrated steel industry--become a growth industry?

Maybe, maybe not.

But what is becoming apparent is that some steel companies learned a number of lessons during the domestic steel industry's most recent downturn.

NEW ATTITUDE. Internal and external reasons account for the improving landscape within the domestic steel industry. Probably the most significant boon has been the overall improvement in the world economy. Additionally, the flurry of consolidation has put the world steel industry into fewer and more fiscally solvent hands.

The question now is whether the industry will maintain its new business philosophy when the industry does turn downward.

According to several consultants to the steel industry, the answer is, "Yes."

Michael Locker, president of Locker Associates, a New York City-based steel consulting firm, says that one big change is that integrated steel mills have decided to hold the line on production. According to a report by Locker Associates, U.S. producers have been able to respond to softening demand for finished steel by reducing production volumes instead of by reducing prices.

Locker Associates reports that the consolidated integrated mills are now able to adjust their blast furnaces to meet declining demand in the United States.

According to the American Iron & Steel Institute, basic oxygen furnace (BOF) steel production in the United States fell by nearly 11 percent last year. Each of the top BOF steel producers took significant action to curb production, with US Steel idling its largest blast furnace for a good part of the year to complete a rebuild. At the same time, Mittal Steel, one of the three top steel producers in the United States, idled its Weirton Steel hot end last May, ultimately deciding to permanently close the mill. Neither of the mills built up inventory to make up for their hot-end outages.

According to the Locker Associates report, while integrated and electric arc furnaces reduced their outputs when demand softened, integrated mills reacted more aggressively to weaker flat-roll demand, which marked a major shift in their overall strategy. In the past, integrated mills were primarily driven by volume.

The result of this output reduction was a higher pricing floor than in prior cycles. Hot roll prices, which topped out in late 2004 at more than $700 per ton, declined to only as low as $435 per ton in August of 2005, before bouncing back to $550 per ton by the end of the year.

The ability to control their production has allowed U.S. steel mills to remain much healthier than in the prior downward cycle. By controlling their production levels, integrated steel mills were able to keep prices from dropping to levels that were seen in previous down cycles, which wiped out a number of steel mills.

Consolidation among the U.S. steel industry was a factor enabling steel companies to hold down their production. Mittal Steel, based in the Netherlands, and US Steel were able to take capacity off line to keep from cutting into finished product prices too deeply. Also, by eliminating excess capacity, the steel industry was able to more quickly rebound with stronger prices.

EAFs also were able to better control their production levels to compensate for a decline in demand last year. However, unlike in years past, according to the report from Locker Associates, the EAF segment was more successful because of its strength in the long-products market, which was more robust last year.

A factor that has previously put integrated steel companies at a distinct disadvantage to electric are furnaces was the cost of raw materials. While companies such as Nucor were able to produce steel at far lower per-ton costs because of relatively low ferrous scrap prices earlier this decade, the climb in ferrous scrap prices has tipped the balance back toward the integrated steel companies, according to Charles Bradford, principal with Bradford Research of New York City, a consulting group to the steel industry.

Concerning the changing outlook for steel, Bradford says, "If you are a steel company right now and you aren't making money, you shouldn't be in business."

Integrated steel companies, which, by percentage, use far less ferrous scrap as a raw material, have been able to more successfully weather the higher ferrous scrap prices recorded in the last couple of years.

RAW MATERIAL COSTS. Companies that purchase ferrous scrap are now seeing their per-ton costs climb far higher than those who have a more captive raw material market. US Steel, which controls much of its raw material, on the other hand, has been able to keep its production costs much lower.

Additionally, mergers and bankruptcy plans are reducing legacy costs for integrated mills, lessening the disadvantage that these companies have been operating under relative to EAF mills and giving them more flexibility.

However, while basic oxygen furnace steel mills rely more on iron pellets and pig iron than on ferrous scrap for their raw materials, iron pellets have also increased sharply in price.

According to Tony Taccone, a steel industry consultant with First River Consulting, Pittsburgh, three iron ore producers--Companhia Vale do Rio Doce, BHP Billiton and Rio Tinto--control around 70 percent of the world iron ore market. Even with the goal of strengthening the steel industry's pricing power through mergers, the stranglehold that iron ore producers have on the market makes integrated steel producers' ability to drive down raw material prices only partly successful.

These iron ore producers have been pushing through several aggressive price hikes. However, for the most part, U.S. steel makers have been able to avoid these price increases because they own much of their own raw material infeed.

In North America, many integrated steel companies are finding it helpful that they already have sizable stakes in their own raw material network. Tacone notes that Dofasco recently purchased an iron mine while US Steel also owns its own iron ore mining facilities. He says that steel companies are attacking yields and trying to keep raw material costs under control.

Meanwhile, EAFs, which are confronted with volatile ferrous scrap prices, are look ing to reduce their dependency on openmarket ferrous scrap by extending their raw materials supply lines.

Commercial Metals has extended its scrap buying network as a way to offset the uncertainty within the market. Schnitzer Steel also has developed a fairly substantial network of scrap suppliers to smooth out the volatility.

For other companies without the network of scrap suppliers, many are looking to become more active in using pig iron, direct reduced iron and hot briquetted iron. This may include building or purchasing plants that manufacture these products.

However, while owning or operating a DRI plant may be an alternative, Bradford says these operations require a significant amount of natural gas, which is also a volatile commodity.

THE NAME OF THE GAME. Most industry observers feel that consolidation will continue to take place among the steel industry and that a number of domestic steel companies will be added to the mix.

One of the biggest beneficiaries of the recent improvement in steel markets has been Mittal Steel. After snapping up International Steel Group (which acquired the bankrupt LTV), Mittal has been on an acquisition binge, taking over large integrated steel operations without having to deal with legacy costs. At press time the company was in negotiations with Arcelor, based in Luxembourg, one of the top steel producers in the world.

While a few of the major acquisitions have been garnering a majority of the attention in the world market, Bradford estimates that in the United States there are probably 20 other deals that should be done to further consolidate the North American steel industry.

The consolidation bug could expand to include both upstream and downstream operations as well. "No one in the United States is big enough to not be consolidated," Bradford adds.

While consolidation has been a driving trend, a related issue is whether the steel industry can and should become more vertically integrated, which would allow for better control of their raw material prices.

In a presentation recently given at a conference on steel and ferroalloys, Frank McGrew, with the research firm Morgan Joseph, based in New York City, noted that significant changes are taking place in the steel and scrap metal industries. For instance, transactions are now driving downstream consolidation to maintain pricing leverage and the scale needed to attract adequate supply. The recent consolidation in the steel industry is helping to maintain pricing discipline, and industry stability appears intact in the near-term, according to McGrew.

McGrew also predicted in his presentation that the attempts by producers to vertically integrate will fail, Russians will become more active in the acquisition market and domestic steel companies and foreign firms will look to joint ventures with increasing interest.

Other analysts say that the steel industry is seeing significant interest from companies based in India and Russia, which are both becoming greater players in the steel industry, in addition to China.

But what about acquiring scrap facilities as a way to guarantee that enough raw material can be obtained? Most consultants say that this is a less likely scenario. Locker says that most scrap companies are too fragmented to have any major impact on a steel company's business.

"There isn't a lot of traction for acquiring scrap yards," Taccone says.

However, a flurry of activity is expected in the steel service centers. This part of the steel industry is highly fragmented, and more steel companies are looking to become more fully integrated by taking a stake in or by outright purchasing service centers to "get closer to the market," one industry watcher notes.

Outside North America a number of steel mills own or operate steel service centers. The North American steel industry, as one consultant puts it, is more the exception and not the rule when it comes to service centers and steel mills.

However, there is greater interest in forward integration into the steel service centers. "It is very clear that is the steel mills' strategy right now," says Locker.

While the steel industry has been enjoying its strong run, the hike in interest rates, as well as the potentially cooling economy, will again pose many of the same questions for the steel producers, whether they operate EAFs or integrated mills. If higher interest rates bring slower growth, or if commercial construction cools down, how mills adjust will be key.

The author is senior and Internet editor of Recycling Today and can be contacted at [e-mail].