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Why minimills give the US huge advantages in steel.

Performance, not overcapacity, has been the real cause of industry problem

Full costs for mini-sheet hot band? $275 per net ton

Look for another wave of restructuring

Without doubt, the minimill revolution has had profound and lasting effects on the world steel industry. Minimills - small-scale steel plants embodying a superior technology and, more importantly, more streamlined management processes - emerged more or less simultaneously in the United States, Southern Europe, and Japan in the 1950s. Despite a limited product range, minimills grew to more than 20 percent of production in all these regions by 1990.

Such plants were still, however, precluded for technical reasons from participating in steel's largest market - the sheets used in automobiles, containers, and other major markets. This changed with the commissioning of Nucor's Crawfordsville, Indiana plant in 1989. The success of this facility initiated a surge of new ones that are revitalizing the US steel industry. By the end of this decade, world-class mini-sheet plants will represent more than 25 percent of US hot-band capacity. By 2000, almost 60 percent of American sheet capacity will be highly competitive by international standards, up from less than 20 percent in the early 1980s - an extraordinary turnaround.

In stark contrast, Europe and Japan have adopted this new production process at a glacial pace. All told, there are around 10 million net tons of mini-sheet capacity operating in North America, Europe, and Japan, most of it representing the "compact strip production" (CSP) technology used by Nucor and developed by the German equipment supplier SMS. More than three-quarters of this capacity around 8 million tons - is in North America [ILLUSTRATION FOR EXHIBIT 1 OMITTED]. Of this, roughly 6 million tons have been installed within the past two years. By comparison, the sole facility in Europe, Finarvedi's Cremona plant, began operations in 1992, as did Japan's only facility, Tokyo Steel's Okayama plant.

The North American lead in this technology is likely to persist for at least the rest of the 1990s. Firm announcements - investments that are either already under way or apparently backed by sound financing - suggest that at least another 8 million tons of mini-sheet capacity will have been installed in North America by the end of the decade. This compares with 2 million additional tons in Europe and none in Japan. North America will thus be home to more than 80 percent of the developed world's mini-sheet capacity until at least the end of the century [ILLUSTRATION FOR EXHIBIT 2 OMITTED]. Given the competitive advantages enjoyed by such facilities, slow adoption by European and Japanese producers is bound to create problems for those industries in the future.

A seminal technology

The fundamental benefits of the thin-slab process used in mini-sheet plants over conventional integrated steel production are undeniable. It offers tremendous savings in capital, overwhelmingly the most critical challenge facing traditional steelmaking technology. It reduces operating costs by at least as much as the two other seminal steel innovations of the postwar era, the basic oxygen process and continuous casting. And it creates incentives for further innovation, thus helping to revamp steel production processes.

Saving capital and operating costs

Thin-slab casting solves the principal problem facing integrated production techniques: investment requirements that are not supported by market prices. Underlying this problem is sustained and substantial excess capacity, which has plagued the world's steel industry for the past 20 years. Low prices and profits over that period have in effect signalled that capacity should exit the industry. Traditional producers have responded by cutting capacity to bring it more in line with consumption and thus boost prices. Higher prices, however, encourage market entry, which in turn revives the excess capacity problem. The static solution - closure and exit - reinforces the dynamic problem, entry.

At its root, the global steel crisis has always been about performance rather than capacity balancing. The source of the excess capacity is more efficient entrants: entrants that have found a lower-capital-cost route for steel production, that can earn an attractive return at typical market prices, and that have solved the problem of creeping obsolescence that plagues increasingly undercapitalized integrated plants. Here lies the key advantage of the minimills.

Against this background, the importance of thin-slab casting emerges in sharp relief. Prior to the commercialization of this technology, small-scale, low-capital-cost options existed for each of the process steps required for sheet production except hot rolling. This process effectively acted as a bottleneck obstructing the development of a capital-saving alternative for sheet production. Conventional hot-strip mills have a minimum efficient scale of around 4 million tons and cost around $200 to $250 per ton of installed capacity in the United States. The CSP technology removes the bottleneck, providing a minimum efficient scale of around 2 million tons at a cost of less than $100 per ton of capacity.

In addition, thin-slab casting offers a potential reduction, compared with conventional practice, of about 10 percent in cash operating costs for hot-band production. For efficient producers, the saving amounts to between $20 and $25 per metric ton [ILLUSTRATION FOR EXHIBIT 3 OMITTED]. It reflects better performance across the board: higher yields, lower energy requirements, and superior productivity. Applying direct or hot charging in a conventional operation might reduce the gap by $3 to $4 per ton.

How do such savings compare with those derived from previous breakthrough innovations? Conventional slab casting had a similar impact of around 10 percent of total costs, perhaps more. With the basic oxygen furnace (BOF), possible savings in cash operating costs were lower- sometimes less than 5 percent. Other advantages, particularly melt quality, underlie the BOF advantage over the open hearth.

Where capital costs are concerned, thin-slab casting enjoys a definite advantage. From a greenfield perspective, a CSP complex incurs roughly 40 percent of the capital charges per ton associated with a conventional caster and hot strip mill. By contrast, both the BOF and conventional caster offered modest - if any - savings in capital expenditures per ton than the technologies they replaced. From a brownfield perspective, conventional slab casting offers a higher return, but only by a small margin: a payback of about four years, as opposed to five for thin-slab casting. Thus thin-slab casting merits a place alongside the BOF and conventional continuous casting as one of the critical postwar innovations in steel production.

In this light, the discrepancy in adoption rates seems even more puzzling. With the BOF and conventional continuous casting, Europe and Japan led the United States in adoption. Yet only the United States looks likely to show much progress toward adopting thin-slab casting technology this decade [ILLUSTRATION FOR EXHIBIT 4 OMITTED].

Two arguments can be used to justify delays in adopting thin-slab casting. The first views it as an interim technology, soon to be replaced by strip casting. This seems doubtful. Given that the output of a successful strip casting machine tends to be relatively low, the operating cost advantages will probably be outweighed by scale diseconomies. On a full-cost basis, then, carbon strip casting is unlikely to yield any cost advantage over thin-slab casting [ILLUSTRATION FOR EXHIBIT 5 OMITTED] and in addition has to overcome substantial technical problems.

The second and more convincing argument concerns product capabilities. CSP technology is unable to serve the entire market. Width, gauge, surface, and deformation constraints limit the range of products it can supply to an estimated 60 percent of market requirements (already higher than the 50 percent that was feasible for the early commercial operation of Nucor's Crawfordsville facility). In principle, there is no reason why the technology, like conventional continuous casting, could not eventually approach 100 percent of market requirements. By contrast, a scrap-based carbon strip casting operation is unlikely to be able to supply more than 26 percent of the market's needs [ILLUSTRATION FOR EXHIBIT 6 OMITTED].

The current product limitations of thin-slab casting technology, however, make it unsuitable as a replacement for existing casting and hot-rolling operations. This is the chief technical reason why its adoption on a global scale has been slower than that of other revolutionary steelmaking technologies. As its capabilities expand, this obstacle will fade.

Promoting innovation

The final reason for the importance of thin-slab casting is its contribution to the pace of industry innovation. It is a critical element in forcing steel producers and equipment suppliers to overcome the problem of creeping obsolescence by developing less capital-intensive methods of steelmaking. In particular, one of the industry's most interesting technologies, the development and refinement of scrap substitutes, has received a tremendous boost from thin-slab casting.

Scrap is one of the key concerns for investors in thin-slab casting technology, since such facilities must currently be linked to electric furnaces in order to maintain their low unit capital costs. Quality requirements for sheet products mandate low residuals - a condition that can only be met through the substantial use of virgin inputs. The spectacular rise in thin-slab capacity in North America has thus greatly increased the incentives for developing scrap substitutes.

The best current example of this phenomenon is iron carbide, which is now being commercialized - not coincidentally - by Nucor to feed its mini-sheet plants. Nucor could have pursued a more proven technology, such as direct reduced iron (DRI), but chose to take a risk on iron carbide, which because of its high carbon content has a potential value-in-use advantage of at least $10 per ton (around 8 percent) over the best DRI [ILLUSTRATION FOR EXHIBIT 7 OMITTED]. Moreover, iron carbide should be cheaper to produce than most currently available scrap substitutes, both because its ore input does not require intermediate processing and because its capital costs are relatively low [ILLUSTRATION FOR EXHIBIT 8 OMITTED].

Given these advantages, the successful commercialization of iron carbide will ultimately produce a net saving for mini-sheet plants of at least $16 per ton of hot band (perhaps much more if the technology works as advertised) compared with the cost of using more conventional DRI products. Moreover, other technologies exist that may prove superior to iron carbide, such as Fastmet. Innovation thus stands a good chance of solving the ferrous input problem posed by the low residuals requirements of mini-sheet plants.

The story does not end there. One of the limitations of iron carbide, particularly as a feedstock for mini-sheet plants in developing countries, is the difficulty of using it for more than about 25 percent of the total charge. If a furnace can be designed specifically for iron carbide, however, this constraint will ease. In theory, the cost per ton of crude steel made in such a vessel would be very low.

If it follows this path, iron carbide - originally regarded as a potential scrap substitute - will enter the race to develop new steelmaking processes on a small scale, at low capital cost, and without the environmentally problematic coke required by traditional blast-furnace technology. With the exception of Corex, the various technologies now in that race - Hismelt, DIOS, the AISI-DOE direct steelmaking research, and so on - are all in early stages of development, leaving both their technical feasibility and their likely economics in the realm of speculation. Nevertheless, initial estimates suggest that iron carbide could be highly competitive, producing liquid steel at a cash operating cost of about $122 per net ton - almost $25 per ton less than the next best alternative, the combination of Hismelt and a conventional BOF [ILLUSTRATION FOR EXHIBIT 9 OMITTED].

Far in the future, the mix of steelmaking technologies may look very different from that prevailing today. From a cost perspective, thin-slab casting will remain the preferred method of converting liquid steel into bands, with a full conversion cost, including capital charges, of around $45 per ton. Consequently, the ideal total complex of the future would link some new primary technology with thin-slab casting.

Should direct steelmaking from iron carbide prove successful, hot band might be produced at a cash cost of $154 per ton [ILLUSTRATION FOR EXHIBIT 10 OMITTED] and a full cost of less than $200 per ton - far below the next best alternative, and $75 per ton less than the projected full cost of today's best option, iron carbide and scrap plus electric furnace plus thin-slab caster. In short, new technologies built around thin-slab casting - and encouraged by its introduction - offer potential cost reductions on a scale unlike anything we know today.

Why Europe and Japan are lagging

Solid, although probably not sufficient, economic reasons exist for the global imbalance in mini-sheet plants. Mini-sheet returns are ultimately driven by the cost advantage this technology provides. Both of the key inputs - scrap and electricity- are traditionally much cheaper in North America than in Europe or Japan. Other things being equal, hot band costs at a North American mini-sheet operation will be some 5 to 20 percent lower than at an identical plant in Europe or Japan.

The competitiveness of the integrated sector also has an influence. Marginal European and Japanese players are more competitive than their US counterparts, raising an additional barrier to entry.

Nevertheless, investment in a mini-sheet facility represents an attractive economic proposition for all three regions. Year-to-year fluctuations in market prices can significantly alter the relative attractiveness of the technology by region. In early 1994, for example, the United States provided the highest returns, while good returns are available in all three regions, yet outside, its position had reversed by the end of the year [ILLUSTRATION FOR EXHIBIT 11 OMITTED].

Political factors are partly to blame. The steel industries of Europe and Japan are more vertically integrated: for example, product distribution channels are frequently tightly controlled by integrated producers. Such producers also play a much larger role in scrap collection than they do in North America. This creates problems for potential mini-sheet investors, who are more dependent on high-quality scrap supplies than traditional non-sheet minimills and, for product quality reasons, rely more heavily on distributor customers than do their integrated sheet competitors. In sum, the greater vertical integration of traditional steel producers in Japan and Europe increases the risks associated with mini-sheet investment.

Finally, government intervention continues to constrain entrepreneurial activity in the European steel industry. Though direct political involvement is less overt in Japan, the extensive links between integrated producers and most minimills impose similar restrictions.

Progress outside the Triad

In the developing world, too, the mini-sheet revolution has been slow to take hold, although it is now gaining momentum. Hylsa's Monterrey (Mexico) facility aside, no mini-sheet production yet exists in a developing country. Until recently, announcements have been limited in relation to the overall prospects for steel growth in these regions; and many of the projects that have been announced were subsequently delayed or terminated.

Mini-sheet facilities should be able to earn good returns in many developing countries, even in the face of relatively high risk premiums. For one thing, the political constraints present in Japan and Europe are lacking. Eventually, mini-sheet facilities will be built in developing countries; indeed, roughly 10 million tons of thin-slab capacity is expected to be in place by the decade's end [ILLUSTRATION FOR EXHIBIT 12 OMITTED].

At least two constraints have restrained mini-sheet investments in developing countries. First, the ideal mini-sheet plant depends on high quality ferrous inputs. Since high quality scrap is unavailable in most developing countries, operations must rely on scrap substitutes, which traditionally incur cost penalties. Many companies, however, are now announcing investments in scrap-substitute facilities. Second, mini-sheet operations still suffer more product constraints than conventional facilities, making a larger total market necessary to support investment. Nevertheless, the small scale of mini-sheet plants make them ideal options for small but growing markets, so that they are likely to make up the bulk of capacity additions in most developing regions.

Effects in the United States

Ultimately, the high productivity of mini-sheet plants will force a day of reckoning on the steel industries of Europe and Japan. For the next few years, however, most of the impact of the mini-sheet revolution will still be felt in the United States.

The best way to think about this impact is from a business dynamics perspective [ILLUSTRATION FOR EXHIBIT 13 OMITTED]. Mini-sheet plants enter the market because their costs allow them to earn an attractive return at market prices. The more they expand, however, the more they generate excess capacity and thus depress hot-band prices, reducing the returns available to new entrants. Additional mini-sheet plants also mean more demand, and thus higher prices, for high-grade ferrous inputs. This again reduces the returns earned by new entrants, while increasing returns for investors in scrap-substitute facilities.

How this system balances out will ultimately define both how much mini-sheet capacity the market will support and what this capacity will do to hot-band prices. The key variable in input prices is the cost and availability of scrap substitutes. Iron carbide, probably produced in gas-rich regions like Venezuela or Trinidad, may well prove the most attractive substitute material in North America. If the technology works as promised, iron carbide could be delivered to the Nucor facility in Hickman Arkansas at a full cost of less than $125 per gross ton, including a 15 percent return on capital. Even if throughput rates are only 75 percent of target, the full cost remains below $140 per gross ton delivered.

If a material like iron carbide turns out to act as a cap on prime scrap prices under normal market conditions, mini-sheet plants will be able to source prime scrap for around $140 per gross ton. Under ambitious but feasible assumptions about operating and capital costs, the "steady state" full cost for mini-sheet hot band is around $275 per net ton.

Mini-sheet investors will enter this market so long as they can earn their cost of capital - that is, until trend-line prices fall to around $275 per net ton. Plants currently operating or announced will probably be enough to achieve this result provided imports maintain their current share. If imports fall, there will be room for more mini-sheet plants, although the equilibrium price will remain at $275. If iron carbide achieves a full cost of less than $140 per gross ton delivered, there will again be room for more entrants, albeit this time with a negative effect on price.

These numbers represent a threat to traditional integrated players, since many plants have current cash operating costs - not to mention fully loaded costs - that exceed $275 per net ton. The pressures that reshaped the industry in the 1980s will return once the current boom has passed. Ultimately, the same holds true for integrated producers in Europe and Japan. The high-productivity, low-cost formula of the minimill revolution - now roughly 40 years old and challenging traditional producers across the entire range of products - cannot be ignored.

Lou Schorsch is a partner in McKinsey's Chicago office.
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Author:Schorsch, Louis L.
Publication:The McKinsey Quarterly
Date:Mar 22, 1996
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