2009 Jan 06 Steel's struggle may turn in 2009 by Tim Alch

1/14/2009 8:52:13 AM 01-06-09 Mining Journal Steel Update.doc 1

This article has been excerpted from the January 6, 2009 on-line edition of the Mining Journal located at http://www.mining-journal.com/reports/steels-struggle-may-turn-in-2009? . * * * * *

Steel’s struggle may turn in 2009 Reports

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06 Jan 2009 3:07pm GMT

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Mining Journal

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Summary Steel has taken a beating in the recent global downturn, where demand for metals has decreased. Nevertheless, as the global steel industry braces for a tough first half of 2009, some investors are betting that what goes down will come back up, believing the markets may have over-corrected the downside – and resource sectors where hard assets exist may be early beneficiaries and hold long-term value. Tim Alch, vice-president senior minerals business analyst at Behre Dolbear & Company (USA), Inc in New York reports Real Time Changes of Fortunes

The unprecedented, precipitous drop in global steel demand and prices since September reflects uncertain business conditions in the US, Europe and Japan that are in recession and declining growth rates within the developing nations, including in China. While there are reasons to be hopeful that markets will rebound, the expression ‘business as usual’ has lost some of its meaning as all have scrambled to adjust in real time to the international credit crisis and a series of unexpected events. In response, steel and mining companies are seeking to preserve cash flow, enacting contingency plans to survive a recession that may persist well into 2009. Many were surprised how quickly fortunes changed but markets, in general, tend to inflate and undervalue prices in the short term. Metal prices in the final quarter of 2008 have slumped, copper by 44%, nickel by 38%, zinc by 28%, lead by 40% and steel in similar fashion. One important factor to consider is that China’s crude steel production may drop by 10% to 15% in 2009, possibly more from the 489Mt it produced in 2007.

Managing During Tough Times

In response to the global credit crisis and the first synchronised global economic recession since World War II various government authorities and policymakers around the world have announced and talk about unprecedented fiscal stimulus plans, bail-outs and investments in troubled industries, and lower interest and tax rates. However, business conditions, as of early December, are weak with demand in most sectors way off or flat at best. This crisis which began with over leveraged balance sheets by many of the world’s financial institutions has


shaken the confidence and reduced the risk tolerance among the world’s executives, investors and consumers. Low-cost credit that fueled the commodities boom from 2001 to 2007 is being revalued and marked to market perhaps too much so, causing global demand and prices to collapse. Steel and mining companies with high costs or that are amidst capital projects face limited financial flexibility as the capital markets, both public and private, are shut, while many mills experience order delays or cancellations. Attempts to stimulate demand by cutting prices have yet to work as orders dried up and consumers struggle having lost property and portfolio wealth and perhaps lost jobs during the past several months. All of which has many waiting for prices to possibly fall further as suggested in early December in various purchasing manager indices, a leading economic indicator, that point to continued weak demand in the US, Japan, Europe and China. But prices have corrected by so much so quickly, that some dismiss the notion that prices can go lower believing the bottoming process may have already begun. Perhaps it has. Earnings visibility in the steel and mining industry looking into 2009 is now less certain as demand and prices may not yet have bottomed after plummeting since September. A key indicator to look for may be order backlogs for large capital goods such as jet engines, electricity-producing turbines and automation equipment that are typically ordered months, if not years, in advance. Big ticket industrial companies and suppliers rely on order backlogs to smooth out results as the economy weakens. If these companies and mining equipment manufacturers’ order books decline in 2009, steel and mining executives may need to evaluate options and contingency plans again early in 2009. Elsewhere, the automotive, appliances and building and construction sectors have been hit hard. The steel and metals industry has idled mills and mines as investors liquidated assets. For example, the US steel industry is operating at less than 50% of capacity in early December down from operating above 83% of capacity as recently as July. Although these data are lagging economic indicators, experts, investors and executives have reduced economic growth forecasts for 2009. Operators since September have been whip-sawed and have had to make adjustments to volatile financial and currency markets while the credit markets tightened. Compounding these difficulties have been unexpected events that fuel uncertainty such as the changing political leadership in the US, Russia’s incursion in Ossetia and other unknowns including economic, monetary, fiscal and environmental policy-related prescriptions that various governments and authorities talk about. The new year may bring further unwelcome surprises. The market volatility has challenged even the best managers and companies to enact plans to prudently manage risk while working to satisfy existing commitments. Steel executives have cut output, costs and spending, delayed expansion plans and are restructuring. All of which has made the final quarter of 2008 a nightmare for steel executives, suppliers and stakeholders. Elsewhere, the focus on avoiding risk and capital preservation has led to investors flocking to the safety of US Treasuries who appear to be less concerned about inflation than deflation, right now. Another surprising twist.

Future Growth Postponed

As many look for leaders, the US is in recession and its political leadership amidst a hopeful transition, with talk of large economic stimulus packages in the US, Japan and Europe and in China, the world’s third-largest economy where after many years of double-digit growth China’s economy grew by 9% in the third quarter, down from 11.4% for all of 2007.

In the US, industrial output in the third quarter of 2008 fell by 6%, the most since 1991 as output from US factories, mines and utilities in September dropped by 2.8%, the most since 1974, after falling 1% in August. Europe and Japan have reported similar declines as have China’s industrial and manufacturing companies that cut output and reported weaker export sales in November for the first time in many years. China’s economy leadership says economic growth of 8% is required to avoid destabilising unemployment.

China’s property prices in places have dropped by 10% to 30% while the Shanghai stock exchange stock index was down 60% negatively impacting consumers’ demand. Likewise, factories and manufacturing have been idled with China’s steel mills recording losses in October and steel prices were cut from record levels in July. In November, China’s manufacturing fell by the most on record and export orders fell according to a purchasing managers’ index that dropped to a seasonally-adjusted 38.8, according to the China Federation of Logistics


and Purchasing. Recent forecasts of China’s economic growth in 2009 suggest a rate of growth of 8% to 9%, some estimate near-term growth may slow to 5%.

The global economic slowdown has evidenced various imbalances among the export-based economies of China, Japan and Germany that are experiencing weak export markets while the credit crisis and business cycle interrupted the commodity boom and postponed the hopes of resource and oil-rich nations. Less than one year ago global economic growth was in synch, resource supplies were tight, intermediaries had access to low-cost, unabated credit and infrastructure bottlenecks all contributed to robust markets.

Although China, India, Brazil and other emerging economies will continue to urbanise and industrialise, the global economic slowdown will postpone fundamental demand growth equal to earlier robust forecasts. Nonetheless, the emerging market economies demand for steel and metals will continue to outpace growth rates in the developed nations. But, the level and intensity of metals demand will be less than recently recorded and will reflect modest economic growth around the world in the near term. As has become painfully apparent, steel and metals markets will not be supply constrained as they were in the recent past as evidenced by the spot price of iron ore that since March has fallen from as much as US$197/t to as low as US$60/t in October.

In any event, the long-term growth story and return of high-demand growth rates for steel and metals echoed in early 2008 will likely be postponed beyond 2009. A key factor driving the duration in the near term will be whether actions by government authorities including the world’s central bankers will satisfactorily resolve the issue of overleveraged balance sheets of many financial institutions, including investors. When the markets settle down and executives and consumers regain confidence, the steel industry will regain its footing.

China Remains a Wildcard

As has been the story in recent years, China the world’s largest producer and consumer of steel will play a major role in future growth of the resource sector. As was highlighted in the May 17, 2008 edition of the Mining Journal in an article titled: Steel: change may be ahead, China’s annual crude steel output rose by more than 338Mt between 2001 and 2007. This fact is especially noteworthy as its increased output is a remarkable capital investment and accounts for a large share of the incremental global demand for the metals and raw materials industries since 2001. This 338Mt of crude steel output equals more than 3.5 times the output of the US steel industry in 2007 as well as three times the output of the world’s largest steel producer Arcelor Mittal.

Notably, China’s crude steel production in October 2008 was equal to 35.9Mt, declining by 17% year over year and 9.4% from September 2008 levels. Although one month’s data do not necessarily make a trend looking at the final two months of 2008 and into early 2009 China’s crude steel production may continue to decline by 10% to 15% versus one year ago. As the global economy and steel industry has slowed with steel mills idling production, the World Steel Association reports that global crude output fell by 12.4% in October versus one year ago and 7.3% less than in September. All of which evidences mills are hunkering down going into 2009 as the world’s manufacturing and industrial sectors weaken steel and metals and suppliers are experiencing soft markets.

While in many respects, China and the developing nations’ economies are in better shape financially and have enacted solid market-based reforms during the past ten years, the US and European economies still account for more than half of the world’s production and consumption. Once these markets enter recession all of the world’s markets are impacted. How long will the US, Europe and Japan remain in recession?

Also noteworthy is that as China cuts steel production and has plans to rationalise less efficient capacity, it will likely continue to expand its involvement in the steel, mining and resource sectors outside of China by expanding its investments, co-operative partnerships and joint ventures and participating in deals to secure access to and delivery of steel making and other raw materials. Given China’s demonstrated resource appetite and rich cache of foreign reserves estimated to be approximately US$1.8 trillion, it is expected that it will continue to invest in resource assets and operations as it has during the past five years amounting to as much as US$31 billion, according to Dealogic. If so, its activities may contribute to and support an early resurgence within the resource sectors.


As regards China’s effort to stimulate domestic demand with its announced US$568 billion fiscal spending package that is focused on infrastructure-related projects, some people question whether it will be enough to offset the expected weakness in China’s export markets. Recall that much of China’s recent growth is attributable to exports to the developed world nations and Asian trading partners that are suffering today. In similar fashion, a number of other emerging economies that have benefited as low-cost manufacturers of capital and consumer goods for the export markets also share the developed nations as their largest end market. Thus, as demand in US, Europe and Japan weakens China and other nations’ manufacturing sectors suffer while also experiencing higher labour and manufacturing costs, despite weak currencies.

While difficult to substantiate though widely reported, on balance today inventory levels of steel and various metals are at relatively modest levels as contrasted to in past recessions when the metals and steel industries suffered severely, it is not likely that demand will restart enough in the next six to nine months to offset the temporarily idled productive capacity that producers will seek to restart as soon as possible, both in the steel and metals sectors. Although hopes have been expressed that when demand restarts there may be an amplified response, as reportedly occurred in Turkey in late November in wire and rods, the demand tapered off, a false start of sorts as furloughed plants quickly filled the void.

All of which is making today’s business conditions as difficult as seen since the 1980s when the steel and metals industries faced very challenging prospects, especially given that the credit market freeze is limiting the availability of some options. Although the steel industry is operating at much less than full capacity, time will be needed to discern whether prices stabilise and confidence in the markets returns and buyers begin placing orders. Firms with development projects need to be mindful of the changed dynamics, be realistic about valuations and seek investors or backers with long-term perspectives, high-risk tolerance and commitment levels and interest required in the resource sector.

Navigating Forward

In the steel and mining business it is always important to manage for the long term and for a variety of potential scenarios as investment horizons and capital projects require planning as best possible for the variability of costs, etc. through the ups and downs of the business and economic cycles. However, today’s confluence of events was unforeseeable.

Typically, during slowdowns, the strong companies get stronger while weaker companies struggle, and sometimes disappear. Cyclical downturns are periods when companies are pressured to restructure although specific circumstances may differ for an EAF steelmaker, for example, than integrated steel maker with higher fixed cost. Firms with high costs and limited finances, generally, will suffer more than those operating at the low end of the cost curves. This time though the volatility and sudden change of fortune as well as unknown length of the recession has required all firms to take steps to survive, very quickly.

Even the best managed companies with the lowest cost operations or reserves now realise the importance of having in place sound business plans and financing to survive extended periods of low prices and demand. Also important has been having the support of experienced managers and advisers and the backing of boards to act as needed to make difficult decisions or take advantage of opportunities resulting from the market dislocations.

While the metals and steel sectors’ management in recent years by and large has reinvested in the boom years and put in place world class, best in practice management strategies, skills and state of the art technology, after having learned the tough lessons they did earlier in the 1980s and 1990s, today’s uncertain markets are not forgiving. Even the best managed companies’ valuations were slashed in October and continue to suffer, despite the long-term growth story that largely remains in place for the steel and mining sectors.

While the steel industry has to its credit, again speaking in general terms, quickly reacted to the changed environment, if the recession persists well beyond the first quarter of 2009, the managements and boards of the steel makers and mining industry may need to consider new options or approaches to navigate forward and avoid pitfalls - making the difference between failure or survival by grasping an opportunity, if one arises. Prudence dictates that management should not take options off the table until they are fully vetted and reflect


the difficult market conditions of today, that were not foreseen six months ago, and that may deteriorate further. On the flip side, with valuations where they are, this may be a time to consider merging, consolidating business activities or joint venturing to gain incremental benefits or possibly divest less than stellar performing business units if need be or possible.

While it is true that assets and talent may be available at lower cost today, it also is true that focusing on core competencies and cash flow positive activities will help to strengthen a firm’s operations. Sometimes seeking the expert counsel can provide the avenue forward whether it involves legal, accounting, strategic, markets, operating or regulatory options, opportunities or obligations. As always, it is prudent to act along long-term business goals, not act hastily. The illiquid and uncertain environment today requires being ready to act and be prepared for the unexpected, including dealing with interested parties seeking to inspect, judge and value assets which also requires being realistic about one’s business, assets and valuations Should an opportunity arise or a value investor or partner make an offer to the management, board and stakeholders must be careful about acting in the best interests of the company and its various stakeholders for the long term as 2007 in retrospect may have been a near-term peak for the global steel industry.

While there are reasons to be hopeful, particularly given that market values have declined to such low levels, it bears repeating that although it is easy looking to the hills, it’s the path through the valley that one should be mindful of. Unexpected events in recent months have dominated the headlines, the end of the credit crisis is not yet in sight, thus it may be that in the coming new year more unexpected events will be forthcoming.

Largest Crude Steel Producing Nations’ Share Of Global Crude Steel Production (Mt)

2001 (MT) and

Ranking 2006 (MT)

2007 (MT)

Jan -March 2008 (MT)

Jan – Sept 2007

Jan – Sept 2008

Percent Change

Jan-Sept 2008/ 2007

Sept 2007

Sept 2008

Percent Change

Sept 2008/ 2007

Oct 2007

Oct 2008

Percent change

Oct 2008/ 2007

Percent Change

Oct 2008/ Sept 2008

1. China 150.9 (1) 423.0 489.2 124.9 368.1 391.0 6.2% 43.6 39.6 -9.1% 42.2 35.9 -17.0% -9.3% 2. Japan 102.9 (2) 116.2 120.2 38.4 89.3 92.3 3.4% 9.9 10.1 1.5% 10.4 10.1 -2.7% 0% 3. United States 90.1 (3) 98.6 97.2 25.4 73.0 76.0 4.0% 8.0 7.9 -1.3% 8.5 7.1 -16.8% -10.1% 4. Russia 59.0 (4) 70.8 72.2 19.2 54.0 57.0 5.4% 5.7 6.1 7.0% 6.2 4.5 -27.1% -26.2% 5. India 27.3 (8) 49.5 53.1 14.3 89.3 92.3 3.4% 4.4 4.6 4.8% 4.6 4.8 3.8% 4.3% 6. South Korea 43.9 (6) 48.5 51.4 13.2 38.2 41.4 8.3% 4.1 4.6 12.7% 4.3 4.6 5.9% 0% 7. Germany 44.8 (5) 47.2 48.5 12.1 36.6 36.2 -1.0% 4.1 4.0 -0.6% 4.2 3.9 -7.7% -2.5% 8. Ukraine 33.1 (7) 40.9 42.8 11.0 31.9 31.6 -1.0% 3.5 2.5 -29.3% 3.6 1.9 -48.7% -24.0% 9. Brazil 26.7 (9) 30.9 33.8 8.6 25.0 26.8 7.3% 2.9 3.0 5.0% 2.9 2.9 -0.1% -3.3% 10. Italy 26.5 (10) 31.6 32.0 8.3 23.5 24.0 2.2% 2.7 2.7 2.4% 2.9 2.6 -12.2% -3.7% Share Of Total 71% 77% 267.9 828.9 868.6 4.8% 88.9 85.1 -4.3 89.8 78.3 -12.8% -8.0% Global Total 850.3 1,250.7 1,343.5 340.7 989.9 1035.8 4.6% 112.0 108.4 -3.2 114.7 100.5 -12.4% -7.3% BRIC TOTAL 263.9 574.2 648.3 167.0 536.1 567.1 5.8% 56.6 53.3 -5.8 55.9 48.1 -14.0%-- -9.8% BRIC Share of Total

31.0% 45.9% 48.3% 49.0% 54.2% 54.7%

-- 50.5% 49.2 -- 48.7% 47.9% --- --

Source: World Steel Association formerly known as the International Iron and Steel Institute (IISI), Brussels, Belgium. Figures may not add up due to rounding.


World and Regional Annual Real GDP Growth Rates From 2005 to 2009F *

(Annual percentage change or %)

2005 2006** 2006*** 2007** 2007*** 2008E** 2008E*** 2009F** 2009F*** (%) (%) (%) (%) (%) (%) (%) (%) (%) United States 3.1 2.9 2.8 2.2 2.0 0.5 1.6 0.6 0.1 S. America & Mexico 4.6 5.3 5.4 5.6 5.6 4.3 4.6 3.6 3.1 Brazil 3.8 3.8 5.4 5.4 4.8 5.2 3.7 3.5 Japan 1.9 2.4 2.4 2.1 2.1 1.4 0.7 1.5 0.5 Euro Area 2.0 2.8 2.8 2.6 2.6 1.3 1.3 1.3 0.2 South Korea 4.2 5.1 5.1 5.0 5.0 4.2 4.1 4.4 3.5 Taiwan 4.1 4.9 4.9 5.7 5.7 3.4 3.8 4.1 2.5 China 10.4 11.1 11.6 11.4 11.9 9.3 9.7 9.5 9.3 Russia 7.4 7.4 8.1 8.1 6.8 7.0 6.3 5.5 CIS 6.6 8.2 8.2 8.5 8.6 7.0 7.2 6.5 5.7 India 9.0 9.7 9.8 9.2 9.3 7.9 7.9 8.0 6.9 Middle East 5.4 5.8 5.7 5.8 5.9 6.1 6.4 6.1 5.9 Africa 5.6 5.9 6.1 6.2 6.3 6.3 5.9 6.4 6.0 World 4.8 5.0 5.1 4.9 5.0 3.7 3.9 3.8 3.0

* Source: The International Monetary Fund (IMF). The above data is computed on the basis of purchasing power parity (PPP). If market exchange rates, were used, world growth would be more than a percentage point less. E denotes estimate while F denotes forecast. ** Figures reflect the IMF data as of April 2008 published in its World Economic Outlook; *** Figures reflect the IMF data as of October 2008 published in its World Economic Outlook

Author Biography Tim Alch, vice-president senior minerals business analyst, Behre Dolbear & Company (USA), Inc. [email protected]. He is a financial and business analyst with more than 24 years of experience of analysis of economic, strategic, valuation and investment issues for industrial and financial clients. His work over the years has focused on the study and analysis of financial, industry and strategic issues concerning the management and performance of companies in the metals, mining, steel and related industry sectors and investments therein. He is an honours graduate of Amherst College where his studies focused on economic geology and continued his studies in the mineral and energy economics MSc graduate programme at Pennsylvania State University. * * * * *

This article has been excerpted from the January 6, 2009 on-line edition of the Mining Journal located at http://www.mining-journal.com/reports/steels-struggle-may-turn-in-2009? . * * * * *

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2009 Jan 06 Steel's struggle may turn in 2009 by Tim Alch