New normal or new bubble?
Mr. Gloom: The last time we spoke, Mr. Bull, you advised me to look out for your steaming freight train that was about to hit, or at least arrive, in Q1 2011. I have been on the lookout ever since, straining my eyes and even buying more powerful binoculars. Scanning the horizon, all I can see is a cloud of dust thrust into the atmosphere by a hot wind that I will call, in your honor, “The New Normal.” Seriously, apart from hot air nothing much has happened since we last met. Sure, steel prices are going up irresistibly, driven by higher raw material prices such as coking coal and scrap. Cheekily though, the steel mills are not only passing on the raw material increases but adding a hefty premium in order to recover their margins.
But is the US market, or indeed the global steel market, ready to absorb these sticker shocks? Not even close. At the end of the day, economic conditions are hardly suitable to trigger steel demand and support the astonishing price announcements we have heard about in the past few weeks. Instead, we are blissfully enlarging a bubble once again and the big question is when it will reach the bursting point. Looking at the US market, I will say sooner rather than later.
I know that is not in conformity with your “new normal.” The facts, however, are that the US government has run out of money and cannot print more for fear of a resurgent inflation. The well-funded private sector is scared to spend any of its huge cash reserves. Europe is a mess in general, Germany’s strong economic performance notwithstanding. It is more than outdone by the financial mess not only in Southern Europe but also in Great Britain where a double dip recession has become a real possibility. So your new powerhouses in Asia will have to come to the rescue, won’t they? Don’t hold your breath. Yes their growth is still impressive, especially in China. They buy a lot of raw materials, making vital commodities such as crude oil, scrap and iron ore even more expensive, which will have negative repercussions in the US and in Europe. Tell me how this is helpful.
Mr. Bull: You’ve got to be kidding me. If this is not a freight train, what is? As a matter of fact, the freight train already hit you but you don’t even know it. Everything played out exactly how I described it in our last conversation. I told you that inventories were too low, prices were too low, production was too low and we were absolutely not ready for any kind of demand pick up, let alone the mild seasonal demand increase that was ahead of us. I should get a medal for predicting the future so accurately. Note to readers: Don’t bother reading Mr. Gloom’s comments anymore—just skip to my sections.
In all seriousness, though, apart from construction, we are out of the woods free and clear. Our economy is growing, consumer confidence is coming back and the manufacturing, automotive, energy sectors are doing great. I am not sure what else you can wish for. Steel prices are going up, mills are nicely filling their order books with profitable orders, and flat-rolled mills are now extending their lead times over two months. As far as imports are concerned, they are still hard to find. Why? International prices are still pretty high, in most cases higher than domestic prices. Also, foreign mills are full and their lead times are longer, with deliveries as far out as June/July. This will keep the imports out of the market for a while for flat-rolled products.
As for long products, they are quite sensitive to scrap. Scrap has been floating toward the upper limit of historic prices, but not quite at the record level yet. Due to bad winter weather, supply hasn’t been great and therefore the prices have been going up relentlessly. But I think scrap has reached a correction point as we speak. Will it tumble down from these high levels? I don’t believe so. Scrap, in the worst of times, has been a tight commodity. Even when mini-mill production levels dropped to the 50-60 percentile range, scrap prices kept their ground. God forbid, if we quickly raise our mini-mill production levels to 80 or even 90 percent levels, scrap will register a new record level, making the previous record levels look like pocket change. Is this a bubble? If you believe so, there should be a bubble in every single commodity: gold, oil, grains, copper, etc. I would disagree, and say the world needs more resources, and this is just a result of supply and demand. Too much demand, not enough supply.
Mr. Gloom: If you want the readers to read your section only, you would have to supply them with your special rose-colored eye glasses that block out anything that does not fit into your over-the-top optimism. Hold the medals at this point; there aren’t too many people around who would award them to you. Let’s start with the US steel industry. One of the US’ largest steel producers, US Steel, just declared net losses of $249 million for Q4 and $482 million for 2010. At the same time, they warned that Q1 2011 will most likely remain in the red, but hopes that this year will at least break even. What tremendous prospects given your “promising” outlook of low inventory, low production and high raw material increases.
As I pointed out before, mills in the US have regularly increased their prices beyond the actual raw material surcharges; but it is obvious to anybody who is reading the financial statements that they are not getting their price increases. Yes, there were a number of inventory purchases; but inventories fill up and then we are back to living from hand to mouth, meaning that steel consumers buy the bare minimum only to keep on producing. End-users just don’t have the confidence that their business will warrant these huge price increases and are afraid to get stuck with massively overpriced inventories again. This is the “new normal” in the steel business and this is why demand will not support the steel mills’ price announcements on a consistent basis. Before I forget: AK Steel, the third largest steelmaker in the US, lost $93.0 million in Q4 and Nucor’s numbers were also not very pretty. You once told me that I should not take this anecdotal evidence out of context and jump to conclusions. But these numbers prove that despite your rosy scenario, steel mills are suffering because they are not getting the prices that they publicly announce they need to attain. Why would that be? Demand is not consistently strong.
Mr. Bull: Of course they will suffer losses in Q4; the markets were horrible then. Mills were dying for orders and raw materials didn’t give them enough room to make money. But don’t try to slant the reality. Mills will make huge amounts of money in Q1, because just like you said they are raising prices above and beyond raw materials increases. Why? Because they can. People like you delayed steel purchases hoping that prices would drop further and then make a killing. Instead you got stuck with no steel in your yard. What’s more, by the time you will have to buy in three or four months, most likely the rally will be over and you will get burned with high-priced inventories. In this “new normal,” you snooze, you lose.
Before you bring up construction, your favorite sob story, let me tell you what I think is going on there. On the housing front, it is absolutely true that we overbuilt. TV shows have proved that even idiots were making money by flipping houses, in addition to regular folks buying homes they couldn’t afford, banks encouraging ridiculous borrowing—and you know the rest. We ended up with the worst two years of housing starts since the US Census Bureau started keeping track in 1959. But the good news is that when you have a severe contraction like this, the housing market tends to overcorrect and a nice steady expansion will follow. I think we are in the beginning of a turnaround for the housing market. I say this because I see the rebar mills relatively busy, and even importers are booking tons for the US Midwest. There have not been any rebar barges going upriver for the last three years and now all of the sudden it’s a hot market. It’s not a coincidence. Housing and construction markets will bounce back this year—this is my prediction, and you know I am good at that.
Mr. Gloom: I don’t slant reality—I try to get past your rose-colored glasses. The steel mills were increasing their prices because they can. I might even agree with that notion. But the market, the steel consumers, will soundly reject these increases because they can do so as well. Demand cannot justify these outrageous prices. Yes, some people were caught short in the recent pricing turmoil and rebar was no exception. But steel consumers have bought what they needed and not a single ton more because they don’t trust this market or, as you call it, the “new normal.” Watch the mills when their order books fail to fill up.
Last time we had a situation like this was 2008. A lot of people made sure that they were not snoozing and bought steel despite completely irrational prices. They were wide awake when they walked into the inventory trap with subsequent inventory write-offs that went into the hundreds of millions of dollars. They will not let this happen again! My favorite sob story, housing, has been an essential ingredient of the American way of life and, indeed, of the steel business for a long time. That is why your much-ballyhooed upward trend will have to wait just a bit longer. I am not quite sure if we have reached the bottom yet, but the National Association of Home Builders has forecasted that just a shade of over half a million homes will be built in 2011 and that 2012 will see 860,000 new construction units. Then and only then will we have reached a plateau where steel mills can dictate pricing because of a strong demand. Mind you, it is a bit like asking the Marlboro man if smoking is bad for you; but let’s hope the NAHB is correct.
Mr. Bull: I have heard many people making references and drawing parallels to 2008. But things were fundamentally different in 2008. We were coming off a big drunken party then, and as a result we had a two-year hangover. But everyone sobered up and our feet are firmly on the ground. There is no fluff in this market, as many years of capacity cuts have taken significant supply out of this market.
Consumers were not buying but now the pent up demand for the last two years is finally kicking in. There is simply not enough steelmaking capacity to satisfy the demand right now. That’s why you see the prices going up. Yes, prices are driven also by raw materials but the same dynamics apply for the raw materials market too. There is a lot more demand from the steelmakers to produce more steel, and the raw materials supply is having a hard time catching up. Scrap is hard to get, coking coal supply has been severely curtailed because of the Australian floods, and iron ore is at record price levels. Steel prices are solid from the raw materials point of view. But, it’s not only cost or supply issues; demand is doing better. Still not great, but better. Banks started lending again, companies are investing and now hiring. Consumers are more confident and they are finally buying.
Even more significant in the greater scheme of things, China, India and the rest of the developing world are marching on relentlessly while their billions of people are becoming consumers in the global economy. This will benefit everyone and keep the world economy growing for many years to come—and steel is in the center of this growth. I just hope that you gain some confidence in global economic fundamentals and stop spreading such bad vibes all over our recovery.