Tuesday, April 26, 2005

WILL CONSOLIDATION RUSTPROOF THE STEEL INDUSTRY?

Forgotten in the tech frenzy, and often but a line item cost in the automobile industry, the steel industry hides a torrent of activity behind its boring exterior. Starting in 2002 with Wilbur Ross’s acquisition of bankrupt LTV Corp, Acme, Bethlehem and Weirton, the latest salvo in the global consolidation was fired by ISPAT-LNM NV with the acquisition of International Steel Group. The deal was consummated for $4.5 billion and puts LNM NV owner Lakshmi Mittal’s valuation at $21 billion. In an industry that once defined the United States, ownership of one of the larger firms has just gone international, with hardly a whimper from unions or government. This merger has capped two of the most successful years for the steel industry that saw U.S. Steel (USX) shares jump 291% and Nucor’s shares rise 153%. With high steel prices and 2004 being the industry’s best year since 1978, will the consolidation make steel shine again?

A study commissioned by American Iron and Steel Institute and conducted by Dr. Timothy Considine of Penn State University reveals a stronger, leaner North American steel industry is emerging from significant restructuring and consolidation. Andrew G. Sharkey, III, President and CEO of AISI says "The industry has repositioned itself not only through ongoing consolidation, but also innovation through development of more advanced steels to meet more stringent customer demands." Michelle Applebaum Research in suburban Chicago believes that consolidation has brought more discipline to the industry. They also claim that the consolidation provides greater leverage with the auto industry and other consumers. Steel analyst Christopher Plummer says “Mittal will have more control over prices because it can simply halt production rather than lower prices when the market gets low.” The latest merger will create price pressure for the consumers. Unions are typically considered anti-consolidation but United Steelworkers of America has come out strongly in support of the ISG-ISPAT merger. USWA International President Leo Gerard says “This is a positive development and we are looking forward to a more secure future of our Steelworkers and the domestic steel industry.” Some analysts say that a perfect storm of factors including consolidation, high Chinese demand for steel and the weak dollar will provide the steel industry with an excellent 2005. Has consolidation changed the landscape of US steel industry enough to ensure growth and control over steel prices? Or are there factors beyond the perfect storm that pose significant challenges to the rosy picture of the steel world? We believe the latter to be true.

Although the local steel industry has been consolidating, the global steel industry remains fragmented. LNM NV, the firm created by merger of ISG and ISPAT, with 54 million tons will have about 6% of a market that is supposed to reach 1 billion tons in 2005 whereas China alone has more than 100 steelmakers with less than 8 ton capacity. In such a fragmented global market, the importance of International Trade Commission’s anti-dumping policy cannot be underestimated. By keeping the import costs high through import taxes and reducing supply in the American market, the policy has inflated steel costs in the American markets and brought about an ideal situation. The steel industry lobbied again this year and renewed the dumping protections for a year. If the U.S. steel industry is really “strong, lean and green” as Dr. Considine’s research suggests, why would the steel industry need import protection? Is it so that the industry can maintain price discipline?

One of the expected effects of the consolidation is a reduction in capacity and economies of scale. Given the highly protected steel markets worldwide, the ability to realize scale by aggregating productive capacity is questionable. Additionally, the new dogs are up to old tricks with significant productivity improvements and a 30% increase in capital spending in the sector. This data stinks of capacity expansion and not contraction. What are the risks of overcapacity if China reduces its demand for steel?

Another area where consolidation has not helped is in lessening supplier power. As the steel industry has consolidated so has the iron ore industry. Japanese steel makers’ cartels, which collectively control more market than LNM N.V., were rudely treated to a 71% increase in ore prices. Vertically integrated companies like U.S. Steel have some respite from ore prices but cost pressures are likely to remain significant with costs of power and transportation also increasing.

The final chapter in this essay is written by the demand side economics. Chinese government plans to reduce expansion of the industry in China. This is good for the industry since it will keep competition lower in the international front. But in the same breath, the Chinese government has also taken measures to lower demand for steel and reduce steel prices. This effort will also make the currently profitable U.S. market an easy target for current suppliers to China and drive down prices in the U.S.

Will the U.S. steel industry be able to sustain its recent successes? We believe it is really going to be a function of government policy. The import protection will not be an easy thing for steel lobbyists to maintain. There is tremendous pressure from automakers to lift the tariff. The car companies feel the tariff artificially increases their costs, and hurts their competitiveness with foreign manufacturers. In its favor, the U.S. will benefit from the Chinese government’s actions to reduce expansion of the industry in China but also stands to lose from its efforts to reduce steel prices. Price pressures seem imminent with capacity increases and a highly fragmented global market that the consolidation has not fixed. The cost pressures also remain significant despite the consolidation with high supplier power and rising costs of inputs. In summary, the U.S. steel industry looks very strong right now and consolidation seems to be working but it will only take a couple of domestic and international policy changes to put a dent in the armor.

By Debasis Rath, Robert Cummings, and Drew DeKett

1 Comments:

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