The slowdown in the commodity price cycle predicted by many analysts for “after the Beijing Olympic Games” did indeed take place and, in just a few months, turned into a downturn of unprecedented violence and scale. It has affected all sectors, even though their fundamentals continue to differ significantly. We examine these trends and attempt to measure the impact of the crisis on the industry and to foresee the duration of the crisis.

The downturn in the commodity price cycle results from a combination of well-known factors:

• A contraction in end demand linked to the economic crisis in developed countries and slower growth in emerging countries.
• A de-stocking movement resulting in a much stronger fall in apparent demand. After several years of struggling to lock in supplies against a backdrop of high and volatile prices, almost all operators can now afford to postpone purchases in order to offload their precautionary stocks and take advantage of declining prices.
• The incapacity of supply (often ramped up as part of a very aggressive investment policy) to adapt to such sudden changes in demand. Some progress is nonetheless visible in this area, in the metals industry for instance, where some producers have implemented voluntary production cuts.
• Deleveraging linked to the credit crisis, and the withdrawal of investment funds which had played a significant role in pushing up prices for some products (oil, copper and cereals).
• Lastly, other factors such as weather conditions resulting in good harvests in 2008.

As in past crises, new balances will eventually be found. Once the de-stocking phase is over, demand will return to its underlying level, while the low prices will have played their Schumpeterian role of weeding out the weakest producers and eliminating surplus capacity. For many sectors, the way out of the crisis is to be sought in China, whose fundamental commodity needs remain huge. Will China manage to impose the streamlining required to counter the effects of past overinvestment or will it give in to the temptation (by lowering export duties, for instance) to export its domestic problems to the rest of the world? This will undoubtedly be a key question for the commodity markets in 2009 and 2010.

Steel: A Lasting Crisis

From early 2004 until last July, the steel industry enjoyed a super-cycle lasting more than four years driven by China’s extraordinary economic boom and positive economic trends in developed countries. Since the beginning of autumn 2008, however, and as the international financial and economic crisis has gained in severity, metal prices have fallen drastically. But how far will prices fall and for how long?

A Sudden and Drastic Price Fall

Having stayed well above their fundamental long-term level between 2004 and mid-2008, steel prices have suddenly tumbled. In Europe, the price of hot-rolled steel sheet has fallen by close to 40% in just four months. The unprecedented phase of prosperity previously enjoyed by he steel industry can justifiably be called a super cycle given its exceptional nature.

Chart 1: Steel Prices
(between 1 January 1997 and 8 December 2008)

Three Causes Underlying the Super Cycle

The main reasons for the 2004-2008 super cycle in the steel industry were:

• Robust economic growth both in developed and emerging countries (notably China but also Russia, thanks to oil revenues, and India and Brazil thanks to mining revenues);
• The decoupling theory according to which growth in emerging countries would relay demand in developed countries, with per capita steel consumption rising to similar levels. Moreover, Chinese steel demand was expected to evolve from an infrastructure market to a mass consumer market.
• Lastly, a relative shortage of iron ore and coking coal as mining companies did not adapt quickly enough to the explosion in world demand.

These factors resulted in a phase of major over-investment in emerging countries, headed by China, whose steel production has grown fivefold over the past 10 years to reach around 500 million tonnes, i.e. almost 40% of world production.

Three Reasons for the Present Sudden Fall

The US sub-prime mortgages crisis in mid-2007 and the resulting slump in the construction market did not affect the steel sector as it was still firmly assumed that Chinese demand could easily offset any weakening in US demand. On the contrary, steel prices inexplicably soared in the first half of 2008 in a way that seems out of kilter with the economic conditions at the time. A possible explanation could be the irrational behaviour of certain players tempted to stockpile steel for speculative reasons.

The second reason is that the speculative bubble only really burst when the Beijing Olympic Games came to an end in mid 2008. In our view the crisis was then aggravated by:

• the slump in the construction and automotive sectors in Europe (both large end-consumers of steel), which spread to emerging countries;
• widespread de-stocking throughout the sector.

A third, more general reason is that the decoupling theory turned out to be invalid. This has been illustrated by China’s economic slowdown, which has triggered a severe crisis in the steel industry.

The Consequences of the Crisis

Given present price levels, even the most efficient steel producers are severely affected by the crisis. Many steel producers are not integrated in terms of iron ore (and coke) and purchase supplies based on fixed-price annual contracts, whose prices will not be readjusted until next April.

Also, seaborne supply of iron ore is dominated by three players (Vale, BHP Billiton and Rio Tinto), who are in a strong position to set prices. The consensus forecast for 2009 iron ore contract prices is for a fall limited to between 20% and 30%.

Note however, that global steel producers currently benefit from very cheap freight costs (Baltic Dry Index). The cost of transporting a tonne of Brazilian iron ore to China is currently around USD 6 versus USD 70 six months ago.

All in all, we estimate that the earnings before interest, taxes, depreciation and amortization (EBITDA) margins of the most efficient non-integrated steel producers are currently close to zero and will remain under pressure until this year at least.

Winners and Losers

The steel companies most exposed to the crisis are undoubtedly:

• the most indebted and those that embarked on major investment programmes just before the price fall;
• those that purchase iron ore and coke at fixed prices, and
• those with obsolete manufacturing facilities or disadvantageous geographic locations.

Conversely, the steel companies advantaged by the crisis are:

• producers integrated in terms of ore (India, Russia) and those that purchase supplies on the spot markets and therefore benefit from the strong decrease in prices. Some Chinese producers are integrated but penalised by high extraction costs and low grades, which lead to higher energy costs. At present transport prices, this integration is no longer an advantage;
• producers that benefit from relatively sheltered niche markets (Northern Europe steel companies).

We still consider the low-cost slab model (producing crude steel close to iron-ore and coal mines) to be appropriate in the medium term but it is not a miraculous solution at present given that transport costs have virtually disappeared.

Adapting Supply: Reducing Capacities

Many steel companies responded to the crisis by announcing plans to reduce production in the fourth quarter of 2008. Based on our information, the production cuts decided total 43 million tones (including 9 million tonnes for Arcelor-Mittal alone), i.e. theoretically equivalent to 13% of world production capacity, a level never seen before.

We do not dispute the positive impact of these measures, which will help limit stockpiling, but we do not think they alone will be enough to overcome the crisis.

In our view, only a major wave of plant closures and a very significant reduction in world capacity would be capable of rebalancing supply and adapting it to actual demand, which was probably significantly overestimated (particularly in China in the euphoria of preparing for the Olympic Games). Based on an initial purely theoretical analysis, we think it would be necessary to reduce production capacity by between 200 million tonnes and 300 million tonnes. Obviously such major restructuring would require governments to respond to the situation and implement support measures.

In conclusion, for us the steel industry has entered a major crisis period, characterised by a very significant structural supply surplus and prices that are too low for most companies. The length of the crisis will naturally depend on an improvement in economic conditions, but also on governments’ capacity to accept and assist the necessary restructuring of the sector.