Tuesday, 28 October 2008

Macro-Level Trends – Raw Materials Supply - Ships in a Bottle(neck)

The massive inflation hikes in raw materials and energy costs that so concerned the auto-industry has largely diminished - for the moment at least. This is possibly the only positive outcome from the global economic contraction caused by the financial markets turmoil and its real-world contagion.

Rocketing commodity costs through-out 2007 to Q208 were more than evident, headline news almost every other day. Automakers were effectively sandwiched between such escalating input prices that fed into unit costs and a franticly competitive vehicle market driven only by phase after phase of incentive waves.

Today, observers from sensitive central banks to literate consumers, recognise that what were painful inflationary pressures have been eased, but at the reletive cost of healthy regional economies - the West moving into near 0% and negative GDP growth. As a result of global contraction input prices, from oil to steel, have returned to what many see as sustainable from their record highs. The oil price best exemplifies this trend, now down to approximately $60 pb from its near $150 pb peak not so long ago; prompting leading political figures like Gordon Brown - seen as the architect of the globally adopted economic reaction plan - to urge petrol pump prices to follow suite.

Knowledgeable investors would have been aware that the previous high commodity prices in turn encouraged the ramping-up of drilling, mining and affiliated processing which post-peak would ultimately result in commodity over-capacity. Hence the speed of the rapidly squeezed global economic climate, along with the credit freeze took many by surprise and so shrunk commodity producers' order-books massively at a time of unparalleled product output. And obviously that massive and quickly emerging over supply- under demand gap. So far an unfortunate exercise in Economics 101.

The contrast between today and 6 months ago is palpable, a boom-time scenario when steel makers like ArcelorMittal, TATA, Nippon, POSCO, US Steel, Baosteel et al were in the driving seat and used that power to demand spot-pricing as opposed to contract pricing on steel orders.

As ever, timing the demand peak & subsequent downturn is the vital trick, and only those investors and steel-makers with attuned macro-economic foresight at the scale of the financial fall-out would have correctly anticipated the timing and acted accordingly. Steelmakers guiding their clients onto long-term stable contract pricing, and investors siding with the more intelligent steel corporations or perhaps temporarily exiting the sector altogether. The capital exit now apparent is retracting plant and operational expenditure, and so reducing capacity, but it will perhaps be the more nimble smaller operators that can react quicker.

But generally, operating a steel mill has the obvious "stopping a super-tanker" analogy given the long-lead time required by upstream participants in the value chain that supply the iron ore and coking coal. Thus many steel-makers will still have comparatively high cost structures and over-capacity for some months which set against the final products very sensitive donward pricing elasticity puts many steel-makers in less than optimum positions - as highlighted in a Goldman Sachs note earlier this month prompting 'sell' guidance on many.

Given their position as the foundations of the modern industrial world, it is not surprising to see the steel sector being hit as hard as it has been on international bourses; the 'whipping boy' of rightly or wrongly paranoid markets. To illustrate the point, steel prices have plummeted from $1099 and $1039 per tonne highs for hot rolled coil and plate respectively in late July '08, a consequence of not just rational estimation of over-capacity but also compounded the markets flight from risk. Ironically, steel has been seen as a true defensive stock, but as with the VW-stcok contortion due to short selling, all standard and reasonable expectations seem to have be thrown well out of kilter.

Of course, steel is not one homogenius commodity, it actually spans 3 different types depending on use.

The worst affected, leading the decline, were those that specialise in, or whose primary mix is, rod & section steel - the core products used in infrastructure and house-building. The rolling bursts of international housing bubbles saw construction falter and so accordant demand. But that housing crash, via sophisticated financial instruments, went on to infected the credit markets which as we've seen has taken a major toll on vehicle demand & production, which obviously dramatically affected the demand for hot/cold rolled sheet. Lastly, and luckiest are those who are those mills least exposed due to their sector dynamics, and these are those who deal in steel plate, primarily used in ship-building and repair.

So from a steel-makers perspective a more stable segment to play within, though with accordant lesser growth prospects given more prevelent barriers to entry for newcomers. This is best seen by POSCO's sheltered market position in the storm compared to others who previously gained more, but now seeing greater losses.

However, though it maintains a lower-profile in steel production output, it is the role of shipping that is today playing a major part in the price equilibrium of steel - specifically regards raw material input in the form of scrapped ships and re-cycled steel.

Yesterday the FT reported that (to quote) “a key safety valve for regulating the world's supply of ships has stopped working...after credit and other problems brought the sale of ships for scrap to a near halt”. In summary, recent sale transactions have been undermined by the plummeting price of scrap steel.

In India specifically, buyer's banks are unwilling to provide letters of credit to vendors typically secured by said vessel as prime secured asset. As with other world-wide asset de-leveraging, the innate worth of the asset is decreasing, yet another victim of accounting's 'mark to market' requirement. (In early September this scrap steel was fetching $740 per tonne, but now only about $300). This loss of transactional confidence has created a systemic bottleneck, where ship-owners prefer to maintain and operate old ships (increasing the likelihood of infringement of recent environmental regulation) or will 'mothball' them for an indeterminate period awaiting better scrap rates.

This disrupts the shipping sector's renewal rate and disturbs ship-operators nominal CapEx renewal plans - a useful interruption given the slowly thawing credit markets many will say. But it also means that the recycled steel input rate has been artificially reduced. That co-incidentally helps to reprieve over-supply capacity pressures in the market and thus stabalise what were spiralling downward price pressures.

Specifically this is good news for the likes of ArcelorMittal and TATA on whose home ground the 'problem' and effects are most widely felt. But the news of constrained recycled scrap will not be good news to the Purchasing Directors of the world's automakers who eagerly relish depressed steel prices and do not have TATA's benefit of close inter-conglomerate relationships between steel and cars. Unlike India and China, the West is not able to play the internal transfer-pricing game.

The US and Europe will be glad to hear that some of China's more labour intensive ship-breaking yards will re-open, after previous poor-productivity closures; essentially re-routing end of life vessels to China. Such an outcome would partially alleviate China's strategic urgency to capture foreign mining resources, but only for a finite period, and indeed the CCP could view the mining and steel sector downturns as a perfect time to increase its alliance and independent interests.
The final outcome depends on whether a recycling battle between India and China emerges, and given present conditions such a scenario looks unlikely in the short-medium term given market rates and ship-owner reticence.

Although automakers worldwide will have been heartened by the retraction of steel prices in recent weeks, they may well be disheartened to see India playing what could be construed as a self-serving game. Especially at a time when agencies like the IMF and World Bank state that international trade co-operation is vital as perhaps the most important mechanism to avert the world from possible economic collapse.

That means US, European and Asian trade commissioners may well be lobbying India on automakers behalf, urging the Bank of India (via BoI guarantees or some-such) to inject the much needed commercial confidence. That may ultimately mean guaranteeing steel scrap values. A notion not a million miles away from Sir Nicholas Stern's words at a recent London School of Economics lecture where he talked of stabalised commodity prices as part of a 'Global Deal'

However, as for the here and now, at a time when global trade is perhaps the greatest concern and quandary facing international government the East is understandably keen to protect its own economic momentum. It does not want to be pulled back down by the West beneath the newly forecast 7-9% ASEAN growth rate - which itself is well off previous growth forecasts.

India and China, aswell as Russia and Brazil, well recognise the very central role steel output has to play, both in terms of the very material that underpins new rounds of infrastructure build and the foreign currency income it brings national reserves. And at a time when their own stock-markets have taken a worse battering than the US or Europe, they may well be implicitly using the very basic tenants of capitalism to their own advantage.

And that could mean a serious additional fracture to the already fragile western automotive picture.

Washington and Brussels will perhaps need to do more than simply pump cash into their respective auto-empires, they'll need to take the fight to the new-world industrial emperors. For it could feasibly be the case that India, so reliant on steel, is trying create a 'steel-price market bottom'.

Ships may well have man-made steel hulls and bottoms, but the prescient question may well be, "should markets"?