China's steel industry is going from bad to worse

While some who watch global energy markets may disagree, analysts at Macquarie bank believe that the global steel industry is currently the “poster child” for the malaise currently facing global commodities markets.

Aided by a once in a lifetime infrastructure stimulus program implemented by China to ward off the effects of the global financial crisis, capacity in the sector boomed, based on the belief that global steel demand would keep increasing at a phenomenal rate in the decades ahead.

China, followed by India, was going to power global steel production, creating near endless steel demand both nations transitioned away from developing to developed economies.

Analysts, miners and bankers bought into the story big time, putting out bullish price predictions, not only for the short term but decades ahead, prompting a raft of lending to finance investment in the sector.

Capacity was installed, as were coking coal and iron ore mines used to fuel them. It was all too good to be true. New production couldn’t come online quick enough.

That was five years ago.

Now the bullish forecasts have been overwhelmed by a dose of bearish reality. Not only does it not appear global steel demand will grow anywhere near the rate expected, but it may not grow at all.

As this chart from Macquarie reveals, global steel consumption has fallen in year-on-year terms throughout 2015, continuing the weakening trend seen from the middle of 2013.

Led by a global economic slowdown, a change of leadership in China and a massive glut of residential housing stock in smaller third and fourth tier Chinese cities, global steel demand is now contracting, wreaking havoc on a sector, and those that supply it, who based their investment decisions on bullish forecasts from several years ago.

“We are talking about an industry which expanded rapidly for demand which not only didn’t come quickly, but increasingly looks like it might not come at all,” wrote Macquarie.

“Many process industries have overcapacity in the world, but steel’s demand problem and relative size make it front and centre in terms wider economic impact.”

As the chart below shows, falling global demand coupled with massive oversupply is seeing capacity utilisation rates fall across the sector.

“The global steel industry is currently operating at 75% capacity utilisation” wrote Macquarie.

“While we have seen sub-80% capacity utilisation rates in the past, these have tended to be temporary events. We have now averaged below 80% for the past seven years. With classical economics now being allowed to work, the normal self-adjustment mechanism of bankruptcies and capacity closures is not in place.”

Macquarie points the figure at extremely loose monetary conditions as a reason why capacity in the sector remains weak, not only because it allowed marginal steelmaking facilities to be built but also because it keeps unprofitable firms operational at a time when they would normally be shuttered.

As a result, many firms, particularly in China, are now running at a loss. This is a problem given the debt levels carried by steelmakers in the nation. The red bars in the chart below represent interest payments for Chinese steelmakers as a percentage of profits made.

Clearly there is a big problem brewing for the sector. The interest bill on debts carried by most steelmakers are equal to or greater than total profits made. It’s clearly unsustainable. Unless capacity declines, or an unlikely global pickup in demand ensues, operating conditions look set to remain bleak.

Indeed, the sentiment expressed by Macquarie is similar to that of Xu Lejiang, chairman of China’s second largest steel producer, Shanghai Baosteel Group.

Speaking at an event last month, Xu stated that Chinese steelmakers were “bleeding cash”, suggesting that steelmaking capacity in the nation – making up over 50% of total global production – could contract by as much as 20% in the years ahead due to chronic sector oversupply.

“The whole steel sector is struggling and no one can be insulated. The sector is facing increasing pressure on funding as banks have been tightening lending to the sector — both loans and the financing provided for steel and raw material stockpiles,” he said.

The bearish outlook offered by Xu was echoed by a recent research report from Morgan Stanley in which they noted recent liaison with Chinese steel industry contacts left with them view that sentiment across the sector had never been so bearish.

The bearish view of those involved within China’s steel industry certainly differs to those of the miners who supply them.

Four months ago Tad Watroba, executive director at Gina Rinehart’s Hancock Prospecting, suggested that the long-term fundamentals for the iron ore industry remained solid despite the price falling to a six-year low of $US44 a tonne in early July.

“It will go back to $US80 a tonne in my view,” said Watroba.

“You’re seeing some price volatility at the moment but some of that high-cost supply will come off and in terms of China demand still remains strong.”

Similarly, BHP is currently forecasting that global steel consumption will hit 2.5 billion tonnes by 2030, some 50% higher than its present level.

Macquarie, though, are sceptical on the bullish forecasts offered by the miners.

“The only people who still seem to think there is significant upside in global steel consumption akin to the past decade are the major iron ore producers,” they wrote.

They suggest that in order to bring some the global steel market into equilibrium, around 275 million tonnes of global capacity would need to be mothballed, equivalent to the current output of Japan and Western Europe.

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