SECTOR BRIEFING number DBS Asian Insights DBS Group27 Research • July 2016 Oversupply in the Global Steel Sector Challenges and Opportunities DBS Asian Insights SECTOR BRIEFING 27 02 Oversupply in the Global Steel Sector Challenges and Opportunities Eun Young Lee Equity Analyst DBS Group Research [email protected] Addison Dai Equity Analyst DBS Vickers Securities (Hong Kong) [email protected] Produced by: Asian Insights Office • DBS Group Research go.dbs.com/research @dbsinsights [email protected] Chien Yen Goh Editor-in-Chief Jean Chua Managing Editor Geraldine Tan Editor Martin Tacchi Art Director DBS Asian Insights SECTOR BRIEFING 27 03 05 Executive Summary Macro Outlook Challenges and Opportunities 09 Outlook for Steel Sector Supply and Demand Price Forecasts for Steel and Raw Materials Efficiency and Cost Analysis of Chinese Steel Mills World Steel Trade Flows Trade Conflicts on the Rise 24 Sifting Out Winners in Steel Sector Growing M&A Deals Post-Depression 30 Risks Abound in Current Landscape High Mortality Rate for Major Steel Companies Bumpy Road Ahead for China’s Steel Sector Reforms Pain of Rising Interest Rates 34 Findings From DBS Steel Survey 38 Appendix DBS Asian Insights SECTOR BRIEFING 27 04 DBS Asian Insights SECTOR BRIEFING 27 05 Executive Summary Macro Outlook Demand outlook: Demand is stagnant. Since 1950, crude steel production has been growing 3.4% annually from 188 million tons to 1.62 billion tons in 2015. The sector experienced strong growth from 1950 to 1975; stagnancy from 1975 to 2000; and astronomical expansion led by strong demand growth in China from 2000 to 2014. We expect the global steel industry to enter a stagnant demand growth stage for the next 10-15 years. The rationale driving this outlook: i) Chinese steel demand and production might have already reached their peaks and are likely to stabilise or decline in the coming years; ii) there won’t be any economies to buffer the slowdown in China; and iii) major steel-consuming industries are also facing overcapacity issues or are expected to see lower growth. In the near term, the World Steel Association (WSA) expects that global finished steel consumption in 2016 is likely to reach 1.49 billion tons, a fall of 0.8% from 2015, on top of last year’s 3% drop from 2014. The key reason for the bearish forecast is the 4% contraction in Chinese consumption. Supply outlook: Oversupply to persist despite restructuring efforts. Excess capacity in the global steel industry has increased significantly since the financial crisis. Despite slowing demand growth in the global market, there continue to be new investment projects in many parts of the world, especially China. According to the Organisation for Economic Co-operation and Development (OECD), the world’s steel-making capacity reached 2.32 billion tons in 2014, more than double the 1.06 billion ton capacity recorded in 2000. Furthermore, global steel-making capacity is expected to climb another 100 million tons to 2.42 billion tons in 2017, factoring in projects that are already underway. China and India, in particular, have the most aggressive expansion plans of 28 million tons and 31 million tons of new installations, respectively, accounting for 59% of the total increase. Steel mills will try to retain their production in the oversupply phase, as long as selling prices are above the cash cost, as this could reduce the fixed cost by increasing production – especially since the recent steel price hikes have prompted steel mills to restart their facilities. Hence, we project global production volume to be stagnant in 2016 and 2017, with the oversupplied volume to remain at 15 million tons. Following the addition of new capacity, the global utilisation ratio is expected to decline up to 66% in 2017. The exacerbation of global steel imbalances and declining utilisation continue to pose risks to the industry for the foreseeable future, unless more concerted efforts are made by the industry and governments to address the challenges. We expect the global steel industry to enter a stagnant demand growth stage for the next 10-15 years DBS Asian Insights SECTOR BRIEFING 27 06 Price outlook: Rangebound prices following weak raw material prices and overcapacity. Dampened by oversupply, hot-rolled coil (HRC) benchmark prices for exports and domestic Chinese HRC prices have declined, on average, 32% and 29%, respectively, in 2015 compared to the previous year. The key reason for weak prices are China’s cheap exports, which have increased 2.6-fold in the last five years, with a whopping 50.4% and 19.8% growth in 2014 and 2015, respectively. China’s exports stood at 112.4 million tons in 2015, which was slightly lower than US steel consumption of 121 million tons. Also, weak iron ore and coking coal prices are another key reason for steel price weakness – of note, both sectors suffered from overcapacity on weak demand attributable to Chinese steel production’s decline. Despite the sluggish demand for raw materials, the major mines are reluctant to cut their production volumes as they aim to increase market share, leading to industry restructuring by competitors who are falling behind in the race. In 2016, we expect HRC benchmark prices to drop another 3.3% in view of the continuing global oversupply, which is mainly due to Chinese exports and weak iron ore prices in 2016 (a 12.5% on-year decline is expected). We expect steel prices to edge up following global steel demand growth, with more tangible restructuring measures from China in 2017. However the improvement is likely to be limited, as the excess capacity should hamper any sustainable price hikes. Challenges and Opportunities Trade conflicts. Steel exports, mainly from China, and steel trade conflict cases have increased significantly the world over. The US has filed 14 anti-dumping and countervailing duties cases – the largest number of lawsuits from a single country. The European Union (EU) has filed 13 lawsuits against imported steel products and Asia has 22 cases of trade conflicts, with ASEAN countries and India filing the most number of such cases. At the same time, emerging countries that have relatively high World Trade Organisation (WTO)- bound rates have raised tariffs for steel imports. Obstacles to China’s sector restructuring. Facing overcapacity, China’s government plans to cut excess steel capacity by 45 million tons this year and 150 million tons by 2020 – endorsed by the central government’s supply-side reforms. Earlier in 2016, the Ministry of Finance released a special subsidy fund amounting to 47 billion Chinese yuan to spur the capacity curtailment of the steel and coal industries. However, local governments are inclined to keep steel mills in operation, given their strong value-added tax (VAT) contributions (17% charged on revenue). Government subsidies for 24 listed companies surged 80% to 6.3 billion yuan or 24 yuan per ton on average. We deem local governments’ vested interests as the key challenge for steel capacity shutdown. Interest rate hikes and currency depreciation. The probability of further interest-rate hikes in the US has fuelled concerns over a rising interest-rate environment for the global economy. This would lead to emerging-currency weakness, including the yuan against DBS Asian Insights SECTOR BRIEFING 27 07 the US dollar. A rising interest-rate environment should also increase the financial burden for steel mills in emerging countries by raising interest cost and increasing the repayment amount for US dollar-denominated debt. While exports from China will benefit from weak currencies in terms of price competitiveness, this will be offset by the higher cost of raw material imports and trade protectionism. Of note, 79% of iron ore requirements in China were imported from Australia and Brazil in 2015. Also, the growing protectionism in export markets will dampen the export price advantage arising from the yuan’s depreciation. Last standing mills. We have ranked major global steel companies based on their financial information, reputation and information available in the steel market. The most respectable steel companies in the world are characterised by high economies of scale, exposure to growing markets and downstream industries, pricing power and less competition in their home markets, value-added products that harness tech innovations, cost competitiveness and profitability. US-based Nucor is the top ranking, followed by South Korea’s POSCO and Japan’s Nippon Steel. Even though it is not a perfectly objective observation, companies with high rankings have been registering more stable earnings than peers. The average shipment of the top 36 companies was 19 million tons and the size of a steel mill was a sufficient, but not a necessary, condition. The analysis suggests that Chinese steel companies need to improve their qualitative competiveness rather than quantitative growth. Chinese companies accounted for 24% of the top 50 makers in terms of size, but made up only 14% of the top 36 world-class steelmakers in 2015. Mergers and acquisitions (M&As) – from restructuring to growth strategy. Before 1990, M&As among steel companies were engineered to increase scale amidst a growing need to restructure domestic steel industries. In 1990, Europe and the US became the starting point for full-scale M&As, peaking in 2006 to 2007 on the back of Mittal’s merger with Arcelor and Tata’s takeover of Corus. M&A deals tend to increase in business up-cycles with an accompanying uptrend in metal prices. This is obvious given M&A engagements are more affordable to undertake using equity and the valuation for deals would be higher during up-cycles. In 2015, the number and value of deals in the steel sector hit 321 cases and US$11.4 billion, representing declines of 4% and 32%, respectively.