If there is one thing UBS Securities' Dieter Hoeppli knows it's steel. As global head of steel, as well as metals and mining in the Americas for UBS, he's spent the last 20 years analyzing the steel business and acting as an advisor on countless mergers and takeover deals. He regularly travels the world and crunches numbers to determine what's going to grow and what's not. In this Gold Report exclusive, we take you inside the recent Forbes & Manhattan summit for some of Dieter's candid thoughts on the shortage of iron ore global steel manufacturers are now facing.
"I am bullish about steel, I think steel has a great future," said Dieter Hoeppli, managing director of UBS Securities' steel and metals group in New York City, during a presentation at the first annual Forbes & Manhattan Resource Summit in West Palm Beach, Florida.
"There is a lot of infrastructure to be built if you go to places, such as India and Brazil, which I came from this morning," he added. "You see a lot of activity taking place; that's going to run for the next 5 or 10 years and a lot of steel is going be consumed for that."
Annual global steel production went from 770 million tons (Mt.) in 1990 to 847 tons in 2000 to roughly 1,367 Mt. in 2010. Steel production is expected to have a compound annual growth rate of 5.6% in each of the next two years and total production should reach 1,524 Mt. in 2012.
Moving Away from the U.S.
He noted, however, that biggest change from 1990–2010 is where steel is manufactured. In 1990, Russia made about 20% of the world's steel; but by 2010, Russian production accounted for just 8%. European and North American steel production witnessed similar or even more drastic declines. And most of that production has shifted to Asia, which now produces about two-thirds of the world's steel.
In 1994, only four of the world's top-40 steel producers were Chinese companies, whereas six were American. Today, seven are based in China and just two are left in America.
Merger and acquisition (M&A) activity in the steel sector peaked in 2006 with 27 deals valued at nearly $60 billion. The number of deals picked up pace following that year, with 39 deals worth roughly $37.3 billion in 2007 and about $20 billion over 32 transactions in 2008. As of Nov. 1, 2010, M&A activity stood at 13 pacts valued at $5.4 billion.
Dieter said the key development in consolidation was the creation of large steel companies with numerous blast furnaces that give them greater production flexibility. In the '90s, many of the small steel companies had but a single furnace, which meant it had to be kept running, even at a loss.
India and Brazil Poised for Future Production Growth
Dieter expects future steel production growth to come from India—a country with a population that rivals China but that only produces about 60 Mt. of steel annually, versus China's roughly 600 Mt. He cautioned, though, that steel production growth in India could take some time.
"India is a very difficult place to build new capacity," Dieter explained; "acquiring land in India and getting permits can take a very long time.
He also sees steel production growth coming from Brazil.
"The BRIC countries [Brazil, Russia, India and China] are going to be the [production] drivers while in more developed markets, we will still have excess capacity," Dieter said.
From July 2008 until mid-2009, North American steel production operated at just over 40% of capacity—even below the levels of the 1982 recession when steel production plummeted to about 70 Mt. from 110 Mt. in 1981. Dieter noted that it took North American steel producers 15 years to return to the 1981 production mark.
It may not take as long this time, however, given that higher steel prices have boosted North American steel production to 70% of capacity—an increase of about 30% since 2008.
The price of hot rolled coil is at roughly $550/ton, up from a low of roughly $210/ton in the late 1990s but down from a peak of $1,100 in 2007.
Dieter believes steel makers can make money selling steel at $550/ton but that the rising cost of raw materials has forced steel producers to get directly involved in mining them to reduce costs.
"If they're not backward integrated, most steel companies are not making money today," he said.
Dieter said there are three main sources of raw material—scrap, iron ore and metallurgical coal.
Scrap prices have skyrocketed from $80/ton in recent years to around $300/ton now, while iron ore prices went from $35/ton in 2005 to between $150 and $175 per ton today.
He said this has led to a change in iron ore contracts. Deals used to be done annually but now prices are adjusted quarterly using a system similar to spot prices—an arrangement that largely favors the iron ore producers.
"[The new system] is very positive for the iron ore companies, but more challenging for the steel companies," Dieter said. He noted that in the near term only two of those raw materials would be in short supply—metallurgical coal and iron ore.
Metallurgical coal (met coal) is used as a fuel and as a reducing agent in smelting iron ore in a blast furnace. The supply deficit in met coal, Dieter said, has led to prices reaching $210/ton, up sharply from $50 per ton in 2001. What's more, steel companies are moving upstream into coal mining operations to reduce or stabilize their costs.
Dieter said there is a similar shortage of iron ore but that by 2015 the deficit would become a surplus after several significant iron ore projects in Brazil and Australia reach production.
Iron Ore Leads Pack
But when it comes to value creation in the steel sector, iron ore clearly leads the pack. Over the previous five years, the prices of iron ore companies have risen a collective 400% owing largely to the growing number of takeovers. Over the same timeframe, steel companies were up a combined 12.1%. Met coal and scrap iron companies were up 34% and 28.1%, respectively.
Although the value of steel companies increased only 12% over the last five years, the value of steel companies based in Latin America increased by a staggering 165%. The value of their Asian counterparts, meanwhile, decreased 31.1% over the same period. Dieter said Latin American steel companies often have the advantage of owning their iron mines, whereas most Asian steelmakers work with tight margins because they have to buy iron ore at market prices.
In the question and answer session following Dieter's presentation, he was asked about consolidation in Quebec's North Shore where a number of iron ore players operate within spitting distance of each other.
Quebec's North Shore features a geological belt known as the Labrador Trough, which first witnessed iron production in 1954. Iron mining continued unabated until steep drops in iron ore prices forced IOC to shutter its operations in 1982.
The camp underwent a renaissance when steel prices started to rebound in the early part of the previous decade. The iron mines in Labrador are served by two rail lines that link to a year-round ocean port at Sept-Îles, Quebec, an advantage not lost on Dieter.
"The mine body is important but logistics are as important. And what's very attractive about the North Shore is that you have two rail lines in place that have lots of capacity," he said. "Consolidated Thompson has shown it can get ore concentrate down to the port at $30/ton. It's highly competitive to produce up at the North Shore. . .Clearly, Consolidated Thompson could be one of the chips that could fall."
"I think there is going to be a renewed focus on attractive companies with great ore bodies, Dieter said, "which I think Alderon Resource has in areas with logistics already in place, where you can actually bring the product to the market in a reasonable period of time."
"Clearly, raw material is an absolutely critical factor in steel manufacturing and I'm sure Alderon is going to play a major role in that," Dieter said.
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