Why Steelmakers Are Plummeting

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Shares of steel companies dropped sharply on Tuesday after AK Steel (NYSE: AKS  ) reported significant losses in the third quarter and warned investors that it expected another loss in the fourth quarter. AK Steel shares fell as much as 7% after the company blamed shipping volumes and low prices for resulting in a $61 million loss.

Though AK Steel is a relatively small player in the global steel market, the headwinds the company faces affect the entire steel industry, and AK Steel's earnings come on the heels of lower quarterly profits from fellow steelmaker Nucor (NYSE: NUE  ) last week. Tuesday's news prompted a broad sell-off that saw domestic operations such as US Steel (NYSE: X  ) decline alongside global players such as ArcelorMittal (NYSE: MT  ) .

Steel has been in the doldrums since the start of the 2007 recession, when the bottom fell out for steel demand in the construction and automobile industries in North America and Europe. This left Western steelmakers beholden to the Chinese market at a time when China was striving for self-sufficiency in steel production. Over the past decade, China has accounted for about half of all global steel consumption, but between 2000 and 2011, China increased its share of global steel production to more than 45%.

As China's economy cools down, its domestic steelmakers are beginning to export more of their product, resulting in a global glut of steel that has left American steel producers unable to achieve pricing power or volume growth. Businesses such as AK Steel are especially vulnerable because they are unable to control their own costs. Without its own mining operation, AK Steel has to buy key inputs such as iron ore on the open market at significant expense.

A rough steel market does bring down iron ore prices as well, but the seaborne iron ore trade is dominated by three global miners -- Vale (NYSE: VALE  ) , BHP Billiton (NYSE: BHP  ) , and Rio Tinto (NYSE: RIO  ) , with Brazil-based Vale controlling 26% of the market alone, and the other two not far behind. This heavy concentration gives iron ore producers significant pricing power, and iron ore prices have already begun rising despite slack steel output.

Some steelmakers, particularly ArcelorMittal but also US Steel, have achieved a good degree of vertical integration, with their own iron mines offsetting rising input costs. Others, like Nucor, focus on recycling scrap steel to manage costs. Companies without any control over their inputs, however, are left to the mercy of the spot price market. AK Steel actually buys its iron ore from ArcelorMittal and Rio Tinto. An iron ore price spike in 2010 set AK Steel on a path to securing half of its own material inputs by 2014, but the company was forced to buy assets at a time when its balance sheet was already weak.

Steel demand is bound to recover eventually. A growing global population needs steel for construction, energy production, and transportation, and no real alternative is available. The recession and the capacity ramp-up in China have left many steel producers selling for fractions of their book value, but that doesn't mean every steelmaker is a good value investment. An "eventual" recovery might be inevitable, but it could be years away, and not every steelmaker is sure to survive until then.

Squeezed by rising input costs and flat demand, smaller and more vulnerable steel companies may succumb to the pressure. Steel remains a highly fragmented industry -- €”ArcelorMittal is the world's largest steel producer yet has only an 8% market share -- €”so there remains a lot of room for consolidation. Investors in the steel industry should come prepared, with long time horizons and an eye for companies that can withstand a prolonged slowdown.

For a patient buy-and-hold investor who can weather the ups and downs of the commodity cycle, Nucor looks like a company built to last. The company's vertical integration provides protection from volatile input prices, while Nucor's steel mills are some of the most efficient in the industry. Best of all, a dividend near 4% means investors get paid to wait for an upturn.

In fact, The Motley Fool believes in Nucor's prospects so much that we have recommended it in our premium newsletter services. Right now, investors can learn more about Nucor as well as discover two other stocks we think are built for the long term in our new report, "3 Stocks That Will Help You Retire Rich." This peak into The Motley Fool's premium research is completely free, but it's available for only a limited time, so click here to get your copy now.

Fool contributor Daniel Ferry owns shares of ArcelorMittal and Rio Tinto. The Motley Fool owns shares of ArcelorMittal. Motley Fool newsletter services recommend Nucor. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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