How Steel Is Making Its Comeback

In a recent 50/50 joint venture, ArcelorMittal (NYSE: MT  ) and Nippon Steel and Sumitomo Metal bought the ThyssenKrupp AG Calvert, Alabama steel complex for $1.55 billion. The plant has a running capacity of 3.5 million metric tons per year. It produces hot rolling, cold rolling, and finished steel from slab steel input. The plant will supply zinc-coated sheet steel to the U.S. automotive and construction industries.

ArcelorMittal and Nippon Steel will purchase 2 million tons of slabs per year from ThyssenKrupp's Brazilian operation for the next five years. ThyssenKrupp's plants in Brazil can produce 5 million tons of slab steel. To keep the plant profitable, ThyssenKrupp will have to operate the plant at least at 80% utilization, producing more than double the amount it will supply to Calvert, Alabama. That leaves about 3 million tons of slab steel for sale in the merchant steel market.

Hit by three years of losses and mounting debt, ThyssenKrup is attempting to restructure away from bulk steel and into elevators and factory components. It hopes to cut about $600 billion in costs over the next two years.

Steel market dynamics
At the top of the steel value chain is iron ore. Iron ore forward prices into late 2014 are backwardated by as much as 15%. Backwardation occurs when the expected future spot price seen in today's transactions is lower than prices for spot delivery. Usually backwardation is symptomatic of larger than anticipated inventories and slower than expected demand at the consumer end of the value chain. It also does not last for very long as producers shift operations from low to high margin regions.

Iron ore is converted into liquid iron and often casted into pig iron. Limestone and coke (from coal to add carbon) are added to iron to produce steel. Crude steel is then formed into ingots, blooms, billets, slabs, and sheets. This is the input to the Calvert mill from the ThyssenKrup Brazilian steel maker.

Form this point slabs are fabricated into various steel products such as hot rolled coils, or HRC and sold as finished steel from the loading dock at Calvert. The spread between slab steel and HRC averages about $175 per ton.

U.S. market grows
Finished steel prices have sagged some in the E.U. and Asia due to slower demand. However, in the U.S. a semblance of an economic recovery, and some significant supply disruptions at U.S. Steel, combine to support prices through 2013.

Supply and demand for any commodity is dependent on the region. Excess supply of iron ore and semi-finished steel will shift from the E.U. and Asia to the Americas. Anti-dumping protection in the U.S. will help insure that U.S. finished steel prices will continue to exceed Asian prices.

It seems this is what ArcelorMittal and Nippon are banking on. The Calvert plant could run at more than 4.5 million tons per year. To do that ArcelorMittal would need to divert about 2 million tons of slab steel to Alabama. The shortfall in the merchant market can be made up by utilizing the ThyssenKrupp Brazilian plant at 80% of capacity.

Payback hedged
In either case, the volumes remain flat, and so too will input prices to the Calvert plant. At a $175 per ton baseline spread, the Calvert plant could earn a margin of over $787 million per year. With infrastructure demand burgeoning in the Americas, HRC prices should be rising while slab prices remain stable. In this scenario payback for the ArcelorMittal-Nippon Steel consortium could take less than two years. The plant should be contributing to dividends within that timeframe.

ArcelorMittal had cut its dividend in 2012. Chairman Lakshmi Mittal cited Chinese steel demand substitution, slower global demand, its own large debt overhang, and reregulation of commodity markets as contributing factors. The opportunity to buy ThyssenKrup's Alabama asset shifts new earnings sources to the Americas. The debt has been reduced. ArcelorMittal's slump may be over.

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