This American Steel Maker Better Keep Its Eyes on Russia

Steel Dynamics is a domestic steel company, but Russia's energy aggression could cause it problems.

Jun 14, 2014 at 6:25PM

Steel Dynamics (NASDAQ:STLD) has navigated a tough steel market exceptionally well. However, this domestic mill could find that the ripple effect from Russia's moves in Crimea hit it harder than you might expect. Why would a U.S. steel mill care about Russia's political moves half a world away?

Steel Dynamics is hitting on most cylinders
The steel industry has struggled through a rough patch, with oversupply crimping prices. Some mills have lost money for half a decade and counting. Steel Dynamics, however, has turned a profit in nine of the last ten years, with its only loss coming at the end of the 2007 to 2009 global recession -- impressive.

That said, the company's operating margin has shrunk over that span from the high teens and early 20s to the mid single-digits. So while Steel Dynamics is handily outpacing key competitors, it's hardly hitting on all cylinders.

A big part of Steel Dynamics' success is that it runs mini-mills that use electricity and natural gas to turn mostly scrap metal into "new" steel. The money-losing competitors generally use blast furnaces that require iron ore and coal. That steel-making process tends to be more expensive. Additionally, many competitors have pension liabilities that younger Steel Dynamics doesn't.

So why care about Russia?
What does any of this have to do with Russia? Natural gas. Russia is sparing with Ukraine over its annexation of Crimea. That's led to sanctions and helped seal a natural gas deal between Russia and China that had long been stalled. For now, anyway, Russia provides Europe with roughly 30% of its natural gas, 16% of which actually flows through Ukraine, according to the U.S. Energy Information Administration.


Source: EIA

Not just a gas issue
The United States, with a plentiful supply of natural gas, and low prices relative to the rest of the world, currently limits the fuel's exports. However, Russia's actions could turn the current export drip into an open faucet. That would help our allies offset the impact of Russia's provocations and China shift. However, it would likely lead to higher domestic gas prices as the supply glut gets exported away.

This isn't just a gas issue. Sure, Steel Dynamics will feel the pinch of higher costs if natural gas prices go up. However, its electric arc furnaces also use electricity. Low domestic gas prices have led an industry shift from coal to natural gas in the utility sector, and it's been a big shift.

Take giant Southern Company (NYSE:SO) as an example. Coal accounted for roughly 70% of Southern Company's power in 2004. In the first quarter of 2014, it was down to 45% (which was actually up from 2013's first quarter of just 32%). The difference was made up by natural gas, which increased from 12% of the mix a decade ago to 35% in the first quarter (but down from nearly 50% in the first stanza last year). Nuclear and hydro power have remained virtually unchanged.


(Source: U.S. Government)

In fact, Southern Company's CEO Thomas Fanning recently estimated that his utility was now one of the top three natural gas consumers in the country. Although Southern Company can shift between fuels to some degree, stringent government regulations have led to more and more coal plants being shuttered. That means that natural gas will be the go-to fuel for an increasing number of utilities—whether they like it or not.

Higher and higher
If the United States exports natural gas, Steel Dynamics will likely find a key input more expensive. However, that could also lead to higher electric bills; there's no choice if coal isn't available as an offset. That's a potential double whammy. With relatively thin operating margins right now, higher costs could hit Steel Dynamics hard. That's why you should keep an eye on the Russia/Crimea/Ukraine/Europe/China mess. The tap-on effects could hit in places you wouldn't expect.

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Reuben Brewer has no position in any stocks mentioned. The Motley Fool recommends Southern Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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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