It's been a rough year so far for iron and steel companies and other metal-related stocks. Once among the market's leading sectors, metals have now become laggards.
The basic cause is not altogether complicated. Just as a steel shortage in the back half of 2004 triggered a price boom, increasing supplies have weighed prices back down. While world economic growth has been okay, it hasn't been strong enough to absorb all the new supply flooding the market.
Once again, we see the basic pattern of a commodity cycle. Producers fall behind in capacity, and buyers begin to consume inventory. Demand then continues to increase to the point of supply shortages, leading to a spike in prices. Suppliers increase output by more than enough to satiate the demand, and prices are pushed back to the point where it no longer makes sense to continue increasing output in earnest.
Warning: Warnings ahead
The markets indicate that metals' latest cycle is finally coming to a head. Worldwide steel output has increased by over 8% through the first five months of the year, with Chinese output increasing over 27%. Even in the best of times, it's tough for the market to absorb that much steel. Consequently, prices have softened -- dropping by as much as one-third per ton in some cases.
Now we're starting to see the ripples hit the metal companies. Recyclers like MetalManagement (Nasdaq: MTLM) and Commercial Metals (Nasdaq: CMC) have reported considerably lower prices in the scrap market, and analyst estimates have started to slide. Always one of the more volatile parts of the metals market, recycling prices and demand have recently become even more unstable as producers and customers adjust to the new market realities.
Steel producers are also beginning to see the effects. Tokyo Steel Manufacturing has announced price cuts, and both Arcelor and ThyssenKrupp have begun cutbacks in response to soft European markets. American steel producers like SteelDynamics (Nasdaq: STLD) and Nucor (NYSE: NUE) have issued second-quarter warnings based largely on weakness in rolled steel pricing.
While the ever-plucky CEO of MittalSteel believes that the market is presently undervaluing and underappreciating steel companies overall, even this mighty producer has acknowledged some supply and price overhang in the market right now.
China Syndrome
China is the focus of the current problem: They're producing far more steel than anyone else. Although the Chinese government appears committed to the notion of slowing down economic expansion, the mills continue to churn out more steel, and China will likely be a net exporter this year.
Despite a surplus of steel, China has also found itself with a surplus of iron ore. China's iron imports have actually managed to exceed steel production, appreciably raising inventory levels at its ports.
As a result, iron ore producers report that the Chinese are rescheduling shipments -- trying to push them back and delay receipt. So while major iron ore producers like RioTinto (NYSE: RTP), BHP Billiton (NYSE: BHP), and CVRD (NYSE: RIO) managed to secure massive iron ore price hikes only a few months ago, they're now forced to sit and wait for China to accept the ore they contracted to buy.
Little ripples become bigger waves
The impact of China's desire to delay iron shipments is also rippling into the shipping sector. Whether China sources its iron ore from Australia or Brazil, it all travels by boat. Now that China is holding back on deliveries, once-hot demand for those cargo vessels has cooled. Day rates on cargo ships have dropped quickly over the past few weeks -- by over $1,000 a day in some cases.
Of course, this isn't all bad news. If you're a major user of steel -- say, a company like Caterpillar, Deere, or Joy Global -- you're grateful to finally see some price breaks on a major cost input.
What now?
As in every commodity cycle, it's anybody's guess what will happen next. On the demand side, you have the risks that Europe could slide into recession and/or that the American housing boom could end badly and hurt the economy here. On the flip side, auto demand (and production) could tick up and major steel-consuming construction projects could accelerate.
On the supply side, the Chinese government is still rather new at their quasi-capitalist system. Will they be able to rein in supply and promote the industry consolidation they say they want? Or will the Chinese mills over-produce themselves into a glut?
Nobody knows, and that's part of what makes investing fun. Companies like Rio Tinto, BHP Billiton, POSCO and CVRD are quality names worthy of investigation by investors who want basic material exposure. But be warned: These are challenging times to get into the steel and iron markets.
Heavy metal fans, rock on with these Foolish takes:
Fool contributor Stephen Simpson has no financial interest in any stocks mentioned (which means he's neither long nor short the shares).
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