The steel industry has been struggling for five years, as the global economy has shown only limited growth over that time period, hitting investors in steel manufacturing particularly hard, even as the rest of the market recovered strongly:
At the same time, the production of natural gas in North America has skyrocketed:
At first blush, it wouldn't seem that these two are related to one another. However, there are two ways in which the expansion in natural gas (and domestic energy production in general) is helping to lift the steel industry, especially Nucor (NYSE:NUE) and its partnership with Encana (NYSE:ECA). Let's take a closer look.
Use what you need; sell what's left
Nucor CEO John Ferriola didn't mince words when he referred to using natural gas to fuel the furnaces in its soon-to-open direct reduced iron (DRI) facility in Louisiana a "game changer" on the company's third quarter earnings call. But he was speaking in wider terms as well, as the analyst question that prompted his response also dealt with the growth of energy in the U.S., and the "steel-intensive" nature of oil and gas production.
And this is a big part of why the company chose to locate this new DRI facility in Louisiana, with much of the domestic energy sector either being based or having significant operations nearby. The company is working to develop new types of plate steel, featured heavily in oil rigs, platforms, and equipment, to grow its business in the energy sector and having a strong presence on the Gulf Coast is important to this happening.
However, the potential volatility of natural gas prices is a concern, which is why the company's venture with Encana gives it a significant advantage versus competitors that also produce DRI. The cost advantage is against companies like U.S. Steel (NYSE:X), which operate more costly integrated mill processes fueled by metallurgical coal to reduce iron to use in steel products. Nucor management provided additional insight into the venture with Encana on the Q3 call, telling us that the expected output of the wells would produce enough natural gas to run two mills the size of the first one at Saint James Parish site currently being completed, with fuel left over. Management also said that it expects the venture to be "cash-flow positive" by sometime next year.
This is a tremendous advantage versus competitors making DRI, not to mention those like U.S. Steel, which don't use the lower-cost, lower-pollution method of reducing iron at all. Not only does the company get the benefit of lower production costs, it will get the upside of sharing in the profits from selling excess fuel. It's a win for Encana, as its exploration and production costs, and the risk of operating the wells, are effectively cut in half.
But it's all about how you make steel
Which is why U.S. Steel doesn't use DRI. Nucor pioneered the "mini-mill" plant some four decades ago when it first moved into the steel business, while U.S. Steel still operated its legacy integrated mills, and has chosen to continue to do so, greatly reducing the company's ability to expand and address new markets and geographies as cost-effectively as Nucor can. The Q3 results bear this out, with Nucor beating earnings projections, largely on the benefit of competitive shortfalls in the sheet steel business, which it was able to meet. Whether U.S. Steel was one of the competitors that couldn't meet demand, we won't know until it announces earnings on October 29.
These sorts of "outside the box" actions are often bad ideas that water companies down and remove focus from what they do best. However, utilizing Encana's expertise to significantly hedge input costs for as long as two decades is a smart move for Nucor. Yesterday's earnings beat doesn't yet reflect the bottom-line impact of the new DRI facility, which will begin operations sometime in December. And as the domestic economy continues to improve, driven in part by expanded energy production, cyclical businesses like Nucor will be big beneficiaries. Now's a great time to dig in and see if Nucor fits your portfolio.
Jason Hall has no position in any stocks mentioned. The Motley Fool recommends Nucor. 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.