Is there Something to Wall Street Hating Anything Steel Lately?

Source: Arcelormittal Media Relations

Steel and steel manufacturing has been and pretty much always will be a cyclical business. Economic outlooks cause demand for these products to wax and wane, and the material suppliers of these products -- most notably raw iron ore and metallurgical-quality coal -- see cycles of boom and bust.

With the steel market still in a lull, it is not surprising to find the likes of Walter Energy (WLTGQ), Alpha Natural Resources (NYSE: ANR), Cliffs Natural Resources (CLF -0.10%), and AK Steel Holding (AKS) on The Wall Street Journal's list of stocks with more than 27.5% of their shares sold short. With so many companies on this list, it begs a question: Is this simply a cyclical swing, or are there some structural differences in the steel market that are causing these companies to sink? Let's look at the argument for both and see where steel may be headed.

It's a cyclical thing

Source: The Wall Street Journal

There have been several signs across the world that indicate the steel market has yet to take off like the rest of the market. Europe has struggled from not just malaise, but cheap natural gas in the U.S. has discouraged significant investments and has even sent other sectors reeling. This is especially troublesome for Alpha Natural Resources since it is America's largest exporter of metallurgical coal, and more than 43% of all exports for Alpha are destined for Europe.

More important to the global steel market is China, which has seen its steel demand slow because of a greater focus on consumer-driven growth rather than infrastructure development. What compounds this problem even more is China's overcapacity to produce steel, which has forced many Chinese steelmakers to export excess capacity. On several occasions, it is being sold at prices less than what it can be produced for. Nucor (NUE 0.31%), one of America's low-cost-steel producers, has even gone so far as to claim China is illegally dumping steel on other markets. So, not only are the direct steel manufacturers like Nucor and AK Steel suffering from an extremely competitive price environment, it also significantly impacts the domestic suppliers of iron ore and metallurgical coal like Walter and Cliffs.

Looking forward, there appears to be signs that these issues are starting to be resolved. The American market in general is starting to see some headway thanks to an uptick in the automotive and energy industries, both of which have a strong need for steel. Also, China's Hebei province, the nation's steel-manufacturing hub, actually wants to cut steel production by 15 million tons per year in an effort to cut carbon emissions. If these trends were to continue, it is very possible American steel and its associated industries could see an uptick in both price and demand for their product rather than imported steel. 

Structural weaknesses
There is one element that all of these companies share that could be the reason they have such strong short positions while companies like Nucor don't seem to have as many naysayers. All of these companies rely on metallurgical coal in some form or the other. Alpha, Walter, and Cliffs are all metallurgical coal suppliers, and a majority of AK Steel's facilities use metallurgical coal in its blast furnaces.

The reason this could become an issue for these companies is the shift away from metallurgical coal and more toward the use of natural gas in steel manufacturing. With natural gas becoming cheaper relative to metallurgical coal, companies like Nucor have made large investments in electric arc furnaces in direct reduced-iron facilities like its new plant in Louisiana. A greater move toward American steel manufacturing using natural gas could put a huge dent into metallurgical coal demand and, at the same time, force companies like AK Steel to make significant upgrades at its existing facilities or risk falling behind in the pricing war.

What a Fool believes
There are reasons to believe that the steel market is on the cusp of an upswing. Still, there are some structural issues that will challenge big time steel-industry suppliers further down the road with natural gas trying to stake its claim as the premier fuel here in the United States. Looking at the macro environment for steel, this may not be the best time to be short a steel supplier. It will still take several years for companies to convert aging facilities from coal to natural gas, so metallurgical coal suppliers probably still have some room left to run.