The relentless rapid economic development in China is a well-documented story. Nevertheless, what has been less understood, until recently, is the explosive impact of this growth on metal and mineral demand. One such industry that is experiencing the full impact and which has yet to come to grips with the changing landscape is the steel industry. By taking a closer look at the 'China Factor' and its immediate and longer-term impact on the industry, one can better gauge the effect and impact, beneficial or otherwise, on local steel producers and downstream manufacturers.
Part 2 : The 'China Factor' - Her Role in the Changing Landscape of the Global Steel Industry
Part 1 of i Capital examined (A) Driver of Production and Consumption and (B) Causes of Raw Material Shortages. Under (B), it reviewed (i) Iron ore and (ii) Coking coal and coke. In Part 2, "The Steel Industry" series continues with (iii) Steel Scrap.
Whilst it may not be the only cause of the skyrocketing steel scrap prices last year, China's increase in crude steel production over the years has greatly influenced the global demand/supply balance of the recycled steel market. Today, approximately one-third of global steel production is based on electric arc furnace (EAF) route, roughly equating to 350 mln MT. Based on the assumption of yields, the total amount of scrap needed is approximately 400 mln MT, of which a quarter comes from the steel mills' own scrap and the balance from merchant scrap (see figure 1). Out of the 300 mln MT of merchant scrap, about 85 mln MT were traded around the world (see figure 2).
Figure 1: Scrap Demand
Figure 2: Scrap Trade
Although China only accounts for 10% of global scrap trade, she is nevertheless the 2nd largest importer behind Turkey. The primary source of her imports is the US, which is the world's largest exporter of steel scrap. Together with South Korea, both countries consumed approximately half of the US's exports. It is the explosion in demand from China to feed her mini-mills that partly caused scrap prices in the US to surge in 2004 (see figure 3). With China scouring the globe for steel scrap and countries like Russia, Ukraine, Korea, Egypt and Taiwan implementing controls or taxes on exports, it is not surprising that a supply panic ensued. Although China has cut back on imports during the winter months on the back of reduced construction activities and government's clampdown on the overheating property and construction sectors, there are fears that an eventual pick up in demand may once again flip the market inside out.
Figure 3: Average Prices of Scrap
Part of these fears stem from the fact that scrap growth cannot exceed the rate at which ore is converted to steel. Supplies of recycled steel scrap is necessarily finite as there is a limit to just how much 'old' steel can be discarded and recovered in any given year. Although there is room for temporary expansion through more intense scrapping of obsolete cars, ships and factories, it is not practical to dismantle an entire industrial base to sell as scrap metal. Moreover, high charter rates are discouraging ship owners from scrapping their vessels, cutting the industry off a vital source of high quality, low-residual scrap. This also correlates with past experiences that indicate scrap supply is actually price inelastic, meaning that scrap supplies at higher price levels do not expand even though the price continues to increase further. Furthermore, if the recent price increases in the raw materials of iron-ore and coke for blast furnaces are not contained, electric furnace recycling may once again be the preferred choice in melting steel and thereby, creating further demand pressure on steel scrap.
For the moment, these fears can be temporarily laid to rest as China is painstakingly clamping down on small, inefficient mini-mills throughout the mainland and encouraging industry integration and consolidation through mergers. It is also heartening that steel making from EAF only formed 18% of China's total melting capacity. Given that the electricity shortage situation is unlikely to be resolved any time soon, this percentage will most likely fall over the medium term. With low-grade construction steel in abundance and its focus centred on moving up the value chain, it is unlikely to encourage further expansion of mini-mills. Over the longer term, however, if demand continues to grow and the present ratio of steel making maintains, the industry could very well revisit the days in 2004 when steel prices can change by 10% in just one day.
(C) China - Net Importer or Exporter?
Undoubtedly, the billion dollar question of whether China will be a net importer or exporter has been hogging the minds of everyone within the industry for the answer will inexorably chart the path of global steel prices over the medium to long term. To better appreciate the issue at hand, one needs to understand how the fragmented but highly intertwined global steel trade works. Despite the occasional erection of trade barriers to insulate domestic markets, increasing globalisation of the industry has meant that the players within it must not only focus on the health of their respective markets but also be quick to adapt to the rapidly changing demand-supply conditions in the other major markets.
The US steel crisis of 1998 was a classic example of how a sudden shift in the demand-supply conditions of foreign markets can decimate a booming and healthy domestic market. To those who remembered, the crisis was triggered by the economic downturns abroad, where many economies collapsed and demand dried up. Asian steel producers and traditional exporters to the region, such as Russia and Brazil, quickly diverted supplies to the US and Europe, where demand was still strong. Not only was imported steel flooding the US market, it was coming in at extremely low prices (Japanese-quality steel at Russian prices), assisted by the depreciating values of the foreign currencies. By the end of 1998, steel imports had increased to almost 38 mln MT, a 33% increase over 1997 and far outstripping the 6% increase in US demand. Because the US market could not absorb the deluge of imports, inventory levels of US steel mills and service centres rose and prices plummeted. Eventually, steel mills had to be shut down and thousands of steel workers were laid off.
On the flip side, the surge in steel prices from 2002 till the early parts of 2005 was driven by the ferocious demand from major import markets such as China, the US and EU. Such was the intensity from the convergence of the three sources of demand that prices of semi-finished steel, finished steel and their respective input materials skyrocketed, not to mention the shipping rates for transporting these goods. However, by Aug 2004, signs of a cyclical peak in steel prices emerged when the US steel service centres stopped orders due to overstocking but global prices held up as US-bound stocks were diverted to the one market that was still absorbing huge quantities - China. Not surprisingly, when the solitary engine of global growth finally stuttered in early Apr 2005 due to government measures to cool its overheating economy and the commissioning of new capacity (40-50 mln MT per annum), global steel price started its cyclical downturn. Worse still, with production growth (26% year-on-year) exceeding local consumption growth (16% year-on-year), Chinese steel products have been making their way to foreign shores, further depressing the overall market. Hence, whether China continues to be a net importer or transforms into a net exporter of steel over the medium to long term will be crucial in determining the overall health of the global steel industry.
As such, let us take a more in-depth look at her present state. In spite of the fact that China is the largest producer of crude steel, she is still unable to satisfy her domestic demand without significant imports (see figure 4).
Figure 4: China's Steel Exports and Imports
In 2004, China imported 29.3 mln MT of steel products - the largest of which was flat-rolled products (cold-rolled, coated and electrogalvanised sheets) and semi-finished steel. In contrast, China's steel exports were 14.23 mln MT, with construction steel (long-rolled products and steel billets) forming more than half of the exports. With the cheaper and low value-added products dominating its exports, the gap between steel imports and exports is much larger in terms of value than it is in terms of quantity. High value-added products, such as steel plates and sheets, accounted for 86% of the country's total steel imports (see figure 5), compared with 41% of its exports. Although the gap between China's steel imports and exports narrowed last year, resulting from a 21% drop in imports and a 74% increase in exports, much of that was fuelled by the 30% difference in pricing between domestic and international markets. The pricing gap has since shrunk to about 11% from as high as 41% in Sep 2004. Whilst the drop in imports is causing some anxieties amongst industry players, there are recent encouraging signs that China is unlikely to alter her position as a major, if not the largest after the US, net steel importer for years to come. What are these?
Figure 5: Imports of Flats vs Total
Well, for a start, China's massive production machinery is centered mainly on the lower-end products (see table 1), which explains why the bulk of her exports comprise steel bars, wire rods and billets. She is still heavily reliant on imports of cold-rolled sheet, zinc-coated sheets, stainless steel plate and cold-rolled silicon steel sheets to feed her rapidly expanding industrial base, led by the automotive and shipbuilding industries. Presently, 40% of these high-grade products are imported. To give a clearer picture, its strip sheet steel ratio is a lowly 34%, as opposed to the more than 60% commonly associated with the major industrialised and developed countries.
Table 1: Breakdown of China's Steel Production ('000 MT)
Under the Mid and Long Term Development Planning for the Iron and Steel Industry, demand for hot-rolled and cold-rolled sheets is likely to reach 85 mln MT and 53 mln MT respectively by 2010, whilst present domestic production only amounts to 54.2 mln MT and 15.5 mln MT respectively (see table 2). This highlights the wide gap that needs to be filled for China to sustain her industrialisation pace, either by a rise in imports or a rapid step-up in technological know-how. Seeing that the learning curve for the latter is steep and involves significant capital investment, not to mention time and resources, increase in imports of steel sheets will be the most likely option for the time being. Nevertheless, recognizing its vulnerability to imports, plans are already underway to boost her sheet-making capacity (table 2). Over time, rising domestic capacity will slowly and surely displace imports and China will be able to achieve her longer-term objective of being self-sufficient. As for how long or quickly it takes to achieve that objective, the jury is still out but rest assured, it will not be this year or the next.
Table 2: China's Present and Future Capacity and Demand for Flat Products (mln MT)