Steel: Bloated Sector Running Out Of Luck

BMI View: Overcapacity will weigh heavily on China's domestic steel industry over the coming quarters, primarily due to contracting growth in fixed asset investment. Weak end-user demand and low prices will maintain pressure on producer margins and we forecast significantly slower production and consumption growth over the previous decade. Central government economic stimulus in the coming months should temper rather than reverse this trend. Meanwhile, reluctance on the part of local governments to curb production by the amount required to address domestic overcapacity and persistently high stocks will continue to encourage exports.

We believe significant overcapacity will continue to undermine China's steel sector over the coming quarters. Stimulus measures from the Chinese government will offer respite for the sector, but this will prove to be short-lived as a number of precarious fundamentals weigh heavily on the industry. According to China Iron and Steel Association (CISA), the average profit margin for 80 major Chinese steel producers reached 0.13% in H113, the lowest among all industries in the country.

We forecast steel production to grow by a modest annual average of 3.7% between 2013 and 2017 to reach 845 mn tonnes (mnt), while consumption will grow by an average of 3.0% over the same period to reach 784mnt. This will mark a drastic slowdown from the previous decade, during which annual production and consumption growth averaged 10.2% and 11.3%, respectively.

Consolidation A Slow Process
China - Steel Production, Consumption & Balance ('000 tonnes)

BMI View: Overcapacity will weigh heavily on China's domestic steel industry over the coming quarters, primarily due to contracting growth in fixed asset investment. Weak end-user demand and low prices will maintain pressure on producer margins and we forecast significantly slower production and consumption growth over the previous decade. Central government economic stimulus in the coming months should temper rather than reverse this trend. Meanwhile, reluctance on the part of local governments to curb production by the amount required to address domestic overcapacity and persistently high stocks will continue to encourage exports.

We believe significant overcapacity will continue to undermine China's steel sector over the coming quarters. Stimulus measures from the Chinese government will offer respite for the sector, but this will prove to be short-lived as a number of precarious fundamentals weigh heavily on the industry. According to China Iron and Steel Association (CISA), the average profit margin for 80 major Chinese steel producers reached 0.13% in H113, the lowest among all industries in the country.

We forecast steel production to grow by a modest annual average of 3.7% between 2013 and 2017 to reach 845 mn tonnes (mnt), while consumption will grow by an average of 3.0% over the same period to reach 784mnt. This will mark a drastic slowdown from the previous decade, during which annual production and consumption growth averaged 10.2% and 11.3%, respectively.

Consolidation A Slow Process
China - Steel Production, Consumption & Balance ('000 tonnes)

China is by far the world's largest steel producer and consumer, accounting for 45.3% and 44.5% of global output and consumption in 2011, respectively. The country runs a domestic steel surplus, but is only a modest exporter.

Demand: Weakness Ahead, Longs To Underperform

The key factor underpinning our downbeat view on China's steel industry is our expectation of a continued sharp slowdown in fixed-asset investment in China, which will see further softening in demand for steel. We expect construction activity in China to moderate significantly in the coming quarters, which will have a notable impact on demand given the steel-intensive nature of the industry.

Waning Support For Steelmakers
China - Select Indicators (% chg y-o-y)

We expect growth in Chinese construction activity to moderate significantly in the coming quarters, and we forecast construction sector value growth of 6.4% in 2013, compared with 9.7% in 2011 and 13.5% in 2010. At the heart of this slowdown will be a rebalancing of the economy away from fixed asset investment. This trend will be exacerbated in the short term by a sharp contraction in residential construction. Our core view remains that the property tightening measures enacted in recent months are unlikely to be rolled back in the face of continued rising prices ( see: 'PMI At New Low As Property Prices Hit New High', July 24). As a result we are forecasting growth in apparent steel use to slow to 3.2% in 2013 from 4.1% in 2012 and 6.2% in 2011.

Demand Slowing As China Shifts Gear
China - Steel Consumption by Sector (2011)

Due to the nature of China's economic slowdown, we expect the flats segment to experience more resilient demand than the longs segment. The longs segment will be weighed down by an end to the boom years for construction, while flats will be supported by a more resilient outlook for domestic manufacturing and consumption. For instance, we anticipate a continued recovery in autos demand and forecast domestic vehicle production to grow by 8.6% and 8.3% in 2013 and 2014, respectively, compared with 5.6% in 2012.

Falling Inventories Won't Last Long
China - Total Steel Inventories

Production: Boom Years Are Over

Production growth will collapse and we forecast growth of 8.1% in 2013 and 3.1% in 2014 compared with an average of 10.2% over 2007-2011. Consolidation of the behemoth Chinese steel sector will be primarily driven by the deterioration in margins that has made production unprofitable at many smaller, inefficient mills ( see: 'Writing On The Wall For Chinese Steel', July 31). While abundant finance has previously allowed such mills to shore up operations in recent years, a recent clamp down on bank lending to the steel sector will accelerate the cost rationalization of production.

Production Growth To Slow
China - Crude Steel Production & Growth

However, production will not collapse as regional governments have a strong incentive to support local production where possible in order to maintain employment and prestige. For instance, although central government has been trying to encourage regional governments to facilitate industry consolidation for several years, such efforts have met with limited success.

Additionally, with the weighted-average cost of production for China's iron ore sector at around US$107/tonne, our forecast for iron ore prices to average US$120/tonne in 2013 is unlikely to instil production cuts that are substantial enough to warrant major price pressure for Chinese steelmakers. As seen in the chart below, more than 92.4% of the country's iron ore output is produced at levels below US$121/tonne, with Hebei being the largest producing province, at 42.7% of total output.

Input Costs Offering Some Respite
China - Iron Ore Cash Costs By Province (LHS) & Iron Ore Production By Province, mnt (RHS)

Exports To Rise In Near-Term

As domestic overcapacity continues to bite, we expect greater volumes of steel to be channelled into exports. Steel exports surged to 55.8mnt in 2012, a 14.1% increase from the previous year, and the highest level since 2008. Indeed, an increasing number of countries are turning the screw on China in recent months over its alleged dumping of steel products abroad ( see: 'Steeling Trade: Trade War Prospects & Implications', June 04). A n overwhelming number of domestic steelmakers are turning to the seaborne market for revenue growth as they battle to cope with the growing woes plaguing the Chinese steel sector.

Imports could also be discouraged, aided by government policy intended to support embattled domestic producers. For instance, CISA has appealed to central government to alter tax incentives to encourage the purchase of high-end steel products from domestic producers by plants that usually rely on overseas suppliers.

Turning To Exports To Arrest Domestic Woes
China - Exports of Steel Products

Stimulus Measures To Have Only Limited Effect

Incorporated into our forecasts is an expectation that central government economic stimulus measures over the coming months will have only a limited impact on turning the ailing steel sector around (see: 'Consolidation Catching Up With Bloated Steel Sector', April 19 ). First, we do not expect stimulus measures to compare with 2009-10 in terms of scale or composition. With regards to the latter point, we expect stimulus measures to be more weighted towards supporting private consumption than the 2009-10 stimulus, which was extremely fixed investment intensive.

Second, Beijing's new leaders are adopting a more cautious stance towards the country's urbanisation drive , fearing another spending binge could push up local debt levels and inflate a property bubble. Local and provincial governments are the primary purchasers of domestic steel and this section of the economy faces mounting debt levels and central government pressure to curb industrial inefficiency.

Steelmaker Margins Crushed
China - Price Ratio: Steel Rebar/Iron Ore

Furthermore, as spotlig hted by the recent bankruptcy of Jiangxi Pingte Iron & Steel Co. Ltd , a relatively small producer with an annual output capacity of 800 thousand tonnes per annum (ktpa) , the Chinese government is adopting an increasing hardline stance by starting to refrain from further corporate bailouts in the behemoth steel sector. This will almost certainly pave the way for industry consolidation once many of the steel mills currently operating on razor-thin profit margins are allowed to go bust.

Large Players To Increasingly Dominate

The dominance of large state-owned steel mills will increase in the coming years as weak margins at inefficient small mills force some consolidation of the sector. While margins at larger mills will also remain weak, state entities will benefit from greater government support. According to CISA, China's 10 largest crude steel makers produced 46% of the country's total crude steel output in 2012. Over the longer term China aims to concentrate 60% of the country's total steel capacity in the hands of its top 10 firms by the end of 2015, according to its latest five-year plan for the industry.

Production To Shift Westwards

Over the long term we expect the focus of China's steel sector to move away from the east of the country as the government announced plans to encourage iron ore mining and steel manufacturing in the west, in provinces such as Xinjiang and Gansu. Land, labour and electricity tend to be cheaper in the west of the country and thus at a time of narrowing margins, companies are looking to lower costs. Approximately 60% of China's steel production is concentrated in six provinces, with Hebei, at 23% of the total output, accounting for the single largest share of production.

China - Steel Production & Consumption (kt, Unless Stated Otherwise)
e/f = BMI estimate/forecast. Source: BMI, WSA
2009 2010 2011 2012e 2013f 2014f 2015f 2016f 2017f
Crude Steel Production 577,070 638,743 683,265 704,446 761,506 785,113 803,171 824,856 845,478
% Change y-o-y 12.6 10.7 7.0 3.1 8.1 3.1 2.3 2.7 2.5
Apparent Crude Steel Use 574,420 612,060 649,850 676,494 698,142 720,482 741,376 762,135 784,237
% Change y-o-y 23.4 6.6 6.2 4.1 3.2 3.2 2.9 2.8 2.9
China - Steel Industry Historical Data (kt, unless stated otherwise)
Source: BMI, WSA
2004 2005 2006 2007 2008 2009 2010 2011
Crude Steel Production 272,798 355,790 421,024 489,712 512,339 577,070 638,743 683,265
Ingots 9,071 9,926 12,346 10,448 9,099 7,735 10,851 9,200
CCS 263,529 345,030 408,048 474,303 483,716 568,532 613,692 683,265
Liquid for casting 2,106 833 630 854 354 804 1,176 1,000
Hot rolled products 297,230 381,510 470,840 566,074 613,795 693,405 802,014 881,313
Hot rolled longs 162,888 190,916 232,970 271,348 276,115 335,361 368,365 407,230
Hot rolled flats 127,658 172,780 214,761 243,897 275,508 297,167 364,347 447,592
Other 6,684 7,474 19,123 18,179 18,179 18,179 18,179 18,179
Heavy sections 7,249 7,113 9,182 10,354 10,255 9,643 9,771 11,038
Light sections 21,875 19,241 25,623 29,270 29,455 36,965 39,661 45,734
Concrete reinforcing bars 57,713 71,232 86,786 103,909 100,927 130,741 141,378 154,056
Hot rolled bars (excluding crb) 23,131 29,779 37,392 45,435 48,089 53,101 65,705 69,401
Wire rod 50,189 60,464 70,638 79,210 82,708 98,907 106,206 122,591
Tube and tube fittings 21,231 28,906 36,614 41,385 50,894 53,214 56,729 66,977
Exports 20,074 27,414 51,706 66,357 56,304 23,969 41,646 47,899
Exports (US$bn) - 15.7 29.2 47 64.7 26.7 30.8 -
Exports of scrap
Imports 33,221 27,312 19,105 17,185 15,622 22,350 17,181 16,349
Imports (US$bn) 25.5 20.5 21.5 24.3 15.8 16 -
Imports of scrap 10,225 10,136 5,385 3,395 3,590 13,692 5,848 6,767

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Sector: Metals
Geography: China
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