A lot of people have talked about investing in commodities as a hedge against inflation. Commodities in the strictest sense are basic building blocks that are needed to make other products (or to eat raw, etc.). Today I am specifically talking about metals and metal ores. Gold, silver, copper, iron ore, platinum, and others are basic commodities. When you invest in a stock as a play on gold, it is usually a gold mining stock. However, the concept becomes a little blurred when you talk about steel and aluminum. Some people view these metals as commodities. Aluminum even traded until recently on the COMEX, when it was delisted. The London Metals Exchange now carries quotes for it.
Strictly speaking, Bauxite ore is the commodity for aluminum. For steel, iron ore is the major commodity. Why is this important? It is important because there is a layer of manufacturing between the commodity and the finished product for steel and aluminum. For example, wheat is a commodity, but wheat bread is not. Wheat bread is manufactured from wheat. Wheat bread is not as good a play on wheat as the commodity itself. If you are hedging against inflation or famine with wheat, wheat is a much better, much more direct instrument than wheat bread. The same is true for metals. Iron ore is the real commodity. It is the direct play on steel (unless there is a big coal or chromium shortage).
Bauxite is the direct play on aluminum. Why is this important? It is important because many emerging economies are trying to manufacture things more cheaply than the more developed countries. This is a familiar pattern. An emerging economy will try to take business away from a developed country by providing cheaper labor, which translates into cheaper manufactured products. Textiles are often a prime first target. However, relatively simple but labor intensive manufacturing of metals such as steel and aluminum are another area of targeted competition.
In the 1960’s and 1970’s Japan took business away from the US steel industry. Later the Koreans became a bigger force. Both of the aforementioned countries soon expanded to autos, and electronics. China is doing the same thing now. One difference is that it already makes over 50% of the worldwide steel. It is the top dog. It can bully the other players. It also like most businesses wants to dominate its market.
The Chinese desire for a global steel monopoly is bad for US steels. They only represent about 5% of the worldwide market (a factor of ten less than the Chinese). They have trouble competing with the Chinese on a efficiency of scale basis alone. Then the Chinese government subsidizes their steel industry (as some recent suits for dumping have found). Plus the Chinese have pegged the Yuan at a significant discount to the USD (effectively mercantilism).
The Chinese have cheaper labor, especially since they don’t have the additional labor union benefit costs. This makes the Chinese steels even more competitive. Plus the Chinese steel industry is operating near capacity. This gives the Chinese steel makers a huge edge over US steels which are currently operating at 50-65% capacity (54% in Q3 2009). US steels have to pay further extra costs to idle, to restart, and to maintain facilities they are not using all of the time. All told this makes them very non-competitive with the Chinese steels (Russian and Ukrainian steels too).
China has doubled its steel exports in the last 6 months. Its manufacturing statistics today, which showed great growth, were up in no small part because steel exports were up a large amount. This means more, cheap steel to compete with US steels. It will likely succeed in taking business away from US steels, some of which are still struggling to return to profitability. The Chinese want to put the US steels out of business if they can. This is a good reason the US steels are not a good direct play on commodities. China is happy to buy the rawest of raw materials (ores), but beyond that they want to supply all of the labor themselves.
If commodity prices go up, usually the steel companies can pass the increased costs on to their customers. This process generally works. However, when the Chinese and others are trying to take your market share with lower priced goods of roughly equal quality, this does not always work. In 2007 to mid 2008 this did work because demand was very near full capacity. It is not now. Plus China is growing its steel production and exports (ditto Russia and the Ukraine), so there is more competition.
US steels will not be able to pass along all added costs. Their margins will be squeezed. Plus they will have to deal with a lot of the factors I described in the previous paragraph. The US steels are not a good direct play on steel as a commodity. There are significant gotchas. Perhaps some US steels such as Cliff Natural Resources (CLF) and US Steel (X) have significant integration (X has iron ore production). However, this still does not save them. With the unemployment in the US and Europe (the two major markets of US steels) likely to remain high through at least 2011, steel use in these markets will remain subdued.
Steel availability will not quickly outstrip demand. Instead greater availability of cheap Chinese (and others) steel will pressure margins to the downside. US steels are not going to return to mid 2008 levels of profitability soon (if ever). The Fed has already stated that one of its biggest worries for 2010 is a commercial real estate implosion. With more people unemployed there will be less need for office space. There will be less need to build new office space. The price of office space will likely drop. This will further discourage new commercial building, which uses a lot of steel.
The US steel companies are at this time far overpriced compared to normal fundamental measures. US steels would normally trade at a TTM PE of 10-20 (or even less). Many are in the top of that range now for FY2010 results, not TTM results. US Steel (X) is far over that range at a FY 2010 PE of 53. The sector is fundamentally due for a retracement. Fitch has all of the US steels on credit watch due to the uncertainty of their Q4 2009 and F 2010 earnings. US Steel (X) fundamentals have strongly called for a retracement for some time. Still US Steel (X) has kept chugging upward on short covering, sector following, and market following. One day soon it will correct drastically. It may be getting to that point, but it is hard to say for sure.
The following three charts of X show the 3-yr, the 1-yr, and the 3-month views of US Steel. It is at a point now that it could head into a correction, or it could again defy its fundamentals. It is too over priced for me to want to buy it, but it might be good short to the downside. If you chose to play US Steel (X) to the downside, you should probably use triggers to get short it at a point slightly below its current price plus the noise level. If X moves up from its current price, you can move your trigger price up, without having lost anything.
X 5-year chart:
X 1-year chart:
X 3-month chart:
This chart shows there is good support at about $46 for US Steel. This might be a good target point for your short, although it could certainly go lower. Still $11+ is a good profit. X is also far above its 50-day SMA. It has not gone more than about 2.5 months in the last year without crossing it. It has been about 2 months since the last cross. This is another reason it may go down.
SLX ETF 1-year chart:
The SLX chart does not show particular weakness in the steels rally yet. This is probably reason to worry about shorting X. More pronounced weakness in SLX would be good. However, much of the profit in an X short would likely be gone before the stronger steels started to fade noticeably.
The London Metals Exchange charts for the two sets of steel prices show the price has not been rising much lately.
The cash buyers Far East Steel Price Chart:
The cash buyers Mediterranean Steel Price Chart:
Neither of the London Metals Exchange Steel Price charts show appreciable price movement upward in the last two months.
Many analysts consider both US aluminums and US steels far overpriced. The only thing that has kept them from falling so far is the HYPE that the economy is going to recover quickly in 2010. I think everyone knows this is not true. They know the strong demand of vibrant worldwide, US, and European economies is a long way off. Yet somehow they have maintained the fantasy that it is happening immediately (a “V-shaped” recovery). Not many still believe this.
In fact many of the pundits I have read lately believe an extended period of poor performance is coming. Many believe China is facing a slowdown soon. China has already moved to tighten credit to combat a real estate bubble of its own. If a bubble bursts, it will hurt steel. If the USD carry trade ends, it could pressure Chinese manufacturing significantly, especially steels. If the export market does not return for China by mid 2010, China may slow down based on that.
In each case a China slowdown would mean a flood of even cheaper Chinese steel exports onto the market. This would mean trouble for US steels. It seems likely one or more of these possibilities will occur to some degree. US steels are likely to be pressured significantly in FY2010 by China and others. This will put significant pressure on their margins, profits, and revenues. X is a short to me, but it may not be to those who see US steels makers only as a commodity plays. I have tried to point out why they are not. Many are saying the price of materials to make steel have been rising, so steel must rise. This is a specious argument with an iota of truth to it. The London Metals Exchange Far East chart seems to have prices falling lately.
US and Canadian potash makers have recently had their legs cut out from under them on price by Brazilian and Russian potash. I would not care to speculate how long this will last in this article. However, the same type of thing could easily happen in steels. Up is obviously a preferred direction, but it is not the only direction. Potash FY2010 multiples are at least reasonable. X’s FY2010 multiple is not reasonable, especially given the large number of uncertainties. Even the high multiple has high uncertainty.
US aluminum makers are in roughly the same situation as steel. One of the most fundamentally overpriced US aluminums is Century Aluminum (CENX), which has a FY2010 PE of 41. Its FY2010 earnings are also very uncertain.
Its chart looks a bit more toppy than X’s. I regard CENX as a short candidate also.
Good luck trading.
Author's Disclosure: I am short X and CENX
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