How to Play the Surge in Steel

Steel stocks are suddenly hot again.

The recent news of massive price increases of 60% or more for iron ore have shattered the consensus view of flat to down pricing and sent investors scurrying to find ways to play this surge.

Here's a recap of this new investment outlook and three sexy steel stocks that just might get you into the green.

In a recent piece I penned on resources in Latin America, I highlighted global mega trends that are affecting natural resources and explained why the next 24 months should be one of the best periods to invest in basic-material stocks.

According to the report, the key to basic materials and steel is: China.

China is suddenly the largest steel producer on the planet. Just look at these numbers:

In 2006, China produced 420 million metric tonnes of steel.

That's more than double the total steel production of 25 European countries (200 million tonnes) ... three and a half times Japan's (120 million tonnes) ... and over four times America's (100 million tonnes).

Just as China has emerged as the world's steel-producing king, it has also become the world's iron-ore glutton.

China needs the iron ore to make steel for its construction industry, now the largest in the world, surpassing expenditures of $120 billion annually.

China needs the iron ore to help feed the new growth in construction -- 20% in 2006, possibly as much as 25% in 2007.

China needs the ore to build residences, highways, railroads, subways and dams.

Result: Total imports for 2007 easily will exceed 355 million tonnes.

Impact No. 1: Prices of iron ore as a basic material for steel-making will continue to escalate.

The biggest buyers -- ArcelorMittal, the Japanese and especially the Chinese steel producers -- are all looking for new sources of iron ore.

Click here for larger image.

Amid limited iron ore supplies, a small list of providers, and the rising cost of ocean shipping, the price of iron ore has been rising, more than doubling over the 2004 to 2007 period.

Three global suppliers account for 75% of the ocean trade in iron ore: Vale, formerly Companhia Vale do Rio Doce (RIO Quote), Rio Tinto (RTP Quote) and BHP Billiton (BHP Quote).

Of these my favorite is Vale. This $180 billion market-cap company ranks as the number one supplier of iron ore for China, and gets a Latin Capital Market "buy" rating. In addition to the Asian export market, Vale is also a leading supplier for the Americas.

Despite the 67% one-year price appreciation, this ADR sells at valuation of only nine times 2009 estimated earnings which still look cheap. Its popularity with investors is reinforced by its use in nearly every major Latin and emerging market indexes and several ETFs. For example, you may already own this own if you also own iShares MSCI Emerging Markets Index Fund(EEM Quote) or iShares S&P Latin American 40 Index Fund(ILF Quote).

Impact No. 2: Alternative forms of iron ore also will see increases.

Very little of the ferrous raw material base of the North American steelmakers is bought from the seaborne iron ore trade. Pellets and steel scrap are more important in the U.S as alternatives to the fine-ore form. While iron ore pellets are normally not exported, the tighter pricing and the new economics along with a lower U.S. dollar have changed this making it possible even for iron ore pellets from the Great Lakes to suddenly be cost effective.