Steel Stocks: How to Play This Bearish Moment

NEW YORK (TheStreet) -- Steel stocks have entered a decidedly bearish moment as the global economic recovery comes into doubt.

Whether you're already a shareholder or looking to take a fresh position now, given that stock prices in the sector have declined more than 30% from their April peak, here's what you need to pay attention to for the rest of the year:

CHINA

The Past: By now, every investor is familiar with "The China Story," as the financial world has come to call it. It goes a little something like this: Breakneck economic growth followed by worries in Beijing about inflating asset bubbles, followed by de facto credit tightening to reduce the risk of those bubbles, followed by terror that the world's highest-flying economy would stall out with a so-called "hard landing."

Steel production in China hasn't slowed, not yet anyway. The nation's furnaces, which produce nearly as much steel as the rest of the world combined, achieved record output again in May, producing more than 56 million metric tons of the stuff. Those numbers would seem to defy the notion that the country had eased back on its growth throttles, a notion that has since March put pressure on prices of commodities as well as metals stocks.

The Present: This week, China's publicly stated intention to allow the yuan (eventually) to run free sparked a brief uptick in the shares of steelmakers based elsewhere in the world.

That's because a stronger yuan would, in theory, discourage Chinese steel exports, reducing the risk of a flooded global market and boosting the competitive advantage of U.S.-based companies. But China's currency promises are, at the moment, just that: promises. And any real economic impact on steelmakers stateside won't be felt for a long time to come.

The Future: For steel equities, the bigger story involves China's plans for production. Recent signals from the People's Republic suggest that the country's mills now intend to cut back on production, and soon. That's because steelmakers there are getting whacked by higher raw materials costs -- far more than their U.S. counterparts. At the same time, global steel prices have gone into decline of late, falling by as much as 10%. To staunch the narrowing of their profit margins, Chinese steelmakers almost have no choice but to calm the blast furnaces (which were first invented in China, by the way, in the fifth century B.C.).

Furthermore, Beijing recently announced plans to reduce carbon emissions by eventually pulling the plug on a good number of the country's older, dirtier, less-efficient mills. The environmental moves could remove as much as 8% of China's overall annual capacity, which stands at 600 million metric tons.

What does this mean for domestic steelmakers like U.S. Steel ( X) and Nucor ( NUE)? Because China has become such a dominant force in the global steel industry, its prices have become the world's prices. Any crimping of creeping supply will thus benefit everyone.

In the end, investors ought to keep an eye on the monthly steel-production dispatches coming from Beijing.

RAW MATERIALS

The Past: Iron ore is now nearly as volatile a commodity as any other tradable metal, a transformation made complete in early spring when the world's three largest mining companies -- Vale ( VALE), BHP Billiton ( BHP) and Rio Tinto ( RTP) -- forced their customers to jettison the annual benchmark-contract system in place for the last 40 years in favor of quarterly contracts linked to iron ore's price on the spot market.

Though the changes have yet to fully shake out, the result so far has been a worldwide spike in the price of this most important of steel feedstocks.

The Present: Companies that must buy their iron ore from other sources are taking it in the gut. Witness the travails of AK Steel ( AKS), which was forced to scale back its earnings forecasts in April due to the rising cost of iron ore and, to a lesser degree, coking coal.

But the real loser amid the changes have been steelmakers in China, where no high-quality iron ore exists. For the good stuff, China must go to Australia and Brazil, thus its weaker negotiating position when attempting to settle contracts with the big miners there.

The winner when it comes to rocketing raw materials costs has been the "integrated" U.S. Steel. The Pittsburgh icon sources all its iron ore from mines it owns in places like Minnesota and the Upper Peninsula of Michigan.

Raw materials costs have also afflicted, though to a lesser degree, the operators of electric-arc furnaces, or mini mills, which use scrap metal as a feedstock -- a situation that in part led Steel Dynamics ( STLD) to issue a profit warning last week. Prices for scrap are also volatile, and these recyclers have sought to diminish the impact of that volatility over the last decade by subsuming as many scrap metal yards as they can around the country. The only problem? Keeping inventory. As the value of scrap rises and falls, so too do the accounting charges and gains, LIFO and FIFO. Lately, though, scrap prices have stabilized.

The Future: Another result of the iron ore contract upheaval: Volatile iron ore prices have led to increasingly volatile steel prices. A new world order appears to be afoot. Wildly swinging prices have left steel buyers wary of increasing their inventories. They'd rather not go long -- and find themselves in the position of a steel speculator. Instead, both service centers and manufacturers have bought only as much steel as they think they need in the short term.

That includes Bill Jones, vice chairman of O'Neal Steel, one of the largest privately held steel service-center operators in the U.S., which has kept its inventory levels as low as possible while still maintaining the ability to meet the demand of its customers (they include manufacturing giants like Caterpillar ( CAT) and Deere ( DE)). "We try to buy only toward our forecasted needs," he says. For that reason, O'Neal has a "domestic bias" when it comes to its suppliers, Jones says. The longer lead times involved in buying steel from overseas would, in essence, force the company to go long on steel.

In the end, look for steel prices to rebound over the next month or two as producers pass along the higher cost of raw materials to their customers. Once again, it will largely be China's doing. As Michelle Applebaum, an independent steel analyst, has explained, , the sheer enormity of the country's steel industry has created a "cost umbrella"for the rest of the world. When Chinese mills pass along the cost to buyers, the higher Chinese price becomes the de facto world standard.

DEMAND

The Past: Sensing an increase in demand earlier this year, steelmakers started hiking capacity, bringing idled mills back into service. Those decisions now look somewhat premature. "The industry probably got a little ahead of itself," says Leo Larkin, the metals and mining equities analyst at Standard & Poor's.

That's in large part because non-residential construction remains all but in the grave. Steelmakers received a kind of double-hit from the collapse of this sector, with demand evaporating not only for the steel that goes into structures (which Nucor specializes in) but also for the metal that goes into the equipment that builds the structures.

The Present: "It's weak," says Bill Jones, of O'Neal Steel, succinctly. And, for the non-residential construction market, he sees no end in sight. "It's very weak, and actually getting weaker." Almost no one expects this sector even to sniff a rebound until 2011, despite all the talk from Washington about second-wave stimulus money underwriting a surge in infrastructure projects around the country.

For steel, summer is always the slow season. That's partly why shipments, after jumping more than 60% year-over-year in the first and second quarters (albeit from an historical pit), have since flattened out. "We couldn't continue that pace even from such a low base," Larkin says.

Still, with onset of the BP oil spill, a massive amount of uncertainty has come to surround another important steel end market: the pipes and tubes used in the rigs and other equipment that drill for oil and natural gas, known in industry parlance as oil country tubular goods, or OCTG. (The company with the most exposure here is U.S. Steel; some 20% of its business has traditionally been OCTG.)

That a New Orleans federal judge recently lifted a White House moratorium on deepwater oil drilling in the Gulf of Mexico has done little to allay worries that the drilling activity could ultimately be hurt by the ongoing disaster, and the regulatory and legislative responses to it.

The Future: One word: cars. If one holds to the conventional wisdom that construction will remain in its coma until next year, at the earliest, and that the oil-rig business looks a dimmer, investors ought to keep their eyes on the road.

Historically, about 17% of the steel produced in the U.S. goes into cars -- the largest single end use. Auto sales have unquestionably rebounded in 2010 -- General Motors, for example, recently announced that it would skip its traditional summer plant shutdowns so it could make more vehicles. But it isn't expected to rebound much (see the chart above).

That's because, much like steel distributors and service centers, car makers are striving to keep inventories as low as possible. In the old days, the Big Three would overproduce, sending cars to dealers at a loss. That helped steelmakers -- but not, obviously, Detroit.

For the second half of the year, key data points will arrive in September, when carmakers unveil their new models. If car builders feel strong enough to boost production even more, demand for steel will follow suit. But if not, expect another steel rout.
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-- Written by Scott Eden in New York

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Scott Eden has covered business -- both large and small -- for more than a decade. Prior to joining TheStreet.com, he worked as a features reporter for Dealmaker and Trader Monthly magazines. Before that, he wrote for the Chicago Reader, that city's weekly paper. Early in his career, he was a staff reporter at the Dow Jones News Service. His reporting has appeared in The Wall Street Journal, Men's Journal, the St. Petersburg (Fla.) Times, and the Believer magazine, among other publications. He's also the author of Touchdown Jesus (Simon & Schuster, 2005), a nonfiction book about Notre Dame football fans and the business and politics of big-time college sports. He has degrees from Notre Dame and Washington University in St. Louis.

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