Growth of Chinese steel production is deaccelerating (finanly)

Association of Chinese Steel Industry just released production data for the first half of 2008. The pig iron production increased 7.9% to 246 M ton compared to 16.9% growth in 2007. Total steel production increased 12.5% to 300 M ton compared to 23.9% growth in 2007. The production growth in the first half of 08 is outpaced by the demand growth. The steel export is 2691.3 ton down 20.35% or 687.8 ton from the same period in 2007. The average export price is $937.38/ton or 41.4% higher than last year.

I predicted the slow down in steel export in the my old post "Chinese steel industry 2008 and beyond". Both tight monetary policy and higher raw material cost are weighting on Chinese steel industry. The average export price is no longer significantly lower than its foreign competitors. As the raw material cost is rising, the labor cost as a percentage of total production cost is much less important than before. On the other hand, the high material cost makes the production efficiency much more valuable today. Thus the cost advantage for Chinese steel companies are diminishing.

This is certainly good news for my POSCO, whose stock has done relatively well compared to its peers recently. Near term, falling oil price will weight on the steel price and the share of steel producers. I am thinking about hedging this position by shorting some other steel makers.

Chinese steel industry 2008 and beyond

Analysis of Chinese steel industry is critical to understand the macro-economic trend in the steel industry particularly east Asia market, as China accounts for the most of demand and supply increase. The competitive advantage of Chinese steel makers is cost. They have access to cheaper coal, labor and mostly importantly cheap capital. Coking coal still trades $100 per ton cheaper than global market recently. While labor is still cheaper in China, it is a much smaller percentage after recent rise in raw material price. The ion ore deposit in China is lower quality and difficult to mine, hence the majority is still being imported, which mean Chinese steel makers pay the same rate as their global competitors. In sum, Chinese steel makers still have lower cost structure than its competitors but it is much smaller now. The biggest driver of the growth in Chinese steel industry is actually cheap capital. In China, local governors are usually evaluated by local GDP growth and employment rate. Hence they have the incentive to subsidize new steel mill by selling land cheaper than the market rates or/and making loans available at local bank. Chinese banks have been hungry for growth in their loan portfolio due to the high saving rate in China. As a result, steel mills at various scales are burgeoning during and supply soon outstripped fast growing demand. Due to their low cost capital, the steel mills are willing to make modest profit on their products. The small mills often make as little as $10 EBITA/ton.

Chinese steel industry is hitting a tipping point now. The small steel mills in China which accounts for a significant share of Chinese steel production are facing tough headwinds. The critical cheap capital is gone. To fight inflation, Chinese central bank has raised reserve rate to 17.5%., up from 7.5% in 2004. The rising price of raw material effectively raised the requirement for working capital, which caused a capital shortage in smaller mills, which are not able to easily obtain loans from banks now. There is also a biased industry structure working against smaller mills. The small mills can not directly negotiate with foreign raw material supplier and have purchase from the state owned steel maker at a much higher price. As a result their already paper thin margin is now zero to negative. The central government also vowed to improve environment by shutting down high pollution small mills by 2010. There is a nation wide consolidation going on. The state owner integrated steel makers are acquiring the suffering small makers and then shun down the low efficient plants. The new build capacity in 2008 will be around 5100M ton, while at the same time 2400M ton capacity will be shut down (1100M ton was shut down in 2007). So the net capacity increase is 2700M ton, which represent a 5.3% increase. The demand for steel in China is projected to be inline with 10% GDP growth, although certain housing related area is likely to slow. The supply/demand of steel in Chinese local market will move toward balance from overcapacity in 2008

Meanwhile Chinese have raised export tax on steel products. The following chart shows Chinese export raise from less than 10M ton in 2004 to close to70M ton in 2007, while the export tax was reduced from 15% to 0-5% depending on specific products. The export volume reached a tipping point in 2007 when the export tax was raised to 5-10%, which coincide with Chinese government’s move to shut down smaller steel mills. This further puts pressure on Chinese steel export.

POSCO (PKX) is the fourth largest integrated steel maker in the world. The shares of most of its competitors have done quite well in the past 6 month, while the shares of POSCO have been under pressure. Why? Pricing! Investors have been criticizing POSCO’s hesitance to raise their price. Weak pricing power usually turns me down especially when the cost inflation is high. In the case of POSCO, this is not because of weak pricing power. In fact, major domestic and Asian competitors have aggressively raised price. POSCO choose to sacrifice near term profit to keep a good long term customer relationship. The market took this strategy negatively which is reflected in POSCO’s stock price. I do not have a value for the intangible customer relationship. As POSCO trades in line with its global competitors at 11 times earning, the market apparently gives no value for the improved customer relationship, which I believe will pay off in the long run.

POSCO’s management team is best of the breed in the steel business. POSCO operates its steel business in a tough environment. 1, rapidly growing Chinese steel producing capacity intensifies price competition in east Asian market. 2, POSCO is heavily exposed to stainless steel, which has been very volatile in the recent years. 3, POSCO has less internally supplied raw material. POSCO also prices their products below domestic competition. Yet they generate better gross margin (21% in the most recent quanter vs Mittal’s 12%, and US steel’s 7%). This is achieved after POSCO exprense its massive R&D in COGS. The ROE of POSCO has been in low 20s and high teens in spite of lower than average financial leverage and massive cash and equity investment on its balance sheet (15% of Equity is in Cash and equivalent and 32.2% in equity investment). Its long term debt to equity ration is 23.7% vs Mittal’s 74.5% and US steel’s 121%

POSCO’s strategy is to leverage its technology innovation to achieve lower cost and product differentiation. Due to its scale, POSCO has successfully leveraged its R&D spending. An interesting figure to look at is 2005-2007 average capex per ton of major steel maker, which I pulled from US steel’s presentation. POSCO spends almost twice the average to improve efficiency of their steel mill and invest in better technology.

Result? POSCO has decreased their coal ratio from 850kg/THM to 700kg/THM. (chart is cited from POSCO’s 1Q 2008 presentation). Given the fact that coal price has increase almost five folds during last 4 years, the value of such efficiency improvement worth a lot more now.

POSCO also leads the industry in production efficiency. (adopted from 1Q 2008 presentation.)

POSCO also invest heavily to produce high value added products to defend its margin from Chinese competition. Although this strategy backfired in 2006 when its stainless steel business recorded a negative margin, product innovation will help them to sustain higher-than-average gross margin.

The competitive advantage of POSCO

The biggest hidden value of POSCO is its leadership in FINEX technology. FINEX is designed to produce molten iron directly using iron ore fines and non-coking coal, eliminating the costly preliminary process of sintering and coke making. Thanks to the reduced iron making process, the overall construction cost will be slashed by 8 percent compared to that of conventional furnaces. The $1.1bn furnace is expected to produce steel about 17 percent cheaper than the conventional ones since it can use cheaper and more abundant coal fines instead of the previously used high-quality sticky coal lumps. As the skyrocketing coking coal price, the cost advantage of new steel mills build with FINEX technology will be even wider.



In the $140 barrel of oil world, being close to customer is a significant advantage. The undergoing urbanization in India and China will sustain the growth in steel demand for the near future. POSCO is well positioned to ride this trend. Chinese government has ordered to close low efficient and high polluting steel mills by 2010, which effectively reduce supply. POSCO will build a 12M ton steel mill in Orissa, India using the FINEX technology. FINEX technology + low cost ion ore will ensure the cost leader status of POSCO India giving a boost to their bottom line. The new steel mill will serve as a significant base for POSCO to expand into India and Middle East market.

POSCO have good long term relationship with its customers and often hold equity investment in their customers. Although POSCO has more pressure to raise their price in a strong market, it will benefit from the customer relationship during tough time. This is evidenced by the 100% utilization rate in its two major mills from 2002-2006, when other domestic producers suffered influx of steel imports..





The disadvantage of POSCO

Both Korean and Japanese steel makers do not have as much cheap self-supplied raw material as their global competitors (Mittal, US steel). The Chinese competitors have access to lower cost coal, while the Indian Competitors have access to cheaper ion ore. Steel price in Asia is lower than those in North America or Europe, while high shipping rates make it more expensive to sell products in US.

Disclosure: I currently have long position in PKX.