U.S. Metals Industry Primed for Strong 2021
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- 2021 outlook
Just as it was for nearly every sector, 2020 was a difficult year for the metals industry. But we also saw company leaders really dig in and figure out ways to survive, whether it was cutting costs, reducing inventory levels or figuring out new ways to do business. Ultimately, these measures have put the industry in a position to take advantage of what’s shaping up to be a strong 2021.
I recently spoke with David Gagliano, BMO Capital Markets metals and mining analyst, about the North American steel sector. We discussed the current state of affairs in raw material prices, the key supply and demand drivers, and some of the other issues that could have an impact on this vital industry.
Following is a summary of our discussion, edited for length and clarity.
Hot-Rolled Coil on Fire
Things are looking good for steel prices heading into 2021. Spot hot-rolled coil prices in the U.S. are at two-plus year highs. They’re now less than 10% from the highs achieved during the 2008 rally in steel prices, and we've seen a nearly 90% rally in U.S. prices since the August lows.
“The best way I can think to really describe the state of affairs in North American steel industry right now is, it's on fire, particularly on the sheet side,” Gagliano said. “This has been the steepest rally from trough to current on a percentage basis in at least 20 years, as best we can tell, and it has clearly outpaced the pricing recoveries both in Asia and Europe. Back in August, U.S. prices were trading at a slight discount to China representative prices. Now, U.S. hot-rolled coil prices are trading at over $300 per ton premium to China hot-rolled prices. A pretty amazing pricing backdrop, especially when you consider we’re in the middle of this god-awful pandemic.”
Supply-Side Squeeze
Gagliano said a timing disconnect between supply and demand is what’s driving these big price moves. When we had the unprecedented demand shock that began in March, we saw hot-rolled coil lead times fall from about five weeks at the end of February to about three weeks by the end of April. Shipments out the doors of the service centers to the end-market customers dropped about 35% between February and May.
Gagliano noted that May posted the level of daily average shipments from the service center to end-market customers since 1983. By October, however, demand rebounded by about 40%. Even so, October shipments were down about 8% year-over-year.
“At first that rebound in demand was easily met with latent, underutilized production capacity, mostly at the mini-mills,” Gagliano said. “So while we saw some recovery in lead times during the summer months, prices continued to trend lower. As we moved through October, November and December, lead times began to stretch out meaningfully and more recently have spiked. Now we're seeing prices spiking and we're hearing some talk of potential near-term shortages among some of the customers heading into the first quarter 2021.”
As demand continued to recover with 23 million tons of capacity taken offline in September, Gagliano said the domestic supply base was in no position to respond to the pace of demand recovery. Meanwhile, Asia staged its rebound in both demand and prices earlier than North America, leading U.S. prices to fall well below incentive pricing necessary to realize a meaningful uptick in import flow. Nonetheless, Gagliano said there’s no cause for concern in terms of supply.
“We do not think the world is going to run out of steel anytime soon,” he said. “We do not have prices in the U.S. that are clearly high enough to incentivize more domestic U.S. mills to restart. And we definitely have seen some supplier-side response, but it's been a little bit too slow when we compare it with the rebound on demand.”
Of the 23 million tons of capacity that was idled earlier this year, Gagliano said about 10 million tons of mostly integrated steelmaking capacity has yet to really enter the production profile. That, coupled with price spreads, should make the market more attractive for imports in 2021.
“We think there's about 14 million tons of annual flat steelmaking capacity that we could see come back as 2021 progresses—that's about a 20% increase in flat steelmaking production capacity over the next 12 months. At the same time, we've got reasonable spreads now at the highest levels in two years, so import offers are increasingly competitive to the point where we think we will start to see more imports, which are down about 25% year to date.”
Gagliano added that the U.S. could see more imports beginning around February. “We do think the supply-side squeeze will ease as we move through the first quarter of 2021. It's important to keep in mind that inventories throughout the supply chain appear to be very low right now, so we think the initial recovery in production will likely be absorbed during a restock cycle. Which, in turn, means that this current spike in prices may have a bit more duration—potentially into the second quarter of 2021.”
Demand Growth
Gagliano maintains an optimistic outlook for overall U.S. steel demand growth in 2021, with weakness in nonresidential construction and energy to be offset with continued strength in automotive, machinery and appliances. All told, Gagliano’s base-case 2021 year-over-year growth forecast is 4.5% and 7.8% in a bull-case scenario.
“2021 should be a year of continued demand recovery, especially if these end-market demand forecasts prove to be reasonably accurate,” he said.
One case to be made for the more optimistic projection is the rollout of the COVID-19 vaccine. As vaccine distribution reaches the general population, the expectation is that economic activity will become more settled. Can that have lasting effects on steel and aluminum pricing as well?
“When you talk to the BMO economists, they would say 2021 is going to be a year of latent, built-up demand,” Gagliano said. “I think what you have seen on the sell side in general from the investment community is a bit of an underestimating the magnitude of a demand recovery. I think there's a valid case to be made that, if anything, more likely we're going to be seeing the higher end of that range [7.8%] as opposed to the midpoint [4.5%].”
Tariffs and the New Administration
With the Biden administration ready to take over, there’s a lot of concern across the industry in terms of what will the next four years look like regarding trade, particularly as it relates to steel and aluminum tariffs under Section 232 of the Trade Expansion Act of 1962 and Section 301 of the Trade Act of 1974.
“Initially there was some concern that Section 232 would go away with the Biden administration,” Gagliano said. “But what we've been hearing so far has been more slanted towards the ‘buy America’ approach. Plus, there are some political battles in the near term that take precedent over day-one elimination of 232.”
While Gagliano doesn’t expect any near-term changes to the tariff situation, he does see a risk in rising hot-rolled coil prices. “One of the indirect challenges associated with $1,000 hot-rolled coil is that the higher the hot-rolled price goes, the more attention and more potential risk associated with political fallout from an end-market customer perspective.”
2021 Outlook: No Room for Bears
In the end, Gagliano expects the current supply squeeze to ease through the first half of 2021. Meanwhile, the combination of demand recovery and low inventories will mitigate the downward pricing risk associated with supply growth.
“We expect prices to peak in the first quarter of 2021, possibly pushing into the second quarter, depending on the magnitude of the restock,” he said. “But we think pricing remains surprisingly resilient as we move through 2021, and we argue it's more likely we end ’21 with hot-rolled coil prices with a six handle on them instead of a five handle. We think these permabears that are out there will once again be disappointed as 2021 progresses.”
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Andrew Pappas
Managing Director, Team Leader and Head of ABL Metals Group
Andrew is a Managing Director / Team Leader and Head of Asset Based Lending (ABL) Metals within the ABL Group of BMO Commercial Bank since 2011. Currently, Andrew o…(..)
View Full Profile >Just as it was for nearly every sector, 2020 was a difficult year for the metals industry. But we also saw company leaders really dig in and figure out ways to survive, whether it was cutting costs, reducing inventory levels or figuring out new ways to do business. Ultimately, these measures have put the industry in a position to take advantage of what’s shaping up to be a strong 2021.
I recently spoke with David Gagliano, BMO Capital Markets metals and mining analyst, about the North American steel sector. We discussed the current state of affairs in raw material prices, the key supply and demand drivers, and some of the other issues that could have an impact on this vital industry.
Following is a summary of our discussion, edited for length and clarity.
Hot-Rolled Coil on Fire
Things are looking good for steel prices heading into 2021. Spot hot-rolled coil prices in the U.S. are at two-plus year highs. They’re now less than 10% from the highs achieved during the 2008 rally in steel prices, and we've seen a nearly 90% rally in U.S. prices since the August lows.
“The best way I can think to really describe the state of affairs in North American steel industry right now is, it's on fire, particularly on the sheet side,” Gagliano said. “This has been the steepest rally from trough to current on a percentage basis in at least 20 years, as best we can tell, and it has clearly outpaced the pricing recoveries both in Asia and Europe. Back in August, U.S. prices were trading at a slight discount to China representative prices. Now, U.S. hot-rolled coil prices are trading at over $300 per ton premium to China hot-rolled prices. A pretty amazing pricing backdrop, especially when you consider we’re in the middle of this god-awful pandemic.”
Supply-Side Squeeze
Gagliano said a timing disconnect between supply and demand is what’s driving these big price moves. When we had the unprecedented demand shock that began in March, we saw hot-rolled coil lead times fall from about five weeks at the end of February to about three weeks by the end of April. Shipments out the doors of the service centers to the end-market customers dropped about 35% between February and May.
Gagliano noted that May posted the level of daily average shipments from the service center to end-market customers since 1983. By October, however, demand rebounded by about 40%. Even so, October shipments were down about 8% year-over-year.
“At first that rebound in demand was easily met with latent, underutilized production capacity, mostly at the mini-mills,” Gagliano said. “So while we saw some recovery in lead times during the summer months, prices continued to trend lower. As we moved through October, November and December, lead times began to stretch out meaningfully and more recently have spiked. Now we're seeing prices spiking and we're hearing some talk of potential near-term shortages among some of the customers heading into the first quarter 2021.”
As demand continued to recover with 23 million tons of capacity taken offline in September, Gagliano said the domestic supply base was in no position to respond to the pace of demand recovery. Meanwhile, Asia staged its rebound in both demand and prices earlier than North America, leading U.S. prices to fall well below incentive pricing necessary to realize a meaningful uptick in import flow. Nonetheless, Gagliano said there’s no cause for concern in terms of supply.
“We do not think the world is going to run out of steel anytime soon,” he said. “We do not have prices in the U.S. that are clearly high enough to incentivize more domestic U.S. mills to restart. And we definitely have seen some supplier-side response, but it's been a little bit too slow when we compare it with the rebound on demand.”
Of the 23 million tons of capacity that was idled earlier this year, Gagliano said about 10 million tons of mostly integrated steelmaking capacity has yet to really enter the production profile. That, coupled with price spreads, should make the market more attractive for imports in 2021.
“We think there's about 14 million tons of annual flat steelmaking capacity that we could see come back as 2021 progresses—that's about a 20% increase in flat steelmaking production capacity over the next 12 months. At the same time, we've got reasonable spreads now at the highest levels in two years, so import offers are increasingly competitive to the point where we think we will start to see more imports, which are down about 25% year to date.”
Gagliano added that the U.S. could see more imports beginning around February. “We do think the supply-side squeeze will ease as we move through the first quarter of 2021. It's important to keep in mind that inventories throughout the supply chain appear to be very low right now, so we think the initial recovery in production will likely be absorbed during a restock cycle. Which, in turn, means that this current spike in prices may have a bit more duration—potentially into the second quarter of 2021.”
Demand Growth
Gagliano maintains an optimistic outlook for overall U.S. steel demand growth in 2021, with weakness in nonresidential construction and energy to be offset with continued strength in automotive, machinery and appliances. All told, Gagliano’s base-case 2021 year-over-year growth forecast is 4.5% and 7.8% in a bull-case scenario.
“2021 should be a year of continued demand recovery, especially if these end-market demand forecasts prove to be reasonably accurate,” he said.
One case to be made for the more optimistic projection is the rollout of the COVID-19 vaccine. As vaccine distribution reaches the general population, the expectation is that economic activity will become more settled. Can that have lasting effects on steel and aluminum pricing as well?
“When you talk to the BMO economists, they would say 2021 is going to be a year of latent, built-up demand,” Gagliano said. “I think what you have seen on the sell side in general from the investment community is a bit of an underestimating the magnitude of a demand recovery. I think there's a valid case to be made that, if anything, more likely we're going to be seeing the higher end of that range [7.8%] as opposed to the midpoint [4.5%].”
Tariffs and the New Administration
With the Biden administration ready to take over, there’s a lot of concern across the industry in terms of what will the next four years look like regarding trade, particularly as it relates to steel and aluminum tariffs under Section 232 of the Trade Expansion Act of 1962 and Section 301 of the Trade Act of 1974.
“Initially there was some concern that Section 232 would go away with the Biden administration,” Gagliano said. “But what we've been hearing so far has been more slanted towards the ‘buy America’ approach. Plus, there are some political battles in the near term that take precedent over day-one elimination of 232.”
While Gagliano doesn’t expect any near-term changes to the tariff situation, he does see a risk in rising hot-rolled coil prices. “One of the indirect challenges associated with $1,000 hot-rolled coil is that the higher the hot-rolled price goes, the more attention and more potential risk associated with political fallout from an end-market customer perspective.”
2021 Outlook: No Room for Bears
In the end, Gagliano expects the current supply squeeze to ease through the first half of 2021. Meanwhile, the combination of demand recovery and low inventories will mitigate the downward pricing risk associated with supply growth.
“We expect prices to peak in the first quarter of 2021, possibly pushing into the second quarter, depending on the magnitude of the restock,” he said. “But we think pricing remains surprisingly resilient as we move through 2021, and we argue it's more likely we end ’21 with hot-rolled coil prices with a six handle on them instead of a five handle. We think these permabears that are out there will once again be disappointed as 2021 progresses.”
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