Ramoun Lazar, Analyst

Steel making margins have almost tripled off the 2016 lows driven by China’s supply side reform policies. The policies, introduced by President Xi in 2015, aimed to reduce overcapacity in industrial sectors to improve margins, reduce debt and drive more sustainable levels of growth. We strongly believe that the higher steel mill margins are sustainable and we see compelling investment opportunities in the steel sector.

A decade of capacity expansion

The steel industry has been a key focus of China’s supply side reform. Proliferation of steel mills saw China’s capacity increase five-fold in the decade through 2014, with supply far exceeding demand. As a result, steel mills in China as well as abroad have struggled with over capacity, resulting in poor profitability, and increasing financial leverage.  The chart below illustrates the rapid rise in China’s steel supply and unused capacity.

Source: Worldsteel Association

The boom in steelmaking capacity led to a quadrupling of Chinese steel exports in 2015. China was exporting more steel than any other country was producing, subsequently leading to a race to the bottom for prices. Financial distress across the steel sector was the catalyst for China’s authorities to initiate restructuring policies. The chart below shows the rapid increase in Chinese steel exports from 2013-15 and subsequent decline post reforms.

Source: CLSA

Steel supply reforms rapidly enacted

After almost two years of supply side reforms, the Chinese steel industry has closed nearly 250 million tonnes of production capacity, representing 20% of total peak capacity. Production rates at existing mills have lifted and surplus exports eased. Steel prices and steel margins have improved, leading to better rates of industry profitability in both China and globally. The chart below illustrates the improvement in steelmaker profitability which is now back above pre-financial crisis average levels.

Source: SBB, Credit Suisse

Reforms to date have been significant. However, the pace of industrial sector restructuring is expected to continue for some time. The most recent Chinese Five-Year Plan outlined an increasing commitment to environmental protection as an additional catalyst of supply side reform. Our recent trip to China reinforced this, with confirmation of strict enforcement of steel production cuts during the most recent Chinese winter aimed at improving air quality across key Chinese cities. Policymakers have also stepped up environmental inspections at a local level, which could lead to a new round of steel mill closures. Furthermore, steel mills will no longer be permitted to add any net new capacity to existing supply. Only upgrading or replacement of old mills will be permitted.

Improved profitability is sustainable creating opportunities

Industrial reforms represent a significant structural shift towards more sustainable growth, delivered through improved profitability, instead of growth at all costs. As investors, we see current regional steel profitability reflective of mid-cycle levels, and not a peak cycle extreme. We remain excited on the relative outlook for the local steel sector, which should result in increased returns for shareholders over the medium term.

In our opinion, Bluescope Steel will benefit from higher and more sustainable regional steel prices that will underpin a period of higher free cash flow generation. The higher returns aren’t being reflected in current valuation multiples.

Sims Metal Management will be an indirect beneficiary of China’s steel reforms. Reduced Chinese capacity has meant a reduction in cheap steel exports. Less exports means steel production in the rest of the world, which relies on Sims’ scrap steel feedstock, will rise, resulting in better volume growth and global prices.

Conclusion

After a decade of expansion of steel capacity, China’s supply side reforms quickly changed the trajectory in 2016. Steel mills in China shut, leading to higher prices and higher steel making margins. Rather than ‘peak cycle’ margins, we see current steel margins as sustainable creating compelling investment opportunities in companies such as Bluescope and Sims Metal Management.

 

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