Turning Up or Down?

The materials sector is rife with confusion today. Commodity prices have done exceptionally well over the past 18 months, but the drivers of that performance are disparate and impossible to aggregate coherently. Some supply constraints are a function of forced shutdowns; some are a function of a decade of underinvestment. Some demand drivers are transitory, coming off abnormally depressed 2020 volumes, and some are potentially secular as portions of the energy and transportation landscape are re-shaped.

Equities across the materials sector have performed well. Companies think this will continue; market price action seems to disagree. The steel industry is an excellent example of this growing divergence.

An index of global steel equities has performed well in 2021, gaining ~70% through the first half of the year. Corporate expectations suggest current earnings will persist; the market does not agree. At present, there is a seven percentage point spread between forecasted cash flow return on investment compared to the market-implied cash flow return on investment. A trend that is persistent across much of the materials industry.

The gap in expectations for global steel aggregates is evident in the market-implied discount rate, which is only slightly above the industry's ten-year median. At the same time, prices have recently broken significantly outside their 10-year trading range.

So, who is correct? Market prices suggest the industry is wrong and that prices at this level are either not sustainable and/or the excess cash generated by the industry will not be spent well.

Historically, that is not irrational. Excess cash flows have often preceded significant increases in CAPEX and M&A, both of which often proceed declining margins. The current easy credit market occurring at a time of peak prices could result in increased use of debt to fund portions of the M&A and CAPEX expansion. In the past, this setup has resulted in declining asset efficiency as measured by asset turns (sales / invested capital, a decent proxy for asset efficiency), decreasing from 0.8x to 0.5x from 2008 to 2020.

Today, however, there is little evidence of balance sheets being over-extended. There has been a slight increase in total debt from the lows of 2016, but nowhere near the peaks of 2010. Additionally, cash balances are much higher, resulting in total leverage hitting decade lows. It may be too early to evaluate the corporate response function to higher earnings, but there is little evidence of management teams eager to dramatically increase CAPEX and M&A activity.

It is also not apparent that the higher prices are not supported. Steel end-market demand remains relatively strong, and inventories remain low. Anecdotally, lead times at mills in the U.S. are at 12+ weeks, with little in the way of attractively priced imports to arbitrage the U.S. prices down.

The premium on U.S. steel prices today may be impacted by the possible removal of Section 232 imports. Still, it would be several months before any price difference between Europe and the U.S. began to close as European steel is also facing availability issues. U.S. imports of finished carbon and alloy steel products from the E.U. are 44% lower, YTD, than their monthly average in 2018. Even if imports were to recover to 2018 levels, it would only amount to ~2Mt of finished steel product, which is about 1.7% of the 2022 finished steel demand in the U.S. It is not clear that additional quantity is sufficient to depress the premium prices in the U.S. market materially.

The pulse on the ground suggests that this run-up in prices has legs. If that is true, the steel industry may end up with some of the cleanest balance sheets in years and decade highs in earnings power. If the market changes its tune, equity prices may have a long way to run as both earnings, and multiples on earnings, expand.

The market was wrong in 2004/05 but largely correct in 2017/18, the last two instances of extreme divergences in expectations. It is rare for divergences to persist and remain unresolved. I expect equity movement in the steel industry (and broader materials industry) to be volatile for some time.