For the first time in several weeks, we saw encouraging numbers concerning the coronavirus pandemic that has halted activity across the globe. The number of new daily cases has started declining, signaling that social distancing and economic shutdowns have helped to “flatten the curve”. This may mean that the economy is closer to resuming some form of normalized activity, and risk assets reflected this promising sentiment. The S&P 500 was up 12% last week, and several industrial commodities rose as well: nickel was up 4%, copper up 3%, iron ore up 4%, and Turkish scrap up 3%. Even HRC futures rallied 2-3% in the summer months.

However, for the steel market, that was the extent of the good news. Spot prices continue to decline, and some transaction are occurring below $500/st for HRC. Now that contract pricing is locked in with the second week of the month index pricing, mills have shifted to filling order books rather than holding higher prices. However, they have struggled to do so at the current spot prices, and have chosen to remove production rather than drive the price lower. Over the last month, US Steel has announced it is idling four furnaces, removing a total of approximately  4.3 million carbon sheet tons annually. ArcelorMittal has also idled two furnaces, removing 2.6 million tons annually. The below chart shows the decline in raw steel production (all steel products), reaching the lowest levels since 2009.

This rapid drop in production is a combination of mills idling furnaces and operating their remaining capacity at reduced rates. Through the size and changes of their order books, mills have the unique ability to gauge demand within the market, and the reductions in production reflect a weak demand picture. Moreover, it reveals the expectation that mill will not be able to prevent prices from falling below their cost to produce. Although scrap prices declined in April, scrap and iron ore prices have held up better than finished good prices, pressuring profitability. Additionally, as mills reduce output, their fixed costs to operate are spread over fewer tons, increasing their cost per ton. Our modeling shows profitability declining, most significantly for BOFs who are breaking even on the marginal ton produced at current prices. This is not promising for future production as the forward curve expects spot prices to fall further. If the spot price continues to decline, further reductions in production are possible.

From an economic perspective, mills reducing production aligns with the domestic market’s need to reduce current supply to match the lower demand level. However, eventually demand will recover and the market will be short physical steel, as production remains low. Mills will not try to get ahead of this through adding production capacity to match increasing demand. Instead, they will increase prices first in order to ensure that they can profitably produce material before increasing the supply in the market. This will create a short squeeze in the market for a period where buyers fight for limited tons amid increasing prices. This type of environment tends to rapidly push prices higher, often to unreasonable levels. However, those with a need for physical material can protect against this through securing low prices on the forward curve. We have already seen some buyers prudently remove this risk from their business, and the curve is continuing to grind higher, leaving those low prices on the curve in the past.