After a quiet start to the year, last week was packed with significant developments increasing both upside and downside risk for domestic flat rolled prices.  Vale’s Brazilian dam collapse from the prior week was the catalyst behind a $10/t WoW rally in iron ore futures that also carried scrap prices higher.

Early in the week, Nucor disseminated an official $40/t price increase letter for flat rolled products, subsequently followed by U.S. Steel, ArcelorMittal and NLMK.  By week’s end, most, but not all, domestic mills that didn’t send out an official letter were asking for higher prices.  The CME Midwest HRC futures curve gained sharply with some months immediately pricing in 100% of the $40/t increase.

Whether prices are in fact headed higher or if the futures move was a short squeeze is yet to be determined.  At FGM, we saw a significant pick up in quoting and purchase orders.  It will be interesting to see if there is follow through at the same rate this week or if last week’s pick up was a short-term response to higher iron ore and the price increase announcements.

Iron ore was in rally mode long before Vale’s dam collapse.  Chinese finished steel prices have been rallying along with iron ore.  As the trade war has put downward pressure on China’s economy, China has been taking a proactive approach on a number of fronts including sales of their U.S. Treasury bonds, a weaker yuan and government/P.B.O.C. operations to increase liquidity in the banking system.  It is clear a certain amount of this easing is moving into their “old economy” boosting ferrous commodity prices.  Chinese economic stimulus measures is already in the Upside Risks list, but is now being moved to the top as the ramifications must be taken very seriously in case it gets out of hand as it did in 2004, 2008 and 2010.

There was a lot of data out of the mills last week as AK Steel, Nucor and U.S. Steel announced earnings and held earnings conference calls.  Then on Friday, Steel Dynamics announced it purchased 75% of galvalume distributor United Steel Supply.

Two weeks ago, 2018 AISI production was examined showing production increased over 4.4m tons or 4.9% YoY.

Examining the balance sheets of the domestic steel mills that have reported their earnings so far shows an increase in inventory in dollar terms of 22.5% YoY and 7.2% QoQ.  How much of that inventory is raw materials, semi-finished or finished steel is unknown, but taking into account the weakness seen in Q4 combined with the three plus months of over 80% capacity utilization rate can lead to certain assumptions.  This combined with the YoY gains in service center inventory begs the question is there too much steel.

Below are YoY shipments, which were up 5.7% YoY.

In addition to this supply side question, a new major downside risk presented itself last Tuesday when Texas Republican representative Kevin Brady, ranking member of the House Ways & Means Committee, said the following regarding U.S.M.C.A.:

“Key things in my discussions with members, Republicans and Democrats, is that they’re not really willing to consider this agreement until the steel and aluminum tariffs are ensured to be lifted off, including quotas,” Brady said Tuesday during a morning appearance at a trade conference in Washington.

“Frankly, quotas can be just as disruptive as tariffs can be … the truth of the matter is the agreement’s strong enough to stand without them. These are fair trading partners, trading fairly in those metals, so I think that’s going to be one of those threshold issues.”

As the week continued, more members of congress on both sides of the aisle voiced opposition to the tariffs.  Then, a number of bills regarding the matter were introduced.  One bill sought to limit the power of the president to levy tariffs under Section 232 and for reasons of national security. A similar bill went a step further requiring a congressional vote on the steel and aluminum tariffs imposed last year on not only Canada and Mexico, but also the European Union.  The industry has struggled with this issue for almost two years, but it seems the risk pendulum has swung from upside risk to downside risk.  Trying to forecast policy changes is a fool’s errand, but if any adjustments, exclusions, reversals, etc. to the 25% tariff on steel occurs, then a sharp and immediate price fall is all but certain, all else being equal.  Thus, Tariff resolution has been moved to the top of the Downside Risks list.

As noted above, there has been an increase in supply with restart of Granite City and JSW coming to market.  The demand side weakened rather dramatically in late 2018. What at first was thought to be a “buyers strike” in response to high steel prices, looks to have been more due to a slowdown in new orders for manufacturing products.  The January ISM Manufacturing PMI fell a shocking 4.5 points to 54.3 with the new orders subindex collapsing to 51.3.  This coincided with a global slowdown in PMIs.  The drop in the ISM PMI also broke through the more than three-year trend line.  It looks as if the uptrend in manufacturing and steel prices ended in late 2018 and is now in a bear market downtrend that started when the ISM and flat rolled prices peaked in the summer of 2018.  Characteristics of bear markets include not only deleveraging and rapid price depreciation, but also sharp rallies or short squeezes, such as the abrupt $40 rally seen over the course of a few days in CME Midwest HRC futures.

While the idiosyncrasies of the steel industry move prices in the short term, the Federal Reserve is at the center of the deleveraging, which is having a dampening effect across not only the U.S. economy, but also the global economy.  This chart compares the assets on the Federal Reserve’s balance sheet with the S&P 500.  Two things become apparent.  First, the correlation between the rise in the Fed’s balance sheet and the strength in the stock market are clear.  Second, it wasn’t long after the Fed started to shrink their balance sheet that volatility increased and not only did the stock market sell-off, but also there were troubling signs liquidity was being withdrawn from corporate bond markets. This also coincided with a steep drop in the price of oil.  In response to these developments, Federal Reserve Chair Powell did an abrupt 180-degree turn communicating a dovish stance regarding the path of further rate hikes, which has successfully calmed markets for now.

The evidence is clear that the trade war has slowed China’s economy dramatically.  China has taken a proactive approach, as discussed above, evidence further below with the increase of assets on the P.B.O.C.’s balance sheet.

One interesting note is that China has maintained a stable level of foreign exchange reserves….

While steadily decreased its holdings of U.S. Treasury Securities since the trade war began selling almost $70 billion worth.

The outlook for the energy industry is a critical component to forecasting steel demand. As oil prices collapsed from $75/bbl to as low as $42.50/bbl in Q4, this report began taking a closer look at the relationship between oil prices and rig counts.  The chart below shows the lagged relationship between oil prices and oil rigs indicating rigs will continue lower in the coming months, a significant drag for OCTG demand and the steel industry.

The Baker Hughes U.S. Rig Count fell 14 rigs last week to 1,045 with its three-month moving average falling below its twelve-month moving average.  After initially falling 10% – 14% at the end of November, OCTG prices took another leg lower last week falling another 7% – 8% (depending on type).

On Friday, the ISM Manufacturing PMI, global manufacturing PMIs, November U.S. construction spending, auto sales and the U.S. employment report were released.  Each report showed signs of slowing growth. The ISM gained, but looks to have moved into a downtrend.  Global PMIs on whole worsened with Germany’s PMI falling below 50.  Construction spending slowed with private residential spending down YoY for the third consecutive month.  U.S. auto sales fell to the lowest level for January sales of the past five years.

The following issues provide the foundation of our view:

• Declining rates of growth in manufacturing and tariff induced demand destruction
• Increased/increasing domestic steel production capacity
• Weakening global economics
• Crude oil price falling sharply
• Higher interest rates
• Strengthening U.S. dollar
• U.S. residential construction industry slowing
• Slowing auto sales
• Falling global flat rolled prices
• Tariff resolution potential