The next few weeks will be critical for the domestic HRC market. As previously discussed, buyers will finally exhibit their willingness to pay higher prices for physical material. Even though the spot price has been above $600 for multiple weeks, many buyers have been able to work through inventory or purchase at much lower levels due to contracts based on lagging indexes.

A typical contract allows buyers to purchase material from the mill based on the index in the previous month i.e. February tons are priced off a January index reading. Because some indexes have lagged the spot market recently, actual transactions are still occurring well below $600, and buyers are deferring to increasing contract buys rather than spot buys. However, expectations displayed in the future market predict these indexes will move higher by February, which will result in a higher March price. Due to current lead times, orders for March delivery will need to be placed within the next few weeks, and buyers will only do so if they see support in their order book for $600+ steel.

This contract construct allows mills to easily fill order books in a rising price environment because buyers will max out the number of tons placed on the contract. This reduces the need to sell spot tons and allows mills to maintain elevated lead times, thus keeping prices higher for a longer period.

While current buying in this upcycle is shifting to contracts, there is another, protracted shift occurring in sourcing method resulting from the almost two years of Section 232 tariffs. Buyers are shifting an increasing portion of their orders to domestic mills for material that was previously imported. The chart below shows the trailing 12-month sum of net sheet and tube imports (imports minus exports) in yellow compared to the trailing 12-month average of U.S. raw steel production from AISI in red.

Many analyzing the domestic steel market over the last year have pointed to an increase in production capacity announced or brought on. However, net imports have declined over the same time, with the most dramatic monthly shifts coming at the end of 2019. Based on current pricing differentials and lead times, we expect net import levels to remain low well into 2020, which will continue to drive this 12-month average lower. Moreover, as buyers increase their purchases at domestic mills with shorter lead times compared to foreign material, service centers and end users will be able to manage their inventory to lower levels.

These changes in purchasing method result in three key dynamics, all serving to increase upside price risks that have been previously identified. First, the shift to contract from spot buys means mills will be less aggressive in negotiating lower prices for spot orders because they have filled more of their order books with contracted tons. Second, less competition from imported material gives the buyer fewer options for sourcing, which also strengthens the domestic mill in negotiating price. Finally, lower inventory levels within the supply chain will amplify any supply shock, driving prices higher than would be the case at previously normal inventory levels. The current spot price does not appear to reflect the total contribution of these additional risks. Additionally, the future curve priced below the current spot price certainly does not account for these upside risks.