Steel has re-emerged as a political and economic topic as the Trump Administration looks to make it a focus area for trade imbalance and potential tariffs.

China and Canada are two countries that will be affected by any escalation of rhetoric – although a reduction in supply may be compatible with many of China’s long term goals.

There continues to be steel oversupply/capacity in China where a reduction in output could have longer term benefit as the country moves higher on the value chain for production (resulting in knowledge jobs), becomes more efficient in scale and technology via consolidation, and reduces pollution (China heavily uses traditional blast furnaces instead of cleaner Electric Arc Furnaces which are cleaner). However, short term structural unemployment may make this transition more contentious.

The steel industry is important in Canada (manufacturing, capital goods and oil rigs for industry), and a more similar demographic and cultural profile to the US (and the same labour, education/training and union issues) in steel towns such as Hamilton mean that there may be stronger political, economic and social ramifications should Trump implement a tariff. Given the US’s larger relative importance for Canadian trade and less levers to pull in terms of fighting back (as Canada is less relevant to the US), tariffs (which may not be exclusive to steel) will hurt the economy and the Canadian dollar.

Below, we provide a discussion on steel over the last while.

Steel, China and Macroeconomics in the Last 10 Years

Demand for steel depends very much on global industry – some good indicators of industrial production include construction, oil production (previously number of rigs was a good proxy but today rigs have become much more efficient and technologically advanced, so each rig can produce much more oil – especially shale oil), durable goods and auto sales.

When the price of steel goes up because of industrial demand, the price of iron ore, met coal and scrap will go up as well because the inputs – and in from the financial crisis to 2014 we saw an extreme metals bull cycle (especially gold) driven by China. During the financial crisis, China needed to continue GDP growth targets and ensure that the economy did not go into recession like the rest of the world (large socioeconomic ramifications if it did) so they engaged in massive government expenditure on infrastructure and construction.

A lot of this construction was funded by debt (in China, primarily bank debt as opposed to bonds due to underdeveloped capital markets)– much of it good, but much of it with questionable return profiles. Nonetheless, growth targets were met and the demand for steel and construction requirements boomed. This took place during the government of Hu Jintao and ended after the handoff of power to Xi Jinping’s government, where the focus continued to shift towards moving China from a manufacturing economy to a knowledge or skill-based economy.

As the kind of debt-fuelled expansion that drove the 7% GDP growth was not sustainable and would result in destroying purchasing power/making people poorer, the focus shifted back towards projects with appropriate returns. A large part of dubious returning projects was due to corruption and kickbacks – this was curtailed significantly due to crackdowns on lavish abuses of power (handbags, Baijiu, Cognac). In addition, as China moved towards being a consumption driven economy from a savings driven one, consumption has replaced the needs of infrastructure development/government spending. Remember, the equation for GDP is Consumption + Investment + Government Spending + Net Exports.

After share price highs across the board for miners, prices plateaued and subsequently plummeted starting in 2013. The run-up in prices and availability of equity (and even high-yield debt and other financing options) resulted in huge mining capex and oversupply of metals. A lot of the mining projects were only economic at very high prices, resulting in projects having to shutter and companies going into financial distress. Commodity prices bottomed in 2016.

Although nothing is certain, it is likely this type of boom will never happen again in our lifetimes. The ingredients involved (largest population, command economy, GDP growth target, high savings rate, industrializing nation) are not even close to being emulated in any other country (there may be a mild boom in India – but learning from China’s debt fuelled mistakes, even if all of the ingredients fall into place, it will not be at the same extreme).

The Shift to Emerging Markets and Technology

This point is much more relevant today due to the Trump presidency won on the back of resentment owing to the loss of manufacturing jobs over time. US Steel (the industry, not just the company) is no longer competitive because the cost of low-skilled or medium-skilled labor is too high compared to that of a developing nation

The only way that a steel plant in the US and other developed nations with wage floors (well above minimum wage), onerous labor restrictions and safety standards (safety is imperative, but the way that unions and laws are structured in developed countries is sometimes geared towards worker perquisites over practicality) can compete with those in a developing country is to have a high technology plant that can automate the expensive labor component.

As such, developed nation steel plants have moved increasingly towards electric arc production while Chinese plants are almost entirely ~90% blast furnace technology. Even this may not be economical (for developed nations) because traditional steel and manufacturing markets (the Rust Belt) may not have the cheapest electricity access, and in a business that is dependent entirely on margin-on-metal (everyone realizes the same price, give or take) this is problematic. Also, as electric arc furnaces are mercy to the availability of scrap steel, they are not as scalable as traditional blast furnace technology.

The Steel Capacity Oversupply

The steel market is a great example of the short-run vs long-run equilibrium difference in entry-level economics. After steel demand has grown at a much reduced pace or even declined after the paradigm shift in Chinese consumption patterns, prices for steel have dropped precipitously. This makes many mills uneconomic, especially in developed nations as we have described above. Since most of these mills are owned by private corporations and these corporations cannot easily adjust their payments due to labor laws and the labor market, they have pressure to shut down.

On the converse, mills in China’s command economy have sociopolitical pressure to stay open even though it may be running a loss. This applies to mills in several other developing nations too (India, Russia) – although in China, these jobs may be shifted to other sectors based on need. This continued oversupply of steel forces private firms to shutter if they are high up on the cost curve. The steel market has historically been fragmented, and this cost dilemma has forced consolidation.

The Chinese, Japanese, South Korean and Russian mills are left standing after many closures, and continue to operate in high volumes even after the curtailment of Chinese demand. Now China is a net exporter (and by far the biggest net exporter) along with the East Asian countries and Russia, while the biggest importer is the USA. China has used scale advantages to use the same mills now for value added process and shipment instead of only as a feedstock for its own consumption.

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