- 1 Basic Materials Sector Overview
- 2 Steel Industry Primer
- 2.1 Steel Industry Overview
- 2.2 How Do Steel Companies Make Money?
- 2.3 Steel Credit Analysis
- 3 Forestry, Pulp & Paper Products Industry Primer
- 3.1 Lumber Industry Overview
- 3.2 Wood Products, Pulp & Paper
- 3.3 Paper & Packaging
- 4 Related Reading for Basic Materials
Basic Materials Sector Overview
Basic Materials or Materials is the sector that covers companies involved with exploration, development, processing and distribution of raw materials. Major subsectors within Materials include Metals & Mining (which in certain banks has its own coverage group), Steel, Petrochemicals or Chemicals, Forestry/Pulp & Paper Products, and Agriculture & Fertilizers (which can be chemicals).
Major global materials firms include:
Mining & Steel
- BHP Billiton
- Rio Tinto
- Southern Copper
- Freeport McMoRan
- Barrick Gold
- Newmont Mining
- Nucor Corporation
- Vedanta Resources
Chemicals & Agriculture
- Dow Chemical
- Air Products
- PPG Industries
- Potash Corporation
- Sinochem Group
- CRH Group
- Martin Marietta
- Arconic Group
- Vulcan Materials
- International Paper
- West Fraser Timber
Steel Industry Primer
Steel Industry Overview
Steel is refined iron and used extensively as an industrial output. Steelmaking is the process of turning iron ore and other components into carbon steel or alloys. This involves heating metallurgical coal (also known as met coal, steelmaking coal – which is a certain grade of bituminous coal) into coke and using the concentrated carbon substance to transform iron ore into steel. Steelmaking also involves the recycling of steel scrap into new steel for commercial use.
Steel is important across construction, infrastructure (rail, bridge), commercial buildings, cars, planes, appliances, and tools – and ubiquitous in any urban setting. Accordingly, steel demand and pricing speaks to the health of the economy and is a strong leading indicator of activity.
Although steelmaking itself is not prominent in Canada, steel’s connection with metallurgical coal (which is a large industry in Canada) and mining as well as it’s role in auto parts (Magna and the Ontario economy) and oil and gas (rig count) make a discussion of the industry and current trends relevant.
Steelmaking coal (more mature and concentrated in carbon content than the softer lignite coal used for heating steam turbines at coal fired power plants for electricity generation) is doused with pre-heated air and becomes much more concentrated coke (almost pure carbon – so very high energy content).
Iron ore is layered on top of the coke in the blast furnace – the furnace is hot enough to melt the iron ore and limestone soaks up impurities and water that are separated from the iron while molten pig iron pools at the bottom (pig iron has a much higher concentration of iron than iron ore and some carbon content). To optimize the process, iron ore should be ground up and refined first for maximum surface area.
The pig iron is put into a basic oxygen furnace (BAF) and blasted with oxygen to remove carbon from the pig iron while being heated, creating carbon dioxide and leaving the appropriate steel desired. The steel is cast into a shape amenable to finishing – where it is rolled using machines to get the steel into standardized form (hot rolled coil, cold rolled coil, rebar, etc.).
Electric Arc Furnace (EAF)
The other main method for steelmaking, the met coal and blast furnace activity is skipped and steel scrap is run through an electric arc furnace heating and purifying the scrap and making it consumable steel. This steel is then cast and finished like with traditional steelmaking.
These electric arc furnaces are much more efficient and clean than old blast furnace methods, but the capex needed, scaling inflexibility and dependence on scrap limit the advantages. EAFs also require low cost electricity for economics.
Hot Rolled Coil and Cold Rolled Coil – Standardized Steel Futures
Machines heat and pressure steel slabs using rolls in a rolling mill to get to the standard for hot rolled coil (HRC). To get to cold rolled coil (CRC) (more expensive as it is more refined than HRC), the HRC is pickled through an acid bath and rolled even thinner. CRC is stronger than HRC.
How Do Steel Companies Make Money?
Steelmaking is extremely commoditized. To generalize, all producers sell at the same global price as standardized steel is extremely specific, so product differentiation is difficult. The difference between a more profitable and less profitable (or unprofitable) steelmaker therefore lies in cost. Where a producer lies on the cost curve will determine its relative attractiveness as a firm.
Revenue is the selling price of the steel in question – which usually is in the form of a commoditized product (hot rolled coil, cold rolled coil, rebar). Usually these products are sold to distribution or service centers who will then resell it to end market users after contributing a steel product more tailored towards that customer.
If the steel company sells to a further distribution channel (which can offer something more bespoke – for instance galvanizing the steel or coating it in zinc to give it anti-corrosive properties), the price is usually going to be the spot market price or whatever it has contracted the price to be for a certain volume – anything that is not contracted will go at the current/spot price. Note that some steelmakers are integrated down the value chain in distribution as well.
For traditional basic oxygen furnaces (BAF), the cost of making steel is primarily iron ore (#1) and met coal (#2) – these are both global commodities (and fairly efficient markets – iron ore is probably the second most important commodity after oil), so barring hedging with futures and forwards, producers will generally get the same price for the commodity alone. Large producers such as ArcelorMittal will be able to have more leeway with volume discounts.
For an electric arc furnace (EAF), the cost of making steel is primarily scrap and energy to power the plant. The price of scrap is heavily correlated with the price of steel. We mention the price of a commodity alone because the actual cost of getting the iron ore, scrap and met coal also depends on how far the plant is from the source of the input and how accessible the plant is – which means transportation costs for shipping and freight will affect plant economics. It is convenient to have a plant close to a large iron ore mine.
So once iron ore, met coal and scrap are taken out, major cost items include energy costs (to run the plant) and labor costs. Energy costs depend on the availability of cheap electricity – so if there is an abundance of low cost generation around, great – if not, expect it to affect the bottom line.
Labor varies from jurisdiction to jurisdiction – foreign exchange plays a part as global commodities are predominantly traded in US$, but median per capita wages will also affect this. If someone costs $35 an hour in Canada with overtime provisions and strong labor protections, this is not competitive when someone in China operates at $4 an hour. This is a reason why steelmaking struggles in industrialized nations – of which we further discuss in the credit section.
Due to the shift in the cost curve for steel as discussed in the trends section, many steel companies that were historically blue chip and investment grade have become much riskier credits – falling into the sub-investment grade range for credit rating agencies.
For the most part, these riskier credits make up most of the investable universe due to the 1) unavailability of certain state-owned and private players in developing nations and 2) the unreliability of markets and uncertain legal frameworks for state-owned and private players in developing nations – while developed nation steelmakers (i.e. the ones whose bonds most debt investors would look at and have access to) have become less cost competitive.
Cyclicality in the Steel Industry
Since steel is a cyclical industry and a margin-based business (everyone gets the same price), revenue, EBIT, and net income can all be extremely volatile. As such, credit should be looked at on a full-cycle or normalized basis. Average EBIT margin of 10%, return on assets of 8% and interest coverage of 5-6x of EBIT is considered healthy.
Economies of Scale in Steel
The size of a company and its breadth across geographies is important. A steelmaker with a large mill will have economies of scale in production. If a steelmaker has lots of capacity, it will be able to get volume discounts on met coal, iron ore and scrap steel. If a steelmaker has many plants, its production is more protected against the effects of a strike, plant failure or supply shock – it can also be flexible in moving production which optimizes profit.
Costs in the Steel Industry
As discussed under business, since steel sales are generally for standardized commodities, saving on the cost front is a huge advantage. How cheaply can iron ore be sourced (contracts, buying power from scale and proximity to & infrastructure from iron ore mines). How cheap is electricity in the plant’s location? Where is the nearest met coal?
Vertical Integration for Mining and Steel
As per most industries, integration is not necessarily shareholder friendly (lack of focus and difficult to segregate value) but a credit positive. If the company owns an iron ore mine lower on the iron ore cost curve, it can pass through the benefits to the mills and make sure there is sufficient supply.
US Steel and Developed Markets
For steelmakers in the investable universe, a lot of credit concerns revolve around the workforce. First, steelmaking employees tend to be unionized and thus there is less labor flexibility in terms of hiring and firing workers as well as recourse against strikes. Also, steelworkers have legacy pensions which can be credit negatives – in investing and banking, pensions are viewed as an obligation not dissimilar to debt and strain financial flexibility.
One unique credit group which should be viewed positively relative to their credit metrics is Japanese steelmakers. Japanese steelmakers are part of large business families/umbrellas called Keiretsu – you may have heard of Mitsubishi, Sumitomo and Mitsui.
These companies have implicit support from society as well as their business family (although not a parent – they are not incorporated or linked by contract), and will likely not be able to go under easily. Over there, a letter of comfort or other credit enhancements which are seen to not fall under the rules of consideration or recourse in Western law are perceived to be certainties in Asia (the loss of reputational risk would be enough to deter withholding support).
Forestry, Pulp & Paper Products Industry Primer
Forestry includes lumber production, wood products, paper and pulp. Investment banking coverage for forestry in Canada will be covered out of Vancouver. In the US, it will be covered by the main Basic Materials group with possible regional coverage in Seattle.
Lumber Industry Overview
Global Lumber Supply and Major Canadian Forestry Companies
The lumber industry involves growing trees and harvesting lumber for raw sales or as refined wood products. North America is the heart of lumber production globally, with much of the timberland in the Pacific Northwest (British Columbia, Washington and Oregon). Sawmills are prominent in the US Southeast and forest and paper product industries feature in the Northeast.
In Canada, lumber production is split between British Columbia and the rest of Canada, with the other major forestry hub being Quebec. Mountain pine beetles can hollow out trees and can diminish lumber supply.
There will be approximately ~63Bfbm (see below for a breakdown of board-foot measurements) of lumber production in North America in 2017 from ~72Bfbm of capacity. US consumption is ~50Bfbm and Canada is ~9Bfbm.
For exports to Asia, North American lumber producers face competition from Russia and the rest of Europe.
From a cost curve perspective, the US South has the lowest log costs and the industry trend has been for Canadian producers to purchase mills over in the US for that reason as well as to avoid having as much exposure to possible trade disputes for Canadian production.
Major Canadian Forestry Companies
- West Fraser Timber
- Resolute Forest Products
- Western Forest Products
Global Lumber Demand
Housing Starts – The biggest driver for demand in North America is housing starts (new housing units started in a certain period), as lumber is widely used in low-density, wood frame buildings that people live in. Housing starts are a key economic indicator that is driven by demographics, income and growth expectations. Housing starts are currently considered to be in the middle of the economic cycle, with housing starts around 2 million before the financial crisis in 2008.
Housing starts are a much more important indicator of the economy in Canada and the US due to the population density trends in North America. North America is spacious and there is a preference for detached houses and extensive roads for driving. Europe and Asia are much more concentrated, leading to a wider use of concrete and steel for tall, multiunit high-rises. As it follows, urbanization trends hurt lumber demand to some extent.
Interior Design and Renovations – In addition to newbuilds, lumber is widely used in housing renovations. Generally, renovations are also a sign of economic health.
Lumber Industry Business Model
Lumber revenue is a function of the price of lumber and the volume of lumber sold. Generally, lumber sold will be fairly close to lumber production.
The difference between lumber production and lumber shipments is inventory. Lumber inventories may fluctuate on egress issues (difficulties moving lumber out) as wood moves primarily by rail and when railroads are constrained they may have to stockpile lumber.
Lumber production is measured in board-feet. A board-foot (or a super foot in Australia) is a square foot of lumber that is one-inch thick. The board-foot is the appropriate measure for rough, unprocessed lumber (versus a 2×4 for dried and processed lumber). Abbreviations can be confusing in the lumber industry.
fbm = board foot
mfbm = thousand board foot
mmfbm = million board foot
Bfbm = billion board foot
Lumber revenue comes from lumber sold from production as well as wholesale. Depending on the grade of lumber and how in demand each grade is, lumber producers will receive different prices depending on how they have contracted or through the price they receive on the open market.
Low quality grades include Spruce-Pine-Fir (SPF/softwoods), Hemlock, and Douglas Fir. Higher grade wood includes Southern Yellow Pine. A E. or W. in front of the wood indicates Eastern or Western.
Costs for lumber producers are mostly wood (usually more than 50% of revenue), followed by labor, with the residual being energy (for power) and other miscellaneous expenses.
The Softwood Lumber Agreement (SLA) and Differences Between US and Canadian Lumber Production
In the US, timberland is private property. In Canada, timber is mostly harvested from government land, where forestry companies pay a fee for harvesting, known as stumpage. The exception to government owned timberland is the Atlantic Provinces/Maritimes, where lumber is on private property.
The influential lumber company lobby in the US uses this as the basis for countervailing duties (“CVD”) in the US/Canada trade dispute, recently brought to the forefront by Trump Administration US Secretary of Commerce Wilbur Ross.
The US has argued that stumpage fees charged by government are lower than what a timberland owner would demand in a competitive market. As it follows, the US makes the case that this is essentially a state-supported subsidy to Canadian producers who are then guilty of dumping.1
Some lumber producers also own electricity generation assets. Power assets represent stable cash flow to the firm, but are separate from the lumber operations.
Lumber producer income and cash flow is heavily influenced by the USDCAD exchange rate. The vast majority of Canadian production is for domestic use or exported to the USA, which is a large point of contention in terms of international trade.
Wood Products, Pulp & Paper
Engineered Wood Products
- Oriented Strand Board (OSB)
- Wood Pellets – Biomass electricity production
- Medium Density Fibreboard
Pulp Industry Overview
- Northern Bleached Softwood Kraft
- Bleached Eucalyptus Kraft
- Northern Bleached Hardwood Kraft
Paper & Packaging
1 Recall that dumping in economics is when producers in one country export to another country at below competitive market rates to gain market control – for further reading refer to GATT-WTO
Related Reading for Basic Materials