STEEL AND ALUMINUM INDUSTRY TRENDS LEADING UP TO THE COVID-19 CRISIS

Michael Sullivan, Vice President of the metals and mining valuation group at Hilco Valuation Services joins Steve Katz on the Hilco Global Smarter Perspectives Podcast Series to discuss the course of steel and aluminum industry trends leading up to the COVID-19 crisis, as well as the factors that are now impacting those industries and the variables that stand to either speed or slow their paths to recovery.

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Steve Katz  0:08  
Hello again and welcome to the Hilco Global Smarter Perspectives Podcast Series. I'm your host, Steve Katz. Today we're speaking with Michael Sullivan, Vice President of the metals and mining valuation group at Hilco Valuation Services about the course of steel and aluminum industry trends leading up to the COVID-19 crisis, as well as the factors that are now impacting those industries and the variables that stand to either speed or slow their paths to recovery. Michael worked in the steel industry for 23 years before joining Hilco. Just as a little background, Hilco's valuation team works extensively in inventory machinery equipment, enterprise valuation from numerous companies in the metals and mining industry, and thoroughly understands the unique dynamics of price volatility on manufacturers, distributors, and fabricators. The company leverages its proprietary market trend data to assist customers in the ongoing assessment of how market forces drive recovery values. With that said, Michael, welcome to the podcast. 

Michael Sullivan  1:05  
Hi, Steve. Glad to be here. 

Steve Katz  1:06  
Well, we're glad you can join us. Michael, it seems like a good place to start on this topic might be to briefly talk about what you often refer to as the three legs of the steel industry; construction, transportation, and energy, and what you've seen happening and each of those over the course of the pandemic here in the U.S. Can you give us a sense for that?

Michael Sullivan  1:24  
Sure, Steve. Construction, energy, and transportation are separate market segments, but in reality, they're closely linked. COVID-19 is going to bring about what I think will be permanent structural changes.  More of us will work remotely eliminating our commute. More of us are going to move out of the high-cost cities like New York City and San Francisco to more affordable areas. So home sales and new construction are booming,  pending home sales are the highest they've been since 2001. New houses come with new appliances, washers and dryers, water heaters, furnaces, air conditioners, which drive up the demand for steel and drive up the demand for trucking. As people move out of the cities they'll need a car.  These lifestyle changes necessitates construction of new houses and that leads to increased demand for auto and truck to serve these new and growing communities. And we're shopping online and the malls are dying and local retail is dying and they'll be a lot of glut off office and retail space. So while housing is booming, retail and commercial are not. The inability of Congress to pass a major federal infrastructure bill has kept highway and bridge projects on the back burner. So all that rebar, beams, and plate remain on paper instead of on the job site.  On the bright side, centers seem to be everywhere in demand for metal buildings, racking, shelving and other goods remain strong. Agriculture is fairly strong. People continue to eat.  I want to point out as a side like that is we think about this, I think someday people are going to go back into stores. People go to a store to buy things but they also go to the store from social aspects; to get out of the house, the choice of goods, to be able to pick up and look at something in real life as opposed to online and I think that x years down the line, I think we're going to have commercial building again in retail. Maybe it's going to be different and maybe the mall concept is gone but closer retail will survive. Energies and other key economic drivers in oil prices were in the low $50 range pre-COVID and now in the $40 range.  Natural gas prices have run-up in the later part of 2019 to about $4 per million BTU. They dropped to $1.50 in June and they're now about $3.  In the energy market, the barometer is the active drilling, the active drilling rig count, which is down from 790 in February to 269. Oil rig counts are down about 60%. Gas rig counts are down about 35%.  A drilling rig is more than a drill site it's a construction site acquires infrastructure, roads, water, power, steel pipe, oilfield services during pre-drilling, active drilling and maintenance and support after establishment. To reduce rig count as a negative effect on many markets, oil and gas consumption are down. At the same time we're moving away from coal which is good for the environment most people would think but it's bad for heavy equipment. Transportation car sales plummeted heavy truck sales plummeted at the peak of the pandemic and they've since comeback. Car sales plummeted at the height of the pandemic and were down about 25% the first six months of 2020 compared to 2019. We're now at a pace similar to 2019. But we'll probably end the year about 2 million units shorter than retrieved in 2019.  Heavy truck sales follow the same pattern as cars significantly, mid-year and they sort have come back to pre-COVID levels. 

Steve Katz  4:35  
Okay, Michael, that's a great overview on each of the legs and it certainly will be interesting to see how things develop moving ahead.  For some additional perspective, I'm wondering if you can discuss where things stood trend-wise in terms of demand and pricing for both the steel and aluminum markets in 2018, 2019, and headed into COVID. And then also what, if any, impact the Section 232 import tariffs had on those pre-pandemic markets and what we're seeing today.

Michael Sullivan  5:02  
Well, we'll go back to the 2018 Section 232 tariffs.  It was about 10%, on aluminum, which simply wasn't enough to drive any major structural changes in the U.S. With a 10% surcharge essentially, nobody was going to go out and build aluminum smelter and there was hardly enough incentive to bring back existing capacity as it was offline although the industry did.  It went from about 800,000 tons in 2018, to back over a million tons in 2019. In reality, the Section 232 was as far as aluminum is concerned was an afterthought, the horse has already left the barn, and the aluminum industry is much reduced and always will be compared to what it was 20 years ago. So right now the U.S. is not a major producer of primary aluminum and market prices are determined by producers in the Middle East, Russia, and China and U.S. market prices follow those prices. Spot aluminum prices were reported on the London metals exchange for about 80 cents a pound pre-COVID, a decrease of about 67 cents a pound, and now they're back at 82 cents a pound. So we're kind of back where we started. There's an additional transportation and warehousing premium in the U.S., which historically has been in the 10 to 14% range and that also went down a little bit.  Steel prices fell significantly in March, April, and May but have since recovered and most product types are now at about where it was pre-COVID, in some cases higher than pre-COVID.  Steel coil prices have really begun to increase since June and now we're at higher than pre-COVID prices. Steel, coil prices drive market prices for steel pipe and tube; tube prices are up. Other things like rebar, steel plate, and other prices have also recovered to pre-COVID levels. Demand has improved. It's still not where we were. But right now we're in kind of a if pre-COVID was a happy price market price-wise, that's kind of where we are right now.

Steve Katz  6:54  
Okay, good. Thanks for that.  Very helpful. Clearly, we've seen demand falling across numerous industries incurred during the course of this crisis. And the two that we're talking about here today are no exception from that. So let's take them one at a time. First, what is the steel industry's response to reduce demand and related factors been and would you say that that response is one that is likely to pay off?

Michael Sullivan  7:20  
Well, the steel industry acted pretty much what they did during the global economic crisis without change. As COVID took effect, the blast furnace based mills shut down most of their blast furnaces and the scrap-based mills throttled back production. At its peak, more than half of the domestic fleet of blast furnaces was idle. Capacity utilization was down to about 50% compared to normal, which is 75%.  As the economy recovered, most of that capacity came back online. But even before COVID, the steel industry was looking for ways to rationalize capacity. COVID probably pushed many of those future plans into 2020. And certain facilities will likely be permanently closed. Steel plants and processing locations are like vampires; they're hard to kill.  Capacity goes offline in bad times can come back to life in good times increasing supply and negatively affecting prices. As far as imports, falling domestic demand, lower domestic prices, coupled with uncertainty, put a damper on demand for imported steel goods. As economy expands and stabilizes, we'll likely see imports begin to increase in a variety of product categories.

Steve Katz  8:24  
Okay, well, makes sense. I guess those closures and delayed plans aren't surprising given the circumstances. Let's turn to the other side of this equation. Right. So what have the biggest challenges on the aluminum side been?  How is that industry dealing with those? Are those actions likely to pay off?  And then one additional piece, I'm curious whether you've seen demand from any specific industry or user type, hold firm, or maybe even gain momentum during the pandemic? 

Michael Sullivan  8:50  
Good question, Steve. Domestic primary aluminum production, which we get by smelting bauxite, it totaled just over a million tons in the first nine months of 2020. It's down about 6% compared to 2019. Closing and restarting aluminum smelting facilities is a very expensive and risky effort. Things can go wrong when you shut down these highly expensive liquid metal processing locations and the industry decided pretty much to keep going and hope there's recovery. Demand for aluminum in automobiles, we saw that at a Ford F-150 Truck and other vehicles, demand for aluminum and vehicles is going to increase as a lightweight mechanism to increase fleet average economy. On the downside aluminum is a big supplier to the aerospace industry. That being said, majority of the primary aluminum consumed in the U.S. is imported. Changes in domestic demand will likely result in increased imports. And as far as will it pay off, there is no path to recovery for the aluminum industry. It's unlikely it's ever going to return to the 4 or 5 million tons we made 20 years ago. Aluminum smelting is driven by energy cost and or by being subsidized by the government and so the production of primary aluminum has gone to the Middle East where energy is cheap, gone to China, where energy can be subsidized by the government into these aluminum plants or by Russia where the economic system is driven by other factors. So, the U.S. economy is very likely to never come back.  We have a robust recycling industry, when cars are shredded the aluminum is recovered when aluminum siding is taken over. So we recycle millions of tons of aluminum and bring that back into the market. And that's going to continue but as far as primary aluminum, barring some draconian import taxes or domestic content regulation, smelting pure aluminum from bauxite will remain a very small part of total domestic production and consumption. Imported aluminum will continue to represent the majority of domestic supply and market prices are going to be controlled outside the U.S. Hopefully, we can hold on to the remaining capacity that we have. But it's probably unrealistic to hope for more than that. And to some extent, the decline in the aluminum industry is a cautionary tale, which more industry leaders and more politicians should be aware of. It's not unreasonable to look at aluminum production trends and say, is steel going to be there in 20 years? And I think some of the things the industry itself has done and some of the things that the government has done to prop them up a bit in hard times, may or may not pay off.

Steve Katz  8:50  
All right, well, let's hope for the industry that it can hold on to the domestic capacity. So Michael, believe it or not, we're running out of time. But let's wrap it up today with your perspective on what you believe we can expect to see in terms of a path to recovery for these two industries. And if you would, as part of that, maybe you can also touch on the recent Cleveland-Cliffs acquisition of ArcelorMittal's U.S. assets because I know, the company also recently acquired AK Steel. These are big investments we're talking about. So I'm thinking that our listeners would be very interested in hearing your thoughts on what moves like this, at a time like this, might indicate for the steel industry as it moves through and beyond the current crisis.

Michael Sullivan  12:01  
Well, Steve, we'll take the aluminum industry first because it's easiest. I'm hoping for the status quo. I'm hoping we can maintain the current levels of primary aluminum production and or expand output from these facilities that are operating and maybe some of the idle facilities come back. That's about as much as we can hope for.  In the steel industry, some of our recent publications from Hilco have talked about the transition from the older integrated steel mills, that use blast furnace technology to take iron ore and convert it into steel, versus the newer technologies, which eliminate many of the middle steps, simplify the operations, and typically melt only scrap or scrap substitutes. So you can build a steel mill and operate a scrap melting thin slab casting steel mill with 200 or 300 people versus 1500 or 2000 in an integrated mill. And then the last couple years, we've seen the oldest of the integrated mills shut down and decrease domestic capacity, being replaced by brand new mills using the latest technology. And so, that was happening pre-COVID and that's going to continue. The Section 232 tariffs as far as the steel industry have kind of run their course. NAFTA was renegotiated which hopefully provides a more level playing field with Canada and Mexico, which in the steel industry, they are two of our largest trading partners. So, there's been no real change in the trade imbalance with China and Chinese sales of steel products into Europe and Asia will continue and then in turn the Koreans and the Turks will look to export their capacity to other places. So, that's kind of how the trade imbalance with the U.S. if it's not Chinese products coming in it's other countries who were dumping goods here because their markets driven down prices. So the 232 tariffs like NAFTA was renegotiated. There were quotas placed on certain countries, and other agreements that helped. And for the most part, the Section 232 tariffs have run their course pre-COVID. So what's left after 232 is probably a return to 2017. And prior when there'll be dumping of a certain product type into the U.S. we'll file a trade case it will drag on through the courts for a year or two and that will be solved and there'll be quotas or tariffs placed on those goods and like a camel getting his nose under the tent in different places, it'll go from hot rolled coils to cold rolled coils to rebar to steel plate to pipe and tube and we'll continue as we were before. But going back to Cliffs in the integrated mills, Cleveland-Cliffs is the largest producer of iron ore in North America, and they've recently announced the acquisition of ArcelorMittal USA.  ArcelorMittal had sales, which averaged about 10.4 billion in 2018 and 2019.  ArcelorMittal included 6 steelmaking facilities, 8 finishing facilities, 2 iron ore mines, and pelletizing operations, coal and coke operations of fairly significant product. And earlier this year Cleveland-Cliffs acquired AK Steel with over 9000 employees with multiple mills, mostly in the Ohio region. So now you've got the largest ore producer owning the two combined is the largest producer of steel in the United States. And by far the largest integrated mill producer. So what we have now is three groups, three sales groups, multiple facilities, that's a lot of duplication and a lot of chances, or rationalization of personnel and in facilities and this we talked about some of our earlier publications. When you're the facility or you're the staff member being rationalized its catastrophic to you and catastrophic to the communities. And this is not something to be taken lightly or to look as a as a positive thing in the short term. But I think the Cliffs acquisition, and you've got three very old, very established companies with their own cultures being combined into one and this is not going to be a cakewalk to combine them into an efficient and homogeneous group going forward. But if successful, it will allow them to rationalize to change where products are supplied from, to cut transportation costs to cut duplication of costs to things in Ohio that were usually had been made in Indiana to sell to people in Ohio or further south. And those type of product moves using those types of rationalizations are going to help keep these former AK and Mittel operations, or store operations, keep them in business, keep them healthy going forward. If done correctly, it's going to be a positive thing long term for the U.S. steel industry.

Steve Katz  16:38  
All right, well, Michael is usual great insights. And for those of you listening in if you have exposure in the steel or aluminum markets within your portfolio or your business, or looking to key metals recovery values, given developments during the ongoing pandemic period, it probably makes good sense to consider reaching out to Michael and the Hilco valuations team. Michael's email is MSullivan@hilcoglobal.com. That's MSullivan@hilcoglobal.com. Michael, thanks again for joining us. 

Michael Sullivan  17:08  
My pleasure, Steve. Thank you.

Steve Katz  17:09  
And listeners. We hope that today's Hilco Global Smarter Perspective Podcast provided you with at least one key takeaway that you can put to good use in your business or share with a colleague or client to help make them that much more successful moving forward. Until next time for Hilco Global, I'm Steve Katz.

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