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26 July 2010
AC
(1-212) 622-6446
michael.gambardella@jpmorgan.com
Tyler J. Langton
(1-212) 622-5234
tyler.j.langton@jpmorgan.com
Key steel leading indicators recently turn positive. In the past week,
Chinese iron ore prices have risen 8% while Chinese steel prices have
increased for the first time in two months. Scrap prices in Turkey, a
major global buyer, have also been moving up recently. In our opinion,
the macro and industry-specific pressures dragging steel stocks down
over the past two months are now turning positive.
X remains the best way to participate in higher steel and iron ore
prices. We see the recent activity in Chinas steel prices, Turkeys scrap
imports, and spot iron ore prices as early indicators for what will likely
be a 4Q recovery for the industry. U.S. Steel (X/OW rated) offers
investors leverage to participate in these themes via its early cycle end
markets and insulation against rising raw material costs at an attractive
valuation. Cliffs Natural Resources (CLF/OW rated) also provides
exposure to this trend, although we would exercise caution heading into
the 2Q conference call on July 29th since CLF is still in arbitration with
some of its North American Iron Ore customers. We also believe
ArcelorMittal (MT/OW rated), with its global reach and captive iron
ore assets, should also benefit in this environment even though we
believe they will have to reduce 3Q guidance on the upcoming call.
Michael F. Gambardella
(1-212) 622-6446
michael.gambardella@jpmorgan.com
Investment Thesis
Notwithstanding temporary dislocations, we believe iron ore prices are ultimately the
key driver of steel, scrap, and steel stock prices as iron ore sits atop the steel cost
pyramid since steel and scrap are basically iron ore derivatives. As a result, we think
higher Q3 iron ore contract prices, supply discipline, and continued economic
improvement will ultimately push steel prices higher as concerns over summer
seasonality, excess blast furnace capacity, and macro risks abate.
In the past week, we have seen Chinese steel and spot iron ore prices post their first
increases since early May. Spot iron ore prices are up 8% while Chinese steel prices
have increased 6%. Scrap prices in Turkey, a major scrap buyer in the world, have
been trending up as well. In addition to the first positive steel industry datapoints, we
are seeing a big shift in the markets perceptions of two key macro drivers of steel
(and materials) stocks the dollar and China. It was only 5-6 weeks ago that the
dollar had rallied against the Euro to 1.19 and many industry observers thought the
dollar was heading to parity with the Euro - a strong dollar is viewed as a major
headwind for steel stocks (and prices), especially U.S.-based steels. Furthermore,
market fears about Chinas credit tightening and slowing demand put additional
downward pressure on steel and other material stocks. Recently, the market appears
to be anticipating that Chinas government is actually getting closer to easing and restimulating growth. As a result, we think the two biggest macro concerns the market
had appear to be fading.
Finally, steel stocks tend to trade around the markets perceptions of inflection points
for future earnings newsflow. Usually these inflection points occur just as the market
consensus appears to be unusually negative or positive. On July 6th, the Wall Street
Journal published a front page story about declining steel prices. In our opinion, the
WSJ story marked a bottom in investor sentiment on the group. In fact, most steel
stocks have outperformed the S&P 500 since the July 6th WSJ story (see Figure 1).
Figure 1: The majority of steel stocks outperformed the S&P since July 6th
135
AKS
130
125
X
120
MT
115
110
STLD
NUE
105
S&P 500
100
95
7/6/2010
Source: Bloomberg
2
7/8/2010
7/10/2010
7/12/2010
7/14/2010
7/16/2010
7/18/2010
7/20/2010
7/22/2010
Michael F. Gambardella
(1-212) 622-6446
michael.gambardella@jpmorgan.com
Brazil-China Freight
Spot Price
250
$/Tonne
200
150
100
50
0
Mar- Jul- Nov- Mar- Jul- Nov- Mar- Jul- Nov- Mar- Jul- Nov- Mar- Jul- Nov- Mar- Jul05 05 05 06 06 06 07 07 07 08 08 08 09 09
09 10 10
Source: Company reports, J.P. Morgan estimates, and Bloomberg.
Figure 3: Spot iron ore prices are currently at a 13% discount to the Q3 contract price
120%
Iron Ore Spot Premium/(Discount)
100%
80%
60%
40%
20%
0%
-20%
-40%
Mar- Jul- Nov- Mar- Jul- Nov- Mar- Jul- Nov- Mar- Jul- Nov- Mar- Jul- Nov- Mar- Jul05 05 05 06 06 06 07 07
07 08 08 08 09 09 09 10 10
Source: Bloomberg.
We think the surge in spot prices through the spring of this year was driven by a
confluence of factors. On the demand side, Chinese monthly steel production
climbed from the high 40 million tonne range in the last two months of 2009 and hit
55 million tonnes in both March and April of this year, topping out at 56 million
tones in May (or an annualized rate of 672mm tonnes vs. 2009 production levels of
566 million tonnes). At the same time, global monthly production ex-China also
started to rebound, increasing from the high 50/low 60 million tonne range in the
October 2009-February 2010 time frame to 66-68mm tonnes in March, April and
Michael F. Gambardella
(1-212) 622-6446
michael.gambardella@jpmorgan.com
May of 2010. This ramping production forced buyers into the spot market, supply
issues in India kept the spot market tight, and prices spiked.
Moderating Chinese steel production in June, in part from the central governments
policy actions to control the overheated property market, was the primary contributor
to the decline from peak iron ore prices. Specifically, Chinese monthly steel
production declined to 53.8 million tonnes in June. Combined concerns over China
slowing, excess blast furnace capacity, sovereign debt risks in Europe, and seasonally
slower summer months for steel buying sent spot iron ore prices sliding from the
April peak.
Michael F. Gambardella
(1-212) 622-6446
michael.gambardella@jpmorgan.com
60.0
Tonnes in Millions
50.0
40.0
30.0
20.0
Nov-07
Mar-08
Jul-08
Nov-08
Mar-09
Jul-09
2002
2003
2004
2005
2006
2007
2008
Mar-10
Jul-07
2001
Nov-09
Mar-07
Nov-06
Jul-06
Mar-06
Nov-05
Jul-05
Mar-05
10.0
Source: Bloomberg.
600
Tonnes in millions
500
400
300
200
100
(100)
1995
1996
1997
1998
1999
2000
Steel Production
2009 2010E
Source: CEIC, J.P. Morgan. 2010 estimates represent January-June actual data plus 2H10 estimate
Michael F. Gambardella
(1-212) 622-6446
michael.gambardella@jpmorgan.com
60.0
50.0
40.0
Mar-10
Nov-09
Jul-09
Mar-09
Nov-08
Jul-08
Mar-08
Nov-07
Jul-07
Mar-07
Nov-06
Jul-06
Mar-06
Nov-05
Jul-05
Mar-05
30.0
Source: Bloomberg.
Figure 7: Captive iron ore production from global steel companies is rare
40.0
30.0
20.0
10.0
Gerdau SA
Ternium
Ahmsa
Usiminas
CSN
Tata
NLMK
Severstal
Evraz
SAIL
U.S. Steel
0.0
ArcelorMittal
50.0
We would also note, as shown in Figure 8 below, that the producers with the highest
levels of raw material self-sufficiency should fare the best from an earnings
perspective in an environment of escalating raw material prices. U.S. Steel remains
our top pick in the U.S. given its iron ore self-sufficiency and favorable met coal
contracts in its North American Flat-rolled operations. We would also point out that
these producers, besides the U.S., are largely in Brazil, Russia and India and don't
export significant quantities of steel to the U.S., thus further reducing the risk of
imports from low cost regions.
Figure 8: Global steel producers with the greatest levels of iron ore self-sufficiency
100%
80%
60%
40%
20%
ArcelorMittal
Gerdau SA
Severstal
Ternium
Usiminas
U.S. Steel
Evraz
Ahmsa
Tata
SAIL
NLMK
0%
CSN
Michael F. Gambardella
(1-212) 622-6446
michael.gambardella@jpmorgan.com
Michael F. Gambardella
(1-212) 622-6446
michael.gambardella@jpmorgan.com
This would stand in contrast to 2009 when the global cost curve was much flatter due
to steep declines in global raw material costs or in 2002 when China was a low cost
producer before rising material costs negated its labor advantage (see Figure 11 &
Figure 12).
In the model below, we have assumed a global seaborne iron ore fines price of
$158/tonne CFR (or the Q3 contract price with pellet prices maintaining a $50/tonne
premium over fines prices), a global met coal price of $225/tonne, and scrap prices
flat with their current levels. Under such a scenario, Chinese integrated steel cash
costs for hot-rolled sheet would jump $268/ton to $593/ton (or an increase of $32/ton
vs. Q2 levels), Japanese integrated costs to $661/ton, and Korea/Taiwan integrated
costs to $611/ton. However, in contrast, cash costs for U.S. integrated steel producers
would only increase to $557/ton while costs for U.S. minimills would move to
$441/ton.
Figure 9: Global Cash Cost Model
We estimate that Chinese cash
costs should increase from
roughly $561/ton in 2Q10 to
$593/ton in 3Q10, mainly based
on higher iron ore prices.
Raw materials
Labor
$661
$611
$593
$600
$500
Energy
$557
$455
$441
$417
$405
$400
$374
$338
$300
$200
$100
$0
2009E
2010E
Japan Integrated
2009E
2010E
Korea/Taiwan
Integrated
2009E
2010E
China Integrated
2009E
2010E
US Integrated
2009E
Source: AMM, Bloomberg, CRU and J.P. Morgan estimates. Note: Estimated cash costs operating at 85% of capacity.
2010E
US Minimill
Michael F. Gambardella
(1-212) 622-6446
michael.gambardella@jpmorgan.com
Tonnes in millions
700
600
500
400
300
200
100
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009 2010E
Source: CEIC. 2010 estimates represent January-May annualized numbers. Calculated production is equal to total iron ore
consumption required for total integrated steel production rates less iron ore imports.
Energy
Labor
$700
$593
$600
$557
$500
$400
$269
$300
$200
$178
$100
$0
2002
2010E
China
Integrated
2002
2010E
US
Integrated
Source: AMM, Bloomberg, CRU and J.P. Morgan estimates. Estimated cash costs operating at 85% of capacity.
Michael F. Gambardella
(1-212) 622-6446
michael.gambardella@jpmorgan.com
Figure 12: Global iron ore contract prices have increased 750% since 2000
140
120
100
80
60
40
20
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2Q10
3Q10
US$/short ton
$600
$550
$500
$450
$400
Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10
China HRC
Source: Bloomberg
10
China Rebar
Longer term we expect China to consolidate its steel industry and rationalize capacity
as a means to limit adverse environmental impacts as well as increase its focus on
higher value exports. The country recently took modest steps toward this goal
through a small amount of blast furnace rationalization in Hebei, removal of export
tax rebates on commodity steel products, and steel producer consolidation.
Scrap prices should move up as well
In the U.S., scrap prices had risen steadily since mid-November through April, with
the increases driven by higher iron ore pricing, seasonal supply constraints, and
strong exports to scrap-short, developing markets. In May through July, however,
prices fell by roughly $50-60/ton from the April peak on a combination of increased
flows and imports, broader macro concerns, and buyer uncertainty. While scrap
prices through seasonally slower months could trade sideways or be slightly down
depending on the region, we believe domestic scrap prices will begin to move up in
early September on higher iron ore prices and increased scrap purchases by
integrated steelmakers as they operate at the high end of their scrap feed to offset
some of their increased iron ore costs. Underscoring this point, we have recently seen
Turkish scrap prices rise 9% over the last month as the mills re-enter the import
market after the European sovereign debt crisis disrupted their ability to attain trade
financing. While some of this activity likely represents buying ahead of the Ramadan
holiday, we view increased activity in this key export market as a positive sign
nonetheless.
Figure 14: U.S. scrap prices should start to rebound as seasonality, macro concerns ease
$700
$600
$500
$400
$300
$200
$100
Jul-10
Jan-10
Jul-09
Jan-09
Jul-08
$0
Jan-08
Michael F. Gambardella
(1-212) 622-6446
michael.gambardella@jpmorgan.com
Source: AMM.
11
Michael F. Gambardella
(1-212) 622-6446
michael.gambardella@jpmorgan.com
Figure 15: Turkey heavy melt mix scrap index moving up in July
$/tonne
$500
$450
$400
$350
$300
$250
$200
12
7/15/2010
6/21/2010
5/28/2010
5/4/2010
4/10/2010
3/17/2010
2/21/2010
1/28/2010
1/4/2010
12/11/2009
11/17/2009
10/24/2009
9/30/2009
9/6/2009
8/13/2009
7/20/2009
6/26/2009
6/2/2009
$150
Michael F. Gambardella
(1-212) 622-6446
michael.gambardella@jpmorgan.com
Companies Recommended in This Report (all prices in this report as of market close on 23 July 2010)
Arcelor Mittal (MT/$32.95/Overweight), Cliffs Natural Resources (CLF/$55.90/Overweight), U.S. Steel Corp
(X/$48.90/Overweight)
Analyst Certification:
The research analyst(s) denoted by an AC on the cover of this report certifies (or, where multiple research analysts are primarily
responsible for this report, the research analyst denoted by an AC on the cover or within the document individually certifies, with
respect to each security or issuer that the research analyst covers in this research) that: (1) all of the views expressed in this report
accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research
analysts compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the
research analyst(s) in this report.
Important Disclosures
Market Maker/ Liquidity Provider: JPMSL and/or an affiliate is a market maker and/or liquidity provider in Arcelor Mittal.
Lead or Co-manager: JPMSI or its affiliates acted as lead or co-manager in a public offering of equity and/or debt securities for
Arcelor Mittal, Cliffs Natural Resources, U.S. Steel Corp within the past 12 months.
Beneficial Ownership (1% or more): JPMSI or its affiliates beneficially own 1% or more of a class of common equity securities of
U.S. Steel Corp.
Client of the Firm: Arcelor Mittal is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to
the company investment banking services, non-investment banking securities-related services and non-securities-related services.
Cliffs Natural Resources is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the
company investment banking services, non-investment banking securities-related services and non-securities-related services. U.S.
Steel Corp is or was in the past 12 months a client of JPMSI; during the past 12 months, JPMSI provided to the company investment
banking services.
Investment Banking (past 12 months): JPMSI or its affiliates received in the past 12 months compensation for investment banking
services from Arcelor Mittal, Cliffs Natural Resources, U.S. Steel Corp.
Investment Banking (next 3 months): JPMSI or its affiliates expect to receive, or intend to seek, compensation for investment
banking services in the next three months from Arcelor Mittal, Cliffs Natural Resources, U.S. Steel Corp.
Non-Investment Banking Compensation: JPMSI has received compensation in the past 12 months for products or services other
than investment banking from Arcelor Mittal, Cliffs Natural Resources. An affiliate of JPMSI has received compensation in the past
12 months for products or services other than investment banking from Arcelor Mittal, Cliffs Natural Resources.
N $28
160
OW $40
OW $37
128
OW $46
Date
23-Oct-08
OW
24.18
06-Nov-08
OW
24.88
40.00
19-Dec-08
25.04
28.00
12-Mar-09
20.27
27.00
OW $45
N $27
OW $55 OW $57
Price($) 96
64
46.00
13-May-09 OW
24.41
37.00
25-Jun-09
OW
33.31
45.00
08-Jan-10
OW
48.05
55.00
27-Apr-10
OW
42.91
57.00
32
0
Oct
06
Jul
07
Apr
08
Jan
09
Oct
09
Jul
10
Source: Bloomberg and J.P. Morgan; price data adjusted for stock splits and dividends.
This chart shows J.P. Morgan's continuing coverage of this stock; the current analyst may or may not have covered it
over the entire period.
J.P. Morgan ratings: OW = Overweight, N = Neutral, UW = Underweight.
13
Michael F. Gambardella
(1-212) 622-6446
michael.gambardella@jpmorgan.com
OW $38
OW $60 OW $81
185
OW $41.5
OW $33.5 OW $53
OW $90
148
OW
Price($) 111
74
37
0
Oct
06
Jul
07
Apr
08
Jan
09
Oct
09
Jul
10
Source: Bloomberg and J.P. Morgan; price data adjusted for stock splits and dividends.
Initiated coverage Dec 04, 2007. This chart shows J.P. Morgan's continuing coverage of this stock; the current analyst
may or may not have covered it over the entire period.
J.P. Morgan ratings: OW = Overweight, N = Neutral, UW = Underweight.
Price Target
($)
04-Dec-07 OW
45.08
19-Nov-08 OW
18.63
54.00
11-Dec-08 OW
27.29
41.50
26-Feb-09 OW
16.14
26.50
03-Apr-09 OW
20.47
30.00
15-Jul-09
OW
23.20
26.00
03-Aug-09 OW
27.39
33.50
01-Oct-09 OW
32.36
38.00
30-Oct-09 OW
34.87
44.00
10-Dec-09 OW
43.14
53.00
18-Feb-10 OW
47.40
60.00
12-Mar-10 OW
60.31
83.00
29-Apr-10 OW
64.33
90.00
14-Jul-10
OW
48.90
81.00
Date
OW
OW $49
OW $86
290
OW $134
OW $56
OW $70
232
OW $115
OW $75
Price($) 174
116
58
0
Oct
06
Jul
07
Apr
08
Jan
09
Oct
09
Price Target
($)
25-Apr-07 OW
103.04
115.00
06-Jun-07 OW
118.66
134.00
03-Aug-07 OW
91.53
--
28-Oct-08 OW
35.20
80.00
19-Dec-08 OW
37.34
56.00
28-Jan-09 OW
34.80
49.00
12-Mar-09 OW
19.10
42.50
28-Jul-09
OW
41.27
55.00
08-Jan-10 OW
60.91
75.00
26-Jan-10 OW
49.61
70.00
28-Apr-10 OW
58.44
86.00
Jul
10
Source: Bloomberg and J.P. Morgan; price data adjusted for stock splits and dividends.
This chart shows J.P. Morgan's continuing coverage of this stock; the current analyst may or may not have covered it
over the entire period.
J.P. Morgan ratings: OW = Overweight, N = Neutral, UW = Underweight.
Coverage Universe: Michael F. Gambardella: AK Steel (AKS), Alcoa (AA), Allegheny Technologies (ATI), Arcelor
Mittal (MT), Carpenter Technology (CRS), Century Aluminum Company (CENX), Cliffs Natural Resources (CLF),
14
Michael F. Gambardella
(1-212) 622-6446
michael.gambardella@jpmorgan.com
Commercial Metals (CMC), Dynamic Materials (BOOM), Freeport-McMoRan Copper & Gold (FCX), Gerdau Ameristeel
(GNA), Globe Specialty Metals (GSM), GrafTech International (GTI), Haynes International (HAYN), Metals USA
(MUSA), Nucor Corp. (NUE), Reliance Steel & Aluminum (RS), Steel Dynamics, Inc. (STLD), Teck Resources
(TCKb.TO), Thompson Creek Metals (TC), U.S. Steel Corp (X), Worthington Industries (WOR)
J.P. Morgan Equity Research Ratings Distribution, as of June 30, 2010
Overweight
(buy)
46%
49%
44%
68%
Neutral
(hold)
42%
46%
48%
61%
Underweight
(sell)
12%
31%
9%
53%
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15
Michael F. Gambardella
(1-212) 622-6446
michael.gambardella@jpmorgan.com
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Michael F. Gambardella
(1-212) 622-6446
michael.gambardella@jpmorgan.com
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