Since September 2011, steel-related equity share prices have increased by about 45 percent while Hot Rolled Coil (HRC) prices have increased by about 10 percent. The rally was one of the largest share price rallies in the sector since 2008.
While investors may be anticipating further steel price increases due to a more optimistic outlook for the U.S. economy, oversupply could cause prices to correct again in the near term.
The price correction could impact North American steel producers including Nucor Corp. (NYSE:NUE), Alcoa, Inc. (NYSE:AA) and United States Steel Corp. (NYSE:X).
CIBC, which downgraded the North American steel sector to "underweight" from "market weight", said the rebounds in steel prices and share prices over the past two months have been surprising given the nominal changes in global average HRC prices during the same period (up about 5 percent).
The increase throughout the traditionally seasonally weak holiday period in late December was particularly surprising. These price increases were likely reflective of better-than-expected strength in the U.S. economy over the past few months.
"However, we do not believe the outlook has improved enough to warrant the significant increases in steel prices and equity share prices over the past few months," analyst Michael Willemse wrote in a note to clients.
Meanwhile, the U.S. is still operating at only 76.8 percent of capacity at the current time which is generally not enough to generate material pricing power.
"We believe end market demand would need to increase by at least 10 percent from current levels for capacity utilization to increase above 85 percent (which is generally necessary for strong pricing power)," the analyst said.
Reports from American Metal Markets suggest that steel scrap prices have declined by about $30-$50/ton over the past week. Scrap prices are generally a leading indicator for finished steel prices. Prices of hot rolled coil have also reportedly stabilized at about $740/ton and recent attempts to increase rebar prices appear to be stalling due to the threat of increased import activity.
While continued optimism related to better-than-expected economic activity in the U.S. suggests that upcoming steel price weakness could be limited, Willemse believes the threat of a sharp supply response (both from domestic steel producers and from imports) could cause a sharper correction in steel prices over the next few months.
A bigger concern for North American steel prices is related to the threat of increased import competition. The U.S. represents only about 6 percent of global steel demand. A significant shift in the supply/demand balance in the global steel industry would have a much more significant impact on North American steel prices rather than changes in the U.S. economy.
"We believe the current spread in steel prices in North America versus global export prices (primarily China) of ~$157/ton (as per Steelbenchmarker) is unsustainable," Willemse said.
Historically, each time North American HRC prices had increased to over $150/ton above global steel export prices, a steel price correction had followed within the next three months.
The analyst expects overcapacity in the North American and global steel industry to continue to constrict profitability to well below $100/ton. Given that current margins are at about $90/ton for a mini-mill steel producer and at about $70/ton for an integrated steel producer, he believes further upside is limited.