Pricing behaviour and Chinese steel

Over-capacity in its steel sector, a deteriorating domestic market, increased exports and low export prices have negatively impacted steel markets globally and steelmakers elsewhere cannot understand how China has been able to export steel at such low prices. Using cost data from CRU’s Steel Cost Service, this Insight attempts to understand the pricing behaviour of Chinese steel mills, but also explores a less well-documented aspect of the Chinese steel industry, the induction furnace sector, and its influence on the market.

In conclusion, based on CRU’s forecasts for steel demand in China, our view is that the Chinese government target to eliminate 150 Mt of capacity does not go far enough, if it is to create a long-term viable steel industry, and an added focus on the IF sector would provide another lever to achieve these aims.

Introduction
Throughout 2015, the Chinese export price for hot rolled coil (HRC) was in decline and, particularly in the second half, prices began to fall significantly, to reach $267 /tHRC, FOB in December of that year, the effects of which were felt by steelmakers across the globe. Since then, the Chinese domestic market has experienced a rebound and this has lifted domestic and export prices to a more rational level but, at the time, many were asking how Chinese steel mills could be exporting at such low prices. The sustainability of the current buoyant market conditions in China is doubtful, given demand fundamentals heading into 2016 Q3, and we have been expecting a downward correction to current high domestic prices, which is now beginning to manifest itself. As such, export prices will also see a correction and it is possible they may return to the low levels of last year. At this point, it is likely that, once again, steelmakers and trade bodies around the world will begin to question the ability of Chinese steel mills to export at such low prices.

In order to help answer these questions, this Insight sets out the cost structure of a typical, coastal Chinese steel mill, based on output from CRU’s Steel Cost Service, and uses this to understand the behaviour and rationale behind low export prices. But, before looking at that, let’s put Chinese export prices into context.

Just how low are Chinese export prices?
In order to answer this question, the plot below sets out the differential between Chinese domestic and export prices for HRC since 2011 and shows that, throughout this period, domestic prices have been higher than export prices on an FOB basis¹. Further, examination of this plot indicates three distinct periods.

The first relates to the post-GFC, stimulus-driven growth period during which the Chinese steel sector experienced significant demand growth and crude steel production increased at a CAGR of 9.5% to satisfy this demand. During this period, export prices were at their lowest compared with domestic prices, with a mean differential of ~$50 /t, but net exports averaged only ~30 Mt/y, as mills were focused on serving the strong domestic market. During the second, ‘cost competitive’, period, export prices were at their highest relative to domestic prices (i.e. the differential between the two is the smallest during the period analysed). It was at this point that the Chinese domestic market began to show the first signs of deterioration but, due to exceptionally high scrap prices during 2014 (i.e. relative to hot metal costs), Chinese steel mills held a significant cost advantage over scrap-based steel makers in SE Asia and, the more distant, Turkey. At the same time, the US market was very strong and each of these factors served to underpin high export prices and record net exports, which lifted 78% during the year, to ~64 Mt. Moving into 2015, scrap prices fell back from the previous highs, the US market lost its gloss and, most importantly, the Chinese steel market experienced a significant downturn, particularly during the second half of the year. During this period, the Chinese steel market entered a cyclical trough and steelmakers began to seek other markets. As a result, net exports increased once again, to ~82 Mt/y in 2015, but the plot indicates that export prices stabilised at ~$30 /t below domestic prices. Given the minimum and maximum differentials exhibited over the previous 4 years, we suggest that the differential in this latter period represents a more normal state of affairs and the low export prices during this latter period a function of the dire domestic market conditions and indicative of steelmakers fighting for survival².

So, low export prices towards the end-2015 were a function of a poor domestic market, but how does that explain how Chinese mills were able to export at such low prices? To answer this, the following section examines the cost structure of a typical coastal, Chinese mill using data from CRU’s Steel Cost Service.

How are Chinese steel mills able to export at such low prices?
CRU’s Steel Cost Service provides a detailed, bottom-up analysis of the cost structure of 256 steel mills globally, including integrated, electric arc furnace (EAF) and hybrid operations located in all major steelmaking regions of the world. The model is flexible and users can interrogate costs in a number of ways. To illustrate, the plot below sets out our view of the cost structure of a typical, coastal Chinese mill based on extant raw material prices during February 2016 and taking into account other expected cost reductions. The steel export price at the time was ~$290 /tHRC, FOB.

The first column in the plot above provides a detailed breakdown of the cost elements making up the average costs of the mill. Included in this cost breakdown are sustaining capital costs, that we include to account for major spend that would normally be capitalised, but which is necessary for the continued safe operation of plant (e.g. the rebuilding of a blast furnace). A steel plant operator would not normally include sustaining capital under operating costs and, particularly under difficult market conditions, it would not be a consideration in the pricing decision. Therefore, in the second column, this has been removed. In the third column, the costs have been re-aggregated into fixed and variable costs and, in the fourth column, account is taken of the VAT rebate available on some exported steel³.

This analysis indicates that, during February 2016, a typical Chinese mill could achieve a full, export cash cost of just over $300 /tHRC but, more importantly, a variable cash cost, after the VAT rebate, of ~$265 /tHRC. This suggests that, at ~$290 /tHRC, exports were being priced at variable costs during this time, after allowing for some headroom to maintain safety margin.

Some factors unique to China
When it comes to steel, China is often portrayed as the demon. A slowing economy and a transition from investment to consumption has exposed the over-capacity in the steel sector. Barring the recent uplift in prices, steel mills in the country have been in survival mode and the focus has been on cost reduction and the minimisation of losses. The result of this has been an increase in exports and, based on the above analysis, steel mills here have been prepared to price marginal sales at close to variable costs, which has had a significant negative impact on the global steel market⁴. However, this is no different from how any steelmaker would behave in these conditions but, obviously, it is not sustainable in the medium- and long-term. But, what appears, on the face of it, to be a confrontation between China and the rest of the world, hides another, altogether different battle.

To illustrate, the plot below on the left compares the price of scrap in China with the European scrap export price. This shows that, prior to 2014, Chinese scrap was priced up to $100 /t higher than European export prices but, during 2014, this differential fell to close to zero; we believe this fall favoured the induction furnace (IF) sector in China that operates entirely on scrap. IFs tend to be small in scale, rurally located and typically operate informally, perhaps sourcing scrap from nearby areas and avoiding paying VAT on inputs and other taxes. Taking into account these factors, the plot on the right sets out our view of the cost structure of a typical IF operation. This shows that, for February 2016, the month of this analysis, full costs of an IF operation were equivalent to delivered steel prices.

Whilst IFs produce low quality construction steel, steel prices across all products are linked, either because steelmakers can make a choice between different products or because end-users can substitute one form of steel for another. IFs would not be able to export material, because of the low quality produced, but we understand that up to 60 Mt of IF capacity exists across China and the supply of this material into the domestic market will pull prices down. Thus, under some market conditions, IFs could hold a key price setting role in the Chinese market. That is, what we see today in the steel sector is not just a confrontation between China and the rest of the world, but a battle is taking place within China, between IFs and ‘big’ steel.

Official statistics ignore the IF sector, it is too fragmented to track, but, according to the above analysis, it could be playing a key role in undermining the domestic market. Further, based on our forecasts for steel demand in China, the current government target to close up to 150 Mt of capacity is not sufficient to return the Chinese steel industry to viability, as it implies continued over-capacity⁵. Therefore, in our view, an added focus on the IF sector is required in order to bring the market into balance.

Footnotes:

1. In this analysis, HRC prices are used as a proxy for all steel prices.
2. The fact that steelmakers were in survival mode during the latter period was illustrated by the moves taken to reduce costs through salary cuts, de-manning, the closure of ~60 Mt of capacity during 2015 H2 and the shift to the procurement of lower priced input materials (e.g. lower grade ores, increased domestic coal purchases) etc.
3. The costs shown include VAT paid on inputs such as raw materials etc. and these are often partially or wholly rebated on both domestic and export sales. As elsewhere in the world, typically, only the end-consumer pays VAT on finished goods.
4. The threat of closure at Tata Steel Europe’s UK operations and other closures, both outside and inside of China, are testament to this.
5. According to our analysis, any steel sector needs to be operating at 85-90% capacity utilisation to generate sustainable levels of profitability.