X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2017 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
What's Really Going on in the Metals Sector? - Views on News from Equitymaster
  • MyStocks

MEMBER'S LOGINX

     
Login Failure
   
     
   
     
 
 
 
(Please do not use this option on a public machine)
 
     
 
 
 
  Sign Up | Forgot Password?  

What's Really Going on in the Metals Sector?
Jun 6, 2016

At the start of 2016, everything was looking bleak for the metal sector. Metal companies were facing severe headwinds from various sources and pleading for support from the government.

The government finally realised the importance of the matter. In the first week of February, the government imposed a Minimum Import Price (MIP) on specific steel products. Similarly, the 2016-17 government budget increased customs duty marginally on primary and other aluminium products.

With this, metal companies finally had a sigh of relief. Not to mention the recent rally in the metal prices.

Rally in Metal Prices
Rally in Metal Prices

This leads to the main question: Are commodities bottoming out? If yes, will the growth be sustained going forward? Is this rally backed by fundamental factors? Or is this a seasonal rally?

To understand the dynamics of the metal sector, we need to dig deeper to find out exactly what is happening.

The demand for metals is sensitive to the business cycle. The revenues are generally higher during economic prosperity and expansion, and lower in periods of economic downturn and contraction.

If the economy is expanding, there will be demand for automobiles, real estate and construction, and capital goods and machinery. This, in turn, creates demand for the metals.

Remember the golden period of 2003-07? India's GDP grew around 8% in 2003-04 and more than 9.5% in the latter part of this years. This indicates India was growing at a good pace. This meant more investment, new capacities, good utilisation levels, robust demand, the boom in real estate, an increase in consumer discretionary income, an increase in sales of automobiles, and so on.

If these components were doing well, there would automatically be strong demand for metals. More demand would result in better realisations, and that would encourage the metal companies to increase their capacity and produce more metal, which would result in more revenues and profitability.

The China Factor

When we are discussing GDP data, one cannot ignore the giant, i.e. China. China grew at an average of 10.6% from 1991 to 2007. Even after the financial crisis, China grew at more than 9%.

What is the reason behind this huge two-decade growth? It started with mass privatisation and the opening of the country to foreign investment, which led to huge investment in various sectors such as infrastructure, energy, and manufacturing. Rising consumer income led to investments in automobiles and real estate.

All these are directly linked to the metals sector. More demand for metals forces metal companies to increase their capacities. More capacity means more demand for mining commodities such as iron ore, coal, bauxite, and zinc.

In this process, China has monopolised metal production and consumption. China accounts for nearly 50% of metal production as well as consumption. In fact, China grew from 12% of the world's metal consumption in 2000 to near 50% today.

How much Does China Consume?
How much Does China Consume?

That's why you cannot ignore China. In fact, now all equations of metal and mining revolve around China.

Excess Capacities and Acquisitions at the Peak of the Cycle

Continuous and robust demand encouraged metal companies to increase their capacities. This was based on the assumption that the demand would continue. Not to mention the big acquisitions at the top of the trading cycle. Indian companies such as Tata Steel and Hindalco made big ticket acquisitions. Every company was hungry for growth.

So far, we have only looked at the demand side of the equation. But the supply side of the equation was coming into play.

The Boom Stops and Dumping Begins

The dragon's appetite was satiated. It no longer required those extra metals from additional capacities. What to do with the surplus? 'Dump' the product at a cheap rate to other countries across the world. This started in 2012 when GDP numbers fell below 8%.

As per economics 101, if there is low demand, supply must dry out to balance the equation of demand and supply. But this didn't happen. The governments simply wouldn't allow steel mills to be closed. They didn't want the local employment and fiscal income to stop. In fact, to avoid job losses, the Chinese government began to provide power subsidies and discounts. This enables it to produce metals at a very low rate compared to other international companies.

Net Steel export by China
How much Does China Consume?

As you can see from the above table, China's exports zoomed post-2012. It is important to correlate this data with the country's GDP numbers. From 2013-15, China grew at an average of 7.3%, much lower than in previous years. With tepid domestic demand, the natural choice was to export or rather 'dump' their production to other countries, including India.

The Government Finally Wakes Up...

For every action, there is a reaction. Many foreign steel companies have shut down their mills or stopped operating entirely as a result of China's dumping. Take Tata Steel Europe for example. Europe's second largest producer plans to sell or shut down their British operations. ArcelorMittal, the largest steel producer in the world, has already shut down at least three plants in South Africa, the US, and Spain.

To protect domestic industry, countries such as India and the US have imposed anti-dumping duties. Similarly, the European Union launched an investigation into Chinese steel exports following protests by steelworkers.

A Turnaround?

After understanding the dynamics of the metal industry, the question remains unanswered. Are commodities bottoming out?

Let's look at the reasons for the rally.

When you anticipate future prices increase, you keep stock or inventory. However, this period gave no such incentive to hold as prices kept falling.

Steel demand tends to pick up around the Chinese New Year due to restocking, and then it tapers. This year, inventories were at multi-year lows. Furthermore, temporary closures and a seasonal demand led to higher steel prices over the last couple of months.

Another driver behind the steel rally was the uptick in raw material prices as China's government stimulus spending and loose monetary policies have lifted economic activity and spurred steel demand and prices.

In India, steel prices have witnessed an increase post the imposition of a minimum import price (MIP) on steel in February 2016. This was further aided by a recovery in international steel prices.

Will It Sustain?

An unexpected rally such as this will only create more supply. While China has engineered some steel capacity cuts, its efforts risk being undermined by a sharp rise in domestic steel prices that has seen mills ramp up output.

In March 2016, China produced record steel production of 70.2 million tonnes, an increase of 2.9% compared to March 2015. Similarly, in April 2016, China produced 69.4 million tonnes, overshadowing 65.5 million tonnes produced by all other nations.

There has been talk of the return of 'zombie firms'. The higher prices have encouraged some closed steel mills to resume production. As per the survey from Chinese consultancy firm Custeel, 68 blast furnaces with an estimated 50 million tonnes of capacity have resumed production in China in light of the steel price surge.

Although the Chinese government wants to bolster the economy and boost demand for the industrial sectors, it is not addressing the supply-side reforms.

A Final Word...

The dynamics of the metal and steel industry are intensely complex and insane. This is an industry where producers are producing more and more metal despite tepid demand... This is an industry where the government subsidises steel plants by providing incentives to steel producers...

A solution to this would be to address the structural problems such as high debt, excess capacity, and deflationary pressure. But that's not easy...

Sarvajeet Bodas

Sarvajeet Bodas (Research Analyst), holds a master's degree in finance. He has been a finance blogger for more than four years, covering various topics in personal finance and investing. His deep interest in behavioral finance was inspired by Charlie Munger, Howard Marks, Guy Spier, and the works of Daniel Kahneman and Richard Thaler. He likes to study the business models of companies in detail, keeping in mind the big picture and focusing on current risks and challenges.

Equitymaster requests your view! Post a comment on "What's Really Going on in the Metals Sector?". Click here!

  

More Views on News

How to Ride Alongside India's Best Fund Managers (The 5 Minute Wrapup)

Jun 10, 2017

Forty Indian investing gurus, as worthy of imitation as the legendary Peter Lynch, can help you get rich in the stock market.

Which Gods Will Bring Down the US Empire? (Vivek Kaul's Diary)

Aug 17, 2017

Mr Trump is in the White House and the gods are in their heavens; what's not to like?

Will They Haul Off Trump's Statue, Too? (Vivek Kaul's Diary)

Aug 16, 2017

All across the country, the old gods become devils. New, gluten-free gods take their places...

This Company Beat the Business World's 'Three Killer Cs' (The 5 Minute Wrapup)

Aug 16, 2017

And what it has in common with beating the stock market too.

5 Steps To Become Financially Independent (Outside View)

Aug 16, 2017

Ensure your financial Independence, and pledge to start the journey towards financial freedom today!

More Views on News

Most Popular

Demonetisation Barely Made Any Difference to Tax Collections(Vivek Kaul's Diary)

Aug 7, 2017

The data tells us quite a different story from the one the government is trying to project.

Proxy Plays: A Smart Way to Bet on 'Off Limits' Companies(The 5 Minute Wrapup)

Aug 4, 2017

The small-cap space is full of small players that are clear proxies to great growth stories and Indian megatrends.

Should You Invest In Bharat-22 ETF? Know Here...(Outside View)

Aug 8, 2017

Bharat-22 is one of the most diverse ETFs offered so far by the Government. Know here if you should invest...

Signs of Life in the India VIX(Daily Profit Hunter)

Aug 12, 2017

The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.

7 Financial Gifts For Your Sister This Raksha Bandhan(Outside View)

Aug 7, 2017

Raksha Bandhan signifies the brother-sister bond. Here are 7 thoughtful financial gifts for sisters...

More

Become A Smarter Investor In
Just 5 Minutes

Multibagger Stocks Guide 2017
Get our special report, Multibagger Stocks Guide (2017 Edition) Now!
We will never sell or rent your email id.
Please read our Terms

S&P BSE SENSEX


Aug 17, 2017 02:04 PM

MARKET STATS