The New York Mercantile Exchange is planning to introduce a futures contract that is based on U.S. Midwest market prices for hot-rolled steel coil (see WSJ article). The steel contracts are expected to be offered later this year in the fourth quarter, and be settled against an index developed by CRU Indices Ltd. The futures contracts offer a new way to price steel, which is typically bought through direct negotiations. The move comes at an interesting time considering that many in Congress and elsewhere are blaming speculators in part for the recent moves in crude oil price. Some steel company executives have also resisted steel futures since they too feel that the new futures market will only benefit speculators. On the other hand, a futures market will allow for more consistent pricing and less dumping into competitive markets. The futures market may also keep companies from bidding against themselves, not to mention allow smaller companies without negotiating power to work on a more level playing field.

Of course, beyond helping to eliminate the dumping of steel, a futures market will open up the potential for companies to hedge their steel cost. Given the increased costs of the energy, coking coal, and other raw materials needed to produce steel, the ability the hedge steel cost could not come at a better time for the automobile makers, aerospace industry, and other large users of steel. Therefore, while a potentially good development for companies such General Motors (GM), Ford (F), and Boeing (BA), the move towards steel futures is probably less good news for larger steel makers, such as U.S. Steel (X), Arcelor Mittal (MT), and Nucor (NUE).

Rio Tinto has completed successful negotiations with Baosteel to hike iron ore prices. Baosteel represents Chinese steel mills. The price increases averaged 85% and were argued in part due to increased freight premiums that are necessary to reflect rising transportation costs driven by higher oil prices. China imported 383 million tons of iron ore in 2007, up 17.4 percent from 2006. Analysts are looking for another 1.5 years or so of additional price increases. A CNBC International video discusses the recent price hikes and their effects on the industry. Given that iron ore is cheaper to ship from Australia as compared to Brazil (from Vale), and market prices are continuing to rise, Baosteel really had no other choice.

Given increased transportation costs, it is unclear exactly how much this price increase may add value to Rio Tinto, although a Agence France-Presse article states, "The deal was "very significant" as iron ore is one of the three main drivers of Rio Tinto's earnings, along with copper and aluminum, a Rio Tinto spokesman said." Nonetheless, even if the deal did not directly affect the bottom line, it should at least give Rio some leverage against BHP Billiton's takeover attempt of the company and may force them to up their offer. Rio is a bigger producer of iron ore than BHP, and the recent negotiations illustrate Rio's ability to drive the market price of iron ore. As of now, companies set the price of iron ore in individual negotiations, although the exchanges are looking at offering iron ore contracts in an over the counter (OTC) swaps market, or even a futures market. BHP has already expressed interest in such markets given that it will allow them more ability to take advantage of higher spot prices on a daily basis, without needing to lock into long-term contracts, or renegotiate as prices move significantly.

While individual investors cannot yet invest directly in iron ore futures, they can purchase a few companies that mine and sell iron ore, such as Rio Tinto (RTP), BHP Billiton (BHP), and Vale (RIO), and can also invest in those companies that are demanding the iron ore - the steel makers, such as POSCO (PKX), ArcelorMittal (MT), U.S. Steel (X), and Nucor (NUE). While there is still concern of a global slowdown, demand for steel and the materials that are used for its production, as least in China, are still strong.

During a recent post I made a case for the steel stocks, along with a follow-up article. During the original article I mentioned how "steel companies themselves are also taking steps to reduce costs. This is becoming more of a worry as iron-ore prices have risen 71%, while prices for coking coal and scrap steel have more than doubled. To meet the problem head-on, some companies are attempting to purchase iron-ore mines, coal mines, and deposits, as well as hording scrap steel in an attempt to hedge against higher raw material prices."

We are now beginning to see more of this phenomenon being played out. ArcelorMittal (MT) has agreed to pay $631 million for a 14.9% stake in Macarthur Coal, a move that not only provides a source of coal for ArcelorMittal, but also makes it less likely that Macarthur will be taken over by Xstrata PLC. The purchase was made from two large shareholders agreeing to sell for $19.96 a share, or an 8.5% premium to Macarthur's last trade. Macarthur is the world's largest exporter of pulverized coal, the coking coal used when making steel. ArcelorMittal has traditionally purchased more than 20% of Macarthur's output. This move insures that ArcelorMittal can continue to receive this raw material. They has also recently signed new long-term contracts for iron ore and pellets with Vale, and a off-take agreement with Coal of Africa Limited.

To help possibly fund this stake and others, ArcelorMittal had recently completed the pricing of a $3 billion bond issue of 5 and 10 year notes. Interestingly, Nucor Corporation (NUE) just recently started a secondary offering of 25 million shares of common stock, and also plans to raise up to $1 billion in the debt capital markets. Press releases state that the secondary offering funds will be used for "general corporate purposes, including acquisitions, capital expenditures, working capital needs and repayment of debt." Don't be surprised if an acquisition or stake in a coal company ends up being considered by Nucor and other coal companies as coal prices continue to rise in price and the commodity becomes more in demand. Many steel companies are already considering similar secondaries and bond offerings to remain flexible for such moves.

As for coal companies, these stocks have also been doing well. Popular and widely held companies to begin looking at include Arch Coal (ACI), CONSOL Energy (CNX), Massey Energy (MEE), Alliance Resource Partners (ARLP), and Peabody Energy (BTU). Each have had nice runs this year. Other plays also exist. More about coal in a later post.

We often hear a lot of discussion, and rightly so, about the prices of crude oil and the agricultural commodities. Their moves over the last year have in some cases been parabolic. Their effect on produced gasoline and food prices are also well documented. Less talked about, but increasingly visible and important is steel. Steel price are continuing to rise, with the alloy's average composite weighted price for all carbon-steel products around $1,000 per metric ton (see chart below, from the WSJ article, by way of MEPS International).


Stock prices of related steel companies have also seen a similar rise in the last few months. The SLX exchange traded fund (see below, chart from stockcharts.com) contains various industry companies that are weighted based on their exposure to the price of steel. The daily chart of the SLX has recently broken out over $100 and is in a nice uptrend. The weekly chart (not shown) has also recently broken out from resistance that was a little below the $90 price.


How are some of the big players in the industry holding up? In a word .... great. Below are the charts for US Steel (X), ArcelorMittal (MT), and Nucor (NUE). Many smaller, less well known players have similar looking price trends. As seen in the charts, the price patterns all look very similar, and also mimic the recent price pattern in the SLX, as to be expected.




While the charts certainly look nice, you have to wonder how long companies can continue to increase prices - not only in response to demand, which could decrease, but also with regard to raw material cost, which have been rising. Will costs get so high that demand destruction will occur? Will raw material cost increase faster than companies can increase product prices, thereby reducing profit margins? Both customers and companies are beginning to take action, but in some cases they are at the mercy of the markets.

In Turkey, a number of construction companies are going on strike, protesting price increases. In India, transportation and housing projects have been put on hold. Other countries are limiting the amount of steel that can leave the country as exports, while at the same time freezing prices and reducing tariffs to increase imports. Even oil companies are beginning to worry that they cannot build or obtain the equipment they need to extract the oil that is in such high demand.

Steel companies themselves are also taking steps to reduce costs. This is becoming more of a worry as iron-ore prices have risen 71%, while prices for coking coal and scrap steel have more than doubled. To meet the problem head-on, some companies are attempting to purchase iron-ore mines, coal mines, and deposits, as well as hording scrap steel in an attempt to hedge against higher raw material prices. Many are worried that the higher raw material costs, which are forcing them to raise their own prices, will in fact reduce demand as customers start looking for cheaper substitutes, such as aluminum and higher strength plastics.

As it turns out, all is not bad for the steel companies. Construction is still strong in many places outside the U.S., and demand for oil is causing a need for increased production for the capital assets used by the oil drilling, exploration, and services industries. Many of the oil service companies do not have an adequate supply of machinery to service their industry, and many of the machines they do have are wearing out and need to be replaced. This replacement cycle could take a number of years to unwind. Given the profits that crude oil companies are generating, it is likely that these companies will continue to spend to upgrade and add to their current assets. This of course is good news for the steel makers.

Car companies, another user of steel, also need to keep their supply up to meet international demand, yet they too are at the mercy of the steel makers. One such example is Toyota Motors, who is expected to agree to a steel sheet price hike exceeding 20,000 yen per ton from Nippon Steel. The demand is also not just coming from oil services, automotive, or commercial construction, but from all corners of the globe. This is even forcing changes within the industry. ArcelorMittal is set to increase prices for its flat carbon products that are sold in Europe. The Russian company OAO Severstal is buying the Ohio steelmaker WCI Steel. Nucor has applied for permits to build an iron-making facility in Louisiana that will produce 3 million tons/year of iron, and has reached a joint venture with Sidenor for the production and distribution of long steel products and plate in the Balkans, Turkey, Cyprus, and North Africa. The story goes on. The international growth and level of demand are exciting.

So what is an investor to do? While raw material cost are increasing for steel companies, they are currently able to raise steel prices to keep up with cost, and in some cases, raise steel prices beyond their current cost increases, generating higher profit margins. Given that demand is strong, and inventory levels are low, it is likely that demand will continue to stay strong for the near future, probably through this year and into 2009. The capital expenditures by the oil service companies, automotive industry, and aerospace industry (with its huge backlog) is also likely to keep demand steady, if not growing.

As for an entry point, it is always hard to buy right after a stock has run up so far and so fast, but looking at the charts of X, MT, and NUE, it is hard to argue that these stocks are not in a strong uptrend. Pullback are likely, but given the recent price action, global demand story, and current shortages, it is more likely than not that pullbacks to the uptrend line (but not breaking it) present buying opportunities, and not a reason to head for the exits.