Hotter than a blast furnace

How long can the steel boom last?

Sparks are flying all around Stelco Inc. these days as bondholders and equity owners play tug-of-war over the company's assets. The Hamilton-based steelmaker's descent into bankruptcy protection last January just happened to correspond with the largest rise in steel prices the world has seen since, in the words of one analyst, “the discovery of iron.” Prices have soared from just US$310 a ton last year to more than US$750 this year, and that means Stelco is likely flush with cash — not something you typically hear about a company that's in “financial distress.” Bondholders say the reorganization must proceed no matter what the current price of Stelco's product or the amount of cash coming into the company, and they have devised a restructuring plan with management that is considered to be in their favour. In response, angry shareholders have launched a lawsuit to preserve the value of their ownership.

But while the Stelco fiasco seems likely to drag on for some time yet — the case goes to court in Nov. 25 — the issue highlights just what a turn of fortune the steel industry has realized of late. With prices up, investors in Canadian steelers have done incredibly well. Two of the healthier names in the Canadian steel industry, IPSCO Inc. (TSX: IPS) and Dofasco Inc. (TSX: DFS), have seen their stock values rise 18% and 69%, respectively, year-to-date.

And no wonder. When Dofasco reported its third-quarter numbers at the end of October, its profits had nearly quadrupled from the same period a year earlier. IPSCO has reported similarly stunning profits. In its most recent quarter, the company reported net income of $2.76 a share, which compares more than favourably to the same quarter last year when it lost 4¢ per share.

IPSCO has decided to pay down some debt with its earnings, and redirected another chunk of it to shareholders by doubling the dividend paid to 10¢ from 5¢. According to the company, that doubling is proof that the board and management think long-term prospects are good. “We are committed to using our robust business platform as the basis for continued growth,” David Sutherland, the CEO, was quoted as saying at the time.

This is welcome news, of course, but it forces investors to confront vital questions: With prices for both steel and the stocks at such suddenly unexpected highs, could we be in for a similarly quick correction? How long can this last, and if it's not long, are we at the top of the cycle? More to the point: Is it time to sell?

Considering the drastic size of the increase in steel prices, it's prudent to assume the current price structure unsustainable. Econ 101 tells us more production will come on-stream or demand will falter at such lofty prices, suggesting we may be nearing the end of this boom. Many have begun dumping their steel holdings, as analysts attach Hold or Underperform Sector ratings to the stocks. That has caused steel prices to come off some since the peak. But the same Canadian brokerage that suggested prices are unsustainable also has Outperform ratings on IPSCO and Dofasco. How can that be?

Well, the most obvious thing about steel is that it's heavy, which makes it hard to move. Obvious, sure, but it may take a while for market corrections to occur and offshore steel to make its way to North America. And that has some analysts saying the current “windfall” prices can be expected to last until the end of 2005, if not longer. In other words, we're into the late innings of this game, but there could be a little way to go yet. And that means keeping the finger on the Sell button and a close eye on macro conditions. The good times will be extended if we see a pickup in the U.S. economy, analysts say, so monetary policy is key. Chinese production and demand are also important, as are oil prices. Steel stocks have come off slightly from their peak a couple months ago. One suggestion is that a drop from that point of more than 10% is a signal that the cycle has run its course and the steel ship is sinking.