August/September 2004

Rapid Changes and Challenging Issues: The current domestic steel landscape does not resemble that which existed even ten years ago. Once proud names, such as Bethlehem, National, and Rouge, no longer exist. In addition to recent raw material shortages, volatile prices, free trade considerations, and global supply and demand issues brought about by macro-economic factors, companies have been challenged by excessive pension and retiree healthcare obligations (“legacy costs”), uncompetitive labor agreements, and large workforces. Domestic integrated mills have responded through bankruptcy filings and consolidations. The result of these transactions is the emergence of three dominant U.S. producers: U.S. Steel, International Steel Group (“ISG”), and Nucor. The adjacent table shows the impact of the consolidation on the concentration of production capabilities. The top 3 steelmakers currently produce 52% of the domestic output of steel, whereas in 1998, the top 3 producers were responsible for only 29%.

International Trade Eats Into US Domestic Sales: The dynamics of production, consumption, and trade patterns had a profound impact on the industry over the last several years. The U.S. is the largest net importer (defined as imports less exports) of steel in the world. As seen below in Figure 1, net imports increased by over 10 million tons between 1993 and 2002. Backed by less expensive labor and government subsidies, U.S. companies allege that foreign steelmakers continued to produce at capacity, despite the fact that this level of production was not supported by demand. Consequently, over the last several years, these foreign producers have searched for an outlet to sell this excess steel. The result has been the dumping of steel in the United States at below market prices. Figure 2 shows the price of hot-rolled steel in the United States since 1985. As of 2002, the price of this type of steel had remained relatively unchanged since 1985, even though production costs such as labor, healthcare, and energy have risen. U.S. companies contend that dumping from foreign producers is a significant driver of this phenomenon.

Figure 1
Figure 2

Mini Mills Also Keep Prices Low: The integrated steelmakers have also faced increasing competition from manufacturers utilizing electric arc furnace (“EAF”) technology (also known as “mini-mills”). Mini-mill production has increased significantly over the last several years, both on an absolute basis, as well as a percentage of total production, as seen below. Companies, such as Nucor and Steel Dynamics, that use EAF technology, manufacture steel through a process that refines scrap into finished steel. Mini-mill processes are less labor intensive and their workforces are generally either non-unionized or a party to more modern labor agreements, resulting in lower labor and benefit costs. Moreover, these newer facilities usually have more efficient equipment. Scrap prices have recently spiked due to soaring Chinese requirements, but this situation is likely only temporary and mini-mills, though they cannot currently produce the wide variety of steel that an integrated mill does, will continue to provide stiff competition in niche markets.

Other Factors Impacting the Industry: Other factors have contributed to the recent deterioration in the domestic steel industry, as well. The shift of manufacturing capabilities to lower cost countries is affecting the demand for U.S. steel. The construction boom in China is consuming an enormous amount of the world’s steel production. In 2003, China consumed over 250 million tons of steel, up 14% from the prior year’s consumption. During the same year, it produced only 210 million tons.¹

A mixed blessing: Normally increasing demand would be great news to suppliers and while this is reducing the dumping of foreign steel in the US, it is creating a new set of challenges. Prices for key raw materials, such as iron ore, coke, and scrap, have risen sharply. At one point, 2004 prices of coke and scrap had more than doubled relative to 2003 levels. Because of long-term sales contracts these price increases weren’t necessarily accompanied by commensurate, offsetting increases in the selling price of steel to all customers. Fortunately, market indicators suggest that pricing for these raw materials may have peaked.

In response to these market factors, companies have instituted surcharges to recover a portion of the increased raw material costs from their customers. While it is true that selling prices have risen dramatically in the last year, large customers of steel companies, such as Ford, General Motors, and DaimlerChrysler have, to this point, been largely unwilling to accept any changes to contract pricing. In fact, General Motors has sued Steel Dynamics in an effort to compel supply of steel at contract pricing absent any surcharges. his has left companies with little alternative, but to pass as much of the cost increases as possible to their spot market customers, while bearing the remaining cost increases themselves. Given the current financial state of many companies in the industry, the burden of these excessive costs is proving difficult for them to withstand.

Survival Requires Changing Labor Relations: Legacy costs and other workforce issues are some of the immediate threats to the domestic mills. Collective bargaining agreements at integrated steel mills have historically included a number of cost prohibitive provisions, such as:

i) a large number of job classifications, which decreases the flexibility of the workforce to perform tasks across a variety of disciplines,
ii) minimum workforce guarantees, which decrease the companies’ ability to right-size their orkforces according to market and economic conditions, and
iii) defined benefit plans, which guarantee certain payment amounts to retirees based on formulas which consider a number of factors, typically including age and years of service.

The adjacent charts show the underfunded position of the pension and other postretirement benefit (“OPEB”) plans of certain steel companies in 1998 and 2003. Note the discrepancy between companies which have not restructured (AK Steel, Stelco of Canada, and Ispat, a subsidiary of a foreign company) and U.S. Steel, which has recently restructured, and other integrated mills and mini-mills.

A: Attempting to restructure labor contracts B: Has restructured labor contracts C: Not applicable

Note that the results shown include companies acquired between 1998 and the present (e.g. ISG's unfunded status in 1998 is comprised of the unfunded positions of Bethlehem, Weirton, and LTV as of 1998).

The chart illustrates the increase in the underfunded status of the pension and OPEB plans throughout the industry, with the exception of ISG, which was formed through the purchase of assets of bankrupt companies. By forming in this manner, ISG not only acquired inexpensive assets, giving it an advantage over its competitors who built or bought the assets at higher prices, but it cleansed nearly $5 billion of unfunded pension and OPEB liabilities from the balance sheets of the companies it purchased.

While U.S. Steel has seen a significant increase in the unfunded status of its plans, it has recently closed its legacy plans, moved to defined contribution plans going forward, and restructured existing labor agreements. Accordingly, it is positioned to capitalize on lower labor costs in the future. Also, mini-mills, such as Steel Dynamics and Nucor, typically do not sponsor defined benefit plans. The result of all of these factors is that a competitive gap now exists between the mini-mills and restructured entities, and those mills that have not restructured.

Bankruptcy filings are the tool of choice: With over 40 bankruptcies in the steel industry since 1998, it is clear that bankruptcy is one of the most common responses (either voluntary or involuntary) to the challenges outlined above. From the company’s perspective, the benefits of bankruptcy protection are twofold.

First, pension and OPEB liabilities can be abolished, thereby eliminating the underfunded status of pension and OPEB plans and the large cash funding requirements which are associated with such status. In most instances, the pension obligations (although typically at a lower amount) are assumed by the Pension Benefit Guaranty Corporation (“PBGC”), a quasi-governmental agency which ensures obligations of companies to retirees. Ironically, the preponderance of bankruptcies in the steel industry has caused concern as to the long-term viability of this institution. Second, labor agreements can be restructured, and unions have few alternatives but to agree to concessions in such a scenario. Typical concessions include adjustments to benefits and work rules.

In a restructuring, companies typically change from defined benefit plans to defined contribution plans. One of the key distinctions between these two types of plans is that companies are insulated from downturns in asset returns with defined contribution plans, because companies bear no responsibility for minimum benefit amounts; they are only responsible for putting a certain amount into the plan, not getting a certain amount out of the plan. Also, defined contribution plans are typically tied to profitability, such that contributions are minimized or eliminated in years in which companies encounter financial difficulty.

In these new labor agreements, companies are negotiating fewer job classes, allowing for greater workforce flexibility and increased ability for layoffs to enable changing workforce size with fluctuating market conditions. As it has proven difficult to successfully restructure and emerge as a stand-alone entity, many companies, such as Rouge, LTV, and Bethlehem, end up selling their assets via section 363 of the bankruptcy code, which essentially allows assets of the debtor to be acquired in the context of bankruptcy absent a formal plan confirmation process.

Bankruptcy is only one of the methods steel companies have used to orchestrate significant restructurings. Other companies are opting for out-of-court restructurings to accomplish the same goals. In the U.S., AK Steel has publicly announced that it is attempting to work with its unions to renegotiate existing labor contracts and the structure of pension and postretirement benefit arrangements. In Canada, Stelco, is operating under the Companies Creditors Arrangement Act (“CCAA”), which is the equivalent of Chapter 11 protection in the U.S. Stelco aims to restructure its labor arrangements with its unions. While not technically “out-of-court,” the CCAA does not allow companies to reject labor contracts as in the U.S., thereby eliminating some of the leverage available in a Chapter 11 proceeding. Although progress has been made, these negotiations are in their infancy, as the unions have understandably been somewhat reluctant to accommodate the companies’ requests.

In any event, the proliferation of bankruptcies has left the companies which have not restructured, but bear significant legacy liabilities and inflexible union contracts, little choice but to take drastic measures. How can companies expect to compete effectively long-term with a cost disadvantage of $30 per ton or higher relative to their restructured peers or their mini-mill competitors? (See the adjacent chart.)

This cost disadvantage must be made up in other areas and, in an industry in which costs are largely fixed in nature and/or driven by market conditions (e.g., raw material inputs), this is a difficult task. In several circumstances, this disadvantage has led to inadequate returns available for reinvestment and capital upgrades, thereby further eroding companies’ competitive positions. This situation has almost forced industry participants to use bankruptcy measures to “self-correct” in an effort to compete in the present environment. Given the financial advantages an integrated steel company realizes through bankruptcy, it should not be surprising that after the initial steel companies filed, many others followed suit.

The U.S. government has attempted to alleviate some of the burden for steel companies. The passage of the Pension Stability Act in April of 2004 served to postpone the pension/OPEB funding requirements for certain companies that are in an underfunded position. However, this is more of a temporary remedy, merely postponing what will inevitably be large future cash outlays associated with these obligations, barring any significant appreciation in the value of these funds. The passage of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 also lessens the requirements associated with OPEB benefits by providing subsidies for companies which sponsor prescription drug benefits programs for retirees. However, this only provides partial relief, and, additionally, the Act does not take effect until 2006.

In response to the amounts of allegedly illegally imported steel, Congress and the Bush Administration implemented the Section 201 tariffs in March 2002, which imposed premiums on certain types of imported steel. These protections were subsequently repealed in December 2003. The recent devaluation of the dollar relative to other currencies and the increased demand for steel in other parts of the world have served to mitigate the impact of repealing these tariffs, by making it less attractive for foreign producers to sell steel in the U.S. However, after years of depressed prices, U.S. mills are finding themselves in poor financial condition and unable to withstand the other factors which are adversely impacting performance.

So what will happen next? While three dominant players have emerged in the shakeout over the last few years, the restructuring is not yet complete. ISG has publicly stated it intends to continue to grow through acquisitions. Additionally, intermediate-sized mills such as AK Steel and Stelco (in Canada)have yet to successfully restructure. While these companies may survive, they likely may need to address their strategic direction or partner with other mills.

Russian-based Severstal North America, Inc. acquired the assets of Rouge Industries in January of 2004, making it a key supplier to the US automotive industry overnight. With U.S. companies becoming smaller players in the global steel market, it will be interesting to see if this serves as a springboard for continued foreign presence in the U.S. market. At a minimum, it may perpetuate the trend of continued globalization in the steel industry as companies attempt to integrate vertically and/or horizontally, and to partner with producers that possess alternative capabilities and access to different end users to mitigate risk and enter new markets. U.S. Steel has followed this trend by acquiring significant production capabilities in Slovakia and Serbia. However, with increased globalization and the presence of giant foreign companies such as Arcelor and ThyssenKrupp, the unanswered question is: will this round of restructuring in the U.S. steel industry be enough to make U.S. companies leading competitors again?

Works Cited

Birmingham Futures Exchange. “Steel, the newest precious metal: Mills raise prices, delay deliveries.” Steel Flash Journal. April 30, 2004. July 10, 2004.
http://www.bfex.net

“China’s steel consumption not to peak before 2010, experts”. People’s Daily Online. January 25, 2004. People’s Daily. July 10, 2004.
http://english.peopledaily.com.cn

International Iron and Steel Institute. Steel Statistical Yearbook 2003. Brussels: Committee on Economic Studies, 2004

Endnote

1 “China’s steel consumption not to peak before 2010…,” People’s Daily.