The Best Way To Play The Steel Sector

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July 24, 2013 3:32pm NYSE:SLX

steel-beamLingering Euro-zone sovereign debt crisis, economic stagnation or slow growth in developed economies and a cooling of emerging market economies has taken a toll on the steel industry. Moreover, the Chinese economy—which had been one

of the main demand drivers for steel in recent years—is slowing down.

Furthermore, overcapacity has been a perennial problem. Stiff competition in the United States from cheaper imports and from domestic producers with new or expanded facilities or under-utilized existing facilities continues to result in significant oversupply of steel compared to demand. (Read: 3 Hot Sector ETFs Surging to #1 Ranks)

Steel Consumption Forecasts

The World Steel Association projects global steel usage to rise 2.9% in 2013 to 1.454 Mt, following a 1.2% increase in 2012. The overall scenario is expected to improve in 2014. World steel demand is expected to increase 3.2% to a record of 1,500 Mt driven by a further pickup in global steel demand with the developed economies increasingly contributing to growth.

Steel Prices – Drivers & Trends

Steel prices have been on the decline in 2013 due to a glut in imports, oversupply in the market from zealous steelmakers, weak demand in Europe and slow growth in Asia.  A sustained downside in steel prices will materially and adversely affect the margins of steel companies.

We believe that the recovery in pricing momentum will be driven by a reviving economy, stabilization in the Euro zone and a rebound in construction activity in the developing countries, particularly in China, India and South Korea.

Consolidation & Divestitures

Mergers and acquisitions (M&A) have remained an important growth strategy in the steel industry. However, companies are currently holding back and instead focusing on conserving cash as they are waiting for a stronger and more sustainable economic upturn to spur a wave of consolidation. Companies are focusing on shedding unproductive operations, cutting costs and restructuring.

We expect M&A activity to remain slow in 2013 until prices stabilize and the industry strikes a balance between supply and demand. Going forward, the abatement of the Euro-zone crisis and recovery in the U.S. and Chinese economy will determine the fate of such deals. (Read:The Comprehensive Guide to Consumer Staples ETFs)

To Sum Up

In 2013, the steel industry will continue to face headwinds in the form of overcapacity and surge of imports. Steel companies are going through a restructuring process, which will have a positive impact on operations in the medium- and long-term. Some major industry trends include strategic cost reduction, vertical integration and capital optimization.

Efforts of the Chinese government to rebalance its economy will contribute to the domestic and global steel demand. Although China is the dominant market in the steel sector, India is also increasing its presence as domestic steel demand move north. The rising middle class population along with increased urbanization will fuel steel demand in the future.

Steel selling prices will improve in line with improved demand across most regions, due to higher raw material prices and an end to the destocking that was observed during the fourth quarter of 2012. In addition to raw material prices, the sustainability of higher steel prices will continue to depend on an increase in sustainable real demand and no further worsening of the Euro-zone debt crisis.

ETF to Tap the Sector

An ETF approach can help to spread out assets among a variety of companies and reduce company-specific risk at a very low cost. There is currently only one ETF available to play this sector.

Market Vectors Steel ETF (NYSEARCA:SLX)

Launched in October 2006, SLX tracks the NYSE Arca Steel Index. The fund has so far attracted AUM of $103.7 million. It has a trading volume of roughly 25,280 shares a day. The fund charges a net expense ratio of 55 basis points a year, while the dividend yield is 2.75% currently.

This index is a modified market capitalization-weighted index consisting of publicly traded companies that are mainly involved in the production of steel products or mining and processing of iron ore. The fund currently holds 26 stocks in its basket, with 77.96% sector weighting toward basic materials and the balance (22.04%) in industrials. The fund has a concentrated approach in the top 10 holdings with 68.03% of the asset base invested in them.

Among individual holdings, top stocks in the ETF include Rio Tinto plc (NYSE:RIO), Vale S.A. (NYSE:VALE) and Tenaris SA (NYSE:TS) with asset allocation of 12.73%, 12.62% and 7.04%, respectively.

This article is brought to you courtesy of Eric Dutram.

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