Steel Producers: The Pressure to Merge Is Rising

Things are heating up in the global steel industry.Image source: Payton Chung, republished under CC BY 2.0.

U.S. stocks are essentially unchanged in early afternoon trading on Monday. TheS&P 500and theDow Jones Industrial Average (DJINDICES: $INDU)are down 0.06% and up 0.21 %, respectively, at 1:20 p.m. ET. It's Macro Monday, on which I examine a macroeconomic trend that has implications for a specific sector; in this case, we're looking at steel manufacturing.

Last Friday, this column alluded to the notion that the +20% one-day pop in iron prices last Monday was driven by sentiment, not fundamentals. At the time, bulls were pointing to a weekend statement from the Chinese government that economic policy would favor growth over restructuring this year.

Iron ore is the chief component in the manufacture of steel. China is the world's largest steel producer and the largest consumer, contributing roughly half of global crude steel production last year. The next largest producer, Japan, accounted for just 6.5%.

However, the market's extrapolation appeared to be a flimsy rationale for a move of that magnitude. Today, a top industry insider essentially confirmed as much.

In an interview, JFE HoldingsCEO Eiji Hayashida told the Financial Times"[W]hat we are seeing now is the bottom and things will not get worse," adding, "the problem (in China) cannot be resolved in one to two years. It will take three to five years for the situation to considerably improve."

JFE Holdings, which has wisely opted for a differentiation strategy by focusing on higher value-added steel products, was the world's ninth-largest steel producer by volume in 2014, with 1.9% of global output (it's No. 2 in Japan).

If Hayashida is correct, investors ought to expect further consolidation in the steel industry worldwide. Last month, Japan's No. 1 producer, Nippon Steel & Sumitomo Metal Corporation (NSSMC),announced it will acquire the No. 4, Nisshin Steel.

As its name spells out, NSSMC is itself the product of a 2012 merger between Nippon Steel Corp. and Sumitomo Metal Industries Ltd.

In making the business case for the acquisition, NSSMC points to an "extremely severe business environment," in which "the global supply-demand condition of steel is rapidly deteriorating due to a decrease in the demand for steel products caused by excessive production capacity centering on Asia, as well as the stalling Chinese economy," adding that "China has approximately 400 million tons/year excessive capacity compared to its domestic demand."

Even prior to last Monday's pop, Goldman Sachs, arguably the most influential investment bank in commodity markets, had been skeptical of the rally iron has staged this year, writing in a report published early last Monday:

Nearly 10 years ago, in June 2006, ArcelorMittal SACEO Lakshmi Mittal said winning companies in the steel industry would have between 150 million and 200 million tonnes of annual capacity by 2015, and that scale is essential to the pursuit of value. Today, even ArcelorMittal itself, the world's largest steel producer, only boasts an annual achievable production capacity of 114 million tonnes.

The c-word is the order of the day for the global steel industry: consolidation. Merger arbitrageurs, take your marks: If the Chinese construction industry doesn't build it, the deals will come.

The article Steel Producers: The Pressure to Merge Is Rising originally appeared on Fool.com.

Alex Dumortier, CFA, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.