“In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them.”
- Frédéric Bastiat, "Ce qu'on voit et ce qu'on ne voit pas" (“What is Seen and What is Unseen”), 1850
by: Ed Walsh
Summary
This paper first highlights factors to consider in analyzing the impact of recent trade policies directed at the steel industry on steel prices, distinguishing macro and micro variables. Second, the paper will note primary and secondary economic effects within the domestic steel industry associated with the recent steel tariffs. Finally, it concludes the U.S. steel industry is dynamic, and secondary effects should be incorporated into a business manager’s forecast and negotiation strategies.
Introduction
Since the United States made its March 2018 decision to impose a 25% tariff on steel products, the dominant narrative in the media has been that the tariffs will invariably lead to significantly higher steel prices. Social media has fueled this fire, and there is no shortage of “clickbait” articles or salacious tweets prognosticating an impending economic catastrophe. These apocalyptic soundbites, however, oversimplify the much more complicated and nuanced reality of how steel prices may change as a result of these tariffs. Put simply, a 25% on imported steel does not necessarily mean that steel will cost 25% more in the American market.
The steel industry is not a static one, and any analysis of the tariffs must account for the way that the market will respond to a change in the cost of imported steel. With that in mind, Pantheon’s approach to understanding the effect of the March 2019 steel tariffs focuses on (1) macroeconomic considerations of trade policy and new disruptive technological advances in steel; and (2) microeconomic considerations of how individual steel producers and customer behavior will change. It is only by looking at this dynamic interplay of factors that Pantheon associates can provide individualized advice to clients about what the steel tariffs will actually mean.
Factual Background
The decision to impose tariffs was based on the February 2013 Department of Commerce report on the effects of steel imports on U.S. national security.[1] The report found that the quantities and circumstances of steel and aluminum imports “threaten to impair the national security,” as defined by Section 232 of the Trade Expansion Act of 1962.[2] In response to the report, on March 1, 2018, President Trump announced tariffs of 25% on imported steel and 10% on aluminum. The Tariff went into effect on March 23rd, 2018. Under Section 232, the President is able to bypass Congress and impose tariffs by executive order.
Brazil, Argentina, and South Korea signed separate trade deals with the United States and are exempted from the tariffs but are subject to quotas.[3] The United States-Mexico-Canada Agreement (USMCA), the renegotiated NAFTA deal, does not include Section 232 tariff protections.
I. Macro-Level Considerations – Trade Policy & Technological Developments
The first-order effects of tariffs are intuitive: imports decrease, domestic prices rise, supplier surplus increases, and profits improve. But the market is radically dynamic, and a number of second-order effects actually work to counteract these changes. Relevant to steel fundamental limitation in the fundamental nature of tariffs and in changes in steel technology that work to limit the ability of domestic producers to raise their prices.
Quotas in the 1980s vs. Tariffs in the Early 2000s
Historically, tariffs have not always accomplished their often-stated goals of allowing domestic firms to raise rates and increase market share. For example, one econometric analysis of plant-level data for steel plants from 1967 – 2002 indicates that tariff-based protection programs show little evidence of positive market power effects. Market power refers to the extent to which a company is able to influence the price of a particular good in the marketplace by manipulating the level of supply, demand, or both. Limited market power reduces the ability for domestic firms to significantly raise their prices and improve profits solely from the tariff protection.[4]
As explained more fully below, the econometric analysis found evidence that binding quantitative restrictions, such as quotas, significantly increase market power because, unlike tariffs, quotas can facilitate collusive pricing by domestic and foreign firms. Voluntary restraint agreements, or quotas, in the 1980s led to both substantial decreases in import penetration and increases in the U.S. industry’s ability to price its products above marginal cost, especially during 1985 – 1989. During this period, the majority of import sources were covered under negotiated agreements with binding quotas.
Conversely, tariffs have lowered import volumes, but there is no evidence that these policies allow domestic firms to significantly increase prices. President George W. Bush implemented a safeguard tariff for the U.S. steel industry in March of 2002, which imposed tariffs ranging from 8-30%, after nearly one-third of the industry fell into bankruptcy. Canada and Mexico were excluded from the tariff as well as several developing countries. Ultimately, the safeguard tariffs were terminated in early 2004 due to a World Trade Organization (WTO) dispute panel ruling against the U.S. safeguard action. Even before they were terminated in 2004, the steel tariffs imposed in 2002 did not drastically increase the cost of steel.
Put simply, if tariffs would otherwise increase the cost of imported steel, then that does not necessarily mean that domestic firms can raise their prices to a corresponding level because the trade policy makes it more difficult to collude and domestic firms are incentivized to compete on price to gain market share.
Technological Developments – Eroding Market Power in the Industry
Changes in technology will also affect the impact of tariffs on steel prices. There are two types of steel making facilities. First, there are “integrated” firms, which produce steel by combining iron ore and coking coal in blast furnaces. Second, there are “mini-mills” facilities, which produce steel from recycled scrap that is melted down in electric arc furnaces.
Over the past few decades, the share of steel production produced from mini-mill steel plants, which melt recycled steel scrap with electric arc furnaces (EAFs) into raw steel and steel products, is ever-increasing and has become the dominant player in the U.S. raw steel production. Blast furnace production share declined from 60% in 1995 to 32% in 2018.[5]
Figure 1: U.S. Raw Steel Production – Integrated vs. Mini-Mill: Comparative Perspective
Econometric analysis also revealed significant differences in market power for mini-mill products versus integrated products. Products that are produced by mini-mills saw their market power erode over time.
II. The Primary and Secondary Effects of the 2018 Steel Tariff
The actual results in the 15 months since the U.S. first imposed 25% tariffs on steel imports has reflected both the primary and secondary effects discussed above. Put another way, despite the proclamations about the end of being nigh, the secondary market effects have lessened the impact of 25% tariffs on steel prices.
Primary Effects
As economic theory predicts, following the imposition of tariffs, imports decreased, domestic prices rose, supplier surplus increased, and profits improved. In 2018, import pentation for steel mill products, excluding semi-finished products averaged 23%. In February 2019, import penetration was 19.6%, a 3.4% decrease from the 2018 average.
Figure 2: Import Penetration of Steel Mill Products Sans Semi-Finished Products (March 2009 – February 2019)
During the first three quarters of 2018, following major events associated with placing tariffs on steel, several producer price indices (PPI) saw significant increases. For example, PPI for Cold Rolled Steel Sheet and Strip and PPI for Hot Rolled Steel Sheet & Strip reached new highs over the previous five-year period (2013-2017).
Figure 3: PPI- Cold Rolled Steel Sheet & Strip (Jan 2013 – Sep 2018)
Figure 4: PPI - Hot Rolled Steel Sheet & Strip (Jan 2013 – Sep 2018)
The increase in prices, reduction of imports, and increased domestic production, resulted in higher profits for the U.S. steel industry. The combined net income for AK Steel, Carpenter Technology, Commercial Metals Company, Nucor, Steel Dynamics, and U.S. Steel hit $1.6B in the fourth quarter of 2018 – the group’s best performance since 2008 .[6]
Figure 5: U.S. Steel Industry Quarterly Net Income (1Q2008 – 4Q2018)
Secondary Effects
In the fourth quarter of 2018, however, the secondary effects began to make its presence felt. Put simply, the market reacted to the price increase, and the allure of higher-priced steel caused individual players to try and capture some of that elusive profit by both increasing capacity utilization and opening new facilities.
Increased Capacity Utilization - According to the American Iron and Steel Institute weekly steel production report, adjusted year-to-date production through May 25th, 2019, domestic raw steel production was 39,417,000 net tons, and reflected a capability utilization rate of 81.8%, a year-over-year increase of 5.2%; capability utilization rate during the same period last year was 76.6%.[7]
New Facilities – Since March 2018, there have been several announcements from the large steel producers on investments to revitalize, reopen, and build new plants. Below are sampling of major initiatives that seek to increase efficiencies and/or provide increased production capabilities from news releases.
March 8, 2018
Republic Steel Positioned to Restart its Lorain, OH Facility and Bring Back 1,000+ Jobs in Response to Steel Tariff Signed Today by President Trump – “Republic Steel, the nation's leading provider of special bar quality (SBQ) steel, announced that it plans to restart its Lorain facility, including its idled electric arc furnace, casters and rolling mills, as a response to the steel tariff.[8]”
August 20, 2018
United States Steel Announces Major Modernization and Asset Revitalization at Gary Works - U.S. Steel Corp. announced a $750 million investment in its Gary Works operations, which is part of a $2 billion asset revitalization effort that will take place over the next several years.[9]
November 26, 2018:
Steel Dynamics Announces a New Organic Flat Roll Steel Mill Investment: Steel Dynamics, Inc. announced that it will construct a new state-of-the-art, electric-arc-furnace (EAF) flat roll steel mill in the United States. The steel maker plans to invest $1.7 to $1.8 billion to construct the facility that is expected to have a production capacity of roughly 3 million tons annually. “The facility is expected to produce a range of flat roll steel products including hot roll, cold roll, galvanized, Galvalume and painted steel. Steel Dynamics intends to use new technologies that will further reduce the gap between existing EAF and integrated steel mill production capabilities.[10]”
March 27, 2019
Nucor to Build New Plate Mill in Kentucky: “Nucor Corporation announced that it will build its new state of the art steel plate mill in Brandenburg, Kentucky, located along the Ohio River southwest of Louisville. The company will invest approximately $1.35 billion to build the mill, which will be capable of producing 1.2 million tons per year of steel plate products. The plate mill will employ more than 400 full-time teammates at an average annual salary of $72,000, and is expected to be fully operational in 2022, pending permit and regulatory approvals.[11]”
May 15, 2019
ArcelorMittal Investing $160M at Burns Harbor: ArcelorMittal announced plans to invest more than $160 million in its Burns Harbor steel mill. The steelmaker's investment will focus on several areas within the facility over the next several years, including improvements to the facility's hot mill, an in-line temper mill, new cranes and a new basic oxygen furnace vessel.
May 20, 2019
Nucor Announces Capital Investment at South Carolina Bar Mill: “Nucor Corporation announced a capital investment that will add vacuum degassing to its engineered bar capabilities at its bar mill in Darlington, South Carolina, which will enable the mill to produce engineered bar products meeting some of the most stringent quality specifications in the industry. The vacuum degassing system is expected to begin operations in late 2020.[12]”
Downward Trend in Prices
As a result of these secondary factors, domestic steel prices have been trending downwards since the fourth quarter of 2018.
Figure 6: PPI- Cold Rolled Steel Sheet & Strip (Jan 2013 – Apr 2019)
Figure 7: PPI- Hot Rolled Steel Sheet & Strip (Jan 2013 – Apr 2019)
III. Application at the Microeconomic Level: Steel Producers and Steel Customers
Adding to the complexity of what the steel tariffs will mean for individual companies is the fact that each company, whether a steel producer or customer, is unique. In other words, the steel tariffs will impact two companies in the same industry differently based on a number of microeconomic factors. Although there are countless firm-specific factors that will affect how individual companies deal with the tariffs, some of the most pertinent are discussed below.
Issues Facing the Steel Producers
Supply Origin. The origin of the steel will, of course, affect the impact of tariffs. Where is the steel sourced – from U.S. firms or international companies? If international, does the steel come from any of the countries that have exemptions? These answers will provide an approximation of how much steel purchased is not impacted by the recent tariffs.
Import Penetration. What is the import penetration for particular product - flat products, long products, pipe and tube, semi-finished?
Plant Type. Are current steel suppliers “integrated” firms or “mini-mill” facilities? Mini-mill facilities embody a variable cost structure strategy, that allow firms to more easily ramp up production, increasing supply and applying downward pressure on price. Additionally, mini-mills use recycled steel as inputs, providing potential for domestic source of inputs not subject to tariffs.
Inventory Levels. How much inventory do steel suppliers have – both of raw inputs and of finished goods? Inventory produced prior to tariffs may lower the average unit cost.
Utilization Rate. What is capacity utilization rate of specific firm? Lower utilization means that a firm could increase production while minimizing start-up costs, and it allows for cost efficiencies by spreading out fixed costs across a larger cost pool.
Issues Facing Specific Consumers/Customers
Timelines. When is the customer’s timeline for purchasing the steel? Does the purchasing timeline span several months or even years? The longer the time span, the greater the probability that secondary effects will impact pricing. In the immediate aftermath of tariff announcements, there may be an increase in price. However, over the mid- to long-run, the incentive structure may result in secondary effects, such as increased domestic production to gain market share, pushing down prices.
Competitiveness of Market. What is the power dynamic between the steel producer and the customer purchasing the steel? Is the steel provided by a sole source vendor, or through competition? The greater the customer leverage, the greater the ability to incorporate terms that closer reflect market dynamics. Applying Porter’s Five Forces framework is one approach to gain a high-level understanding of the competitive forces at work in a firm’s particular industry. [13]
Contractual Risk Allocation. What are the contract terms? Is there specified pricing and for how long? Current pricing may be tied to a specific index or indices and then allowed to track agreed-upon indices, but within a particular band – such as, 5% or 10% above or below the initial price. Such terms bound the risk that either party assumes and may place structural constraints against significant price increases associated with tariffs.
For steel producers and consumers, the effect of the tariffs will be like snowflakes: each will be different and fundamentally unique based on a myriad of factors. The uncertainty at the macroeconomic level and the complexity of individualized effects at the firm level mean that a meaningful answer to the question of “what will the steel tariffs mean” requires a nuanced and deliberate analysis.
IV. Conclusion
Primary effects suggest that the tariffs will limit foreign competition and decrease supply, applying upward pressure to steel prices. However, there are two factors that may result in increased competition within the U.S. steel production market with secondary effects reducing this phenomenon.
First, nearly 70% of the U.S. steel production market consists of mini-mills that are more flexible than integrated facilities and have lower fixed costs. Second, the capacity utilization was in the low- to mid-70 percent during 2017 and early 2018. Tempted by higher prices from the tariff and from a secular bullish market, companies may be forced to compete on price to gain market share.
This article confined itself to the supply side of the equation and does not comment on domestic and global demand. Ceteris peribus, the change in the more advanced, efficient technology is resulting in a flatter supply curve and one that appears to be shifting to the right. Recent press releases highlight the increased level of investments in facilities and capabilities across the industry, while existing mills are increasing their utilization.
Although we do not know if the U.S. steel market is at its inflection point on domestic steel prices, as Bastiat noted in 1850, the good economist and business manager must not only plan, negotiate, and structure contract terms to address the “seen” effects but also foresee those that are “unseen.”
Companies seeking to anticipate these “unseen” factors should contact Pantheon Integrated Solutions, Inc. to discuss how the steel tariffs will affect them. Our associates are experienced in applying both the macro- and micro-level factors to our customer’s individual circumstances.
Appendix: Secretary Ross Releases Steel and Aluminum 232 Reports in Coordination with White House
Key Findings of the Steel Report:
The United States is the world’s largest importer of steel. Our imports are nearly four times our exports.
Six basic oxygen furnaces and four electric furnaces have closed since 2000 and employment has dropped by 35% since 1998.
World steelmaking capacity is 2.4 billion metric tons, up 127% from 2000, while steel demand grew at a slower rate.
The recent global excess capacity is 700 million tons, almost 7 times the annual total of U.S. steel consumption. China is by far the largest producer and exporter of steel, and the largest source of excess steel capacity. Their excess capacity alone exceeds the total U.S. steel-making capacity.
On an average month, China produces nearly as much steel as the U.S. does in a year. For certain types of steel, such as for electrical transformers, only one U.S. producer remains.
As of February 15, 2018, the U.S. had 169 anti-dumping and countervailing duty orders in place on steel, of which 29 are against China, and there are 25 ongoing investigations.
Recommendations of the Steel Report:
Secretary Ross has recommended to the President that he consider the following alternative remedies to address the problem of steel imports:1. A global tariff of at least 24% on all steel imports from all countries, or
A global tariff of at least 24% on all steel imports from all countries, or
A tariff of at least 53% on all steel imports from 12 countries (Brazil, China, Costa Rica, Egypt, India, Malaysia, Republic of Korea, Russia, South Africa, Thailand, Turkey and Vietnam) with a quota by product on steel imports from all other countries equal to 100% of their 2017 exports to the United States, or
A quota on all steel products from all countries equal to 63% of each country’s 2017 exports to the United States
Each of these remedies is intended to increase domestic steel production from its present 73% of capacity to approximately an 80% operating rate, the minimum rate needed for the long-term viability of the industry. Each remedy applies measures to all countries and all steel products to prevent circumvention.
Key Findings of the Aluminum Report:
Aluminum imports have risen to 90% of total demand for primary aluminum, up from 66% in 2012.
From 2013 to 2016 aluminum industry employment fell by 58%, 6 smelters shut down, and only two of the remaining 5 smelters are operating at capacity, even though demand has grown considerably.
At today’s reduced military spending, military consumption of aluminum is a small percentage of total consumption and therefore is insufficient by itself to preserve the viability of the smelters. For example, there is only one remaining U.S. producer of the high-quality aluminum alloy needed for military aerospace. Infrastructure, which is necessary for our economic security, is a major use of aluminum.
The Commerce Department has recently brought trade cases to try to address the dumping of aluminum. As of February 15, 2018, the U.S. had two antidumping and countervailing duty orders in place on aluminum, both against China, and there are four ongoing investigations against China.
Recommendations of the Aluminum Report:
Secretary Ross has recommended to President Trump three alternative remedies for dealing with the excessive imports of aluminum. These would cover both aluminum ingots and a wide variety of aluminum products.
A tariff of at least 7.7% on all aluminum exports from all countries, or
A tariff of 23.6% on all products from China, Hong Kong, Russia, Venezuela and Vietnam. All the other countries would be subject to quotas equal to 100% of their 2017 exports to the United States, or
A quota on all imports from all countries equal to a maximum of 86.7% of their 2017 exports to the United States.
Each of the three proposals is intended to raise production of aluminum from the present 48% average capacity to 80%, a level that would provide the industry with long-term viability. Each remedy applies measures to all countries and all steel products to prevent circumvention.
The tariffs and quotas would be in addition to any duties already in place. The report recommends that a process be put in place to allow the Secretary to grant requests from U.S. companies to exclude specific products if the U.S. lacks sufficient domestic capacity or for national security considerations. Any exclusions granted could result in changed tariffs or quotas for the remaining products to maintain the overall effect.
[1] U.S. Department of Commerce, Bureau of Industry and Security, “The Effect of Imports of Steel on the National Security,” January 11, 2018, https://www.commerce.gov/sites/commerce.gov/files/the_effect_of_imports_of_steel_on_the_national_security_ -_with_ redactions_-_20180111.pdf (accessed February 20, 2018).
[2] The Secretary of Commerce defined national security broadly for the investigation to include domestic production needed to satisfy national defense requirements as well as other measures of economic welfare. In determining whether a weakening of the U.S. economy by such imports may impair national security the following factors could be considered: The impact of foreign competition on the economic welfare of individual domestic industries, any substantial unemployment, decrease in revenue of government, loss of skills, or any other serious effects resulting from the displacement of any domestic products by excessive imports.
[3] For more details on Section 232 updates, please see: https://www.steptoe.com/en/news-publications/section-232-update-expanded-tariffs-quotas-and-international-retaliation.html
[9] Although U.S. Steel Corp detailed plans in 2017 for investing $35 million, the announcement in 2018 was a significant increase over its 2017 plans. For more detail, visit https://www.ussteel.com/newsroom/united-states-steel-announces-major-modernization-and-asset-revitalization-gary-works
[13] The conceptual framework is named after Michael Porter, who first outlined the approach in his 1979 Harvard Business Review article. To read more on Porter’s Five Forces analysis can impact in corporate strategy, please see https://www.isc.hbs.edu/strategy/business-strategy/Pages/the-five-forces.aspx