The Steel Industry Is Going Vertical

Steel is a cyclical industry and right now it's suffering through a supply/demand correction. Part of dealing with this is trimming production and cutting costs. Key industry players like Nucor , U.S. Steel , and ArcelorMittal are also trying to control expenses by bringing more of their raw material purchases in house.

Vertical integration
Vertical integration is when a company is involved in multiple parts of the same business. For steel makers, that means things like owning steel mills, iron ore operations, and coal mines. The goal is to be able to remove the middle men, and added costs, from the process of making steel. It's a road that several of the industry's biggest players have been going down.

For example, Nucor recently inked a second deal with Canada's Encana after initiating a relationship with the natural gas driller in 2010. That first agreement has been a smashing success, "exceeding the expectations that Nucor modeled for that investment by more than 60%." It's no wonder they've gone back to the well again.

The current agreement is larger and will help Nucor fill the natural gas needs of a new iron facility it has built. However, that's just the start. In addition to the new facility, these two deals have the potential to "provide enough natural gas to equal Nucor's usage at all of [its] steel mills in the U.S." It could even provide enough gas for another iron facility, too.

Partnering with Encana is also a good call, since it stops Nucor from trying to be both a steel mill and an exploration and production company. While that may result in higher costs for Nucor than if it tried to do it alone, running an E&P business is very different from making steel.

Iron ore
Another big expense for steel mills is iron ore. U.S. Steel owns an iron ore mine and has interests in two joint ventures that give it access to almost 900 million tons of iron ore reserves. Combined, the company has the capacity to produce around 25 million tons of iron ore pellets a year. And U.S. Steel believes it can expand that another 10% or so.

But that's not the only vertical moves the company has made. U.S. Steel also claims to be completely self sufficient with regard to coke, another key input. Although these investments haven't helped the company turn a profit during the industry's dark days, they do position it well for the eventual upturn.

The giant
ArcelorMittal is probably one of the biggest proponents of vertical integration. The company has coal mining and iron ore operations. It is looking to expand its iron ore production from 56 million tonnes in 2012 to 84 million tonnes by 2015, increasing production by about 50%. ArcelorMittal considers iron ore mining to be a cornerstone for growth, presenting it alongside expanding its steel presence in the automotive industry.

In addition, the company produces over 8 million tonnes of coal. That's about as much metallurgical coal as U.S. coal miner Arch Coal expects to produce this year. In other words, ArcelorMittal produces a lot of met coal. Owning and operating such large mining operations isn't without risk, of course, but it provides both ArcelorMittal and U.S. Steel with notable control over costs.

No guarantee
Going vertical is no panacea, as the recent string of quarterly losses at ArcelorMittal and U.S. Steel clearly highlight. However, as this pair, and Nucor, gain more control over their key inputs, they also gain more control over their costs. That's a big benefit that will pay dividends as the steel market recovers and this trio uses their investments to become low-cost leaders.  

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Reuben Brewer has no position in any stocks mentioned. The Motley Fool recommends Nucor. 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.

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