US Steel Could Have Further to Fall

US Steel was one of the great trades of 2013. The company's shares jumped more than 60% on a winning combination of higher steel prices and lower costs as a result of management's aggressive restructuring plan.

However, that was last year. Unfortunately, this year has not started off well for the company. So far, US Steel's shares have fallen nearly 19% this year, thanks to a perfect storm of events, and it would appear that things are only going to get worse for the company as the year goes on.

A Chinese problem
Here's the problem: The price of hot-rolled coil steel, HRC for short, is currently sitting at a premium of more than $200/mt to Chinese prices here in the U.S. Meanwhile, Chinese steel exports are currently at multi-year highs as construction rates slow within the country, but steel mills continue to run at full capacity.

Specifically, during the first three months of this year Chinese steel exports totaled more than 6 million tons; that's up around 30% year on year. It seems as if export volumes are only going to rise from here on out as the Chinese construction market is contracting; property sales fell 8% during April of this year, and new construction starts fell 22%. All in all, Chinese construction, which consumes around 50% of Chinese steel output, has slumped. China consumes around 50% of the world's steel.

What's more, historically, whenever U.S. HRC prices have traded at a premium to Chinese prices, they have collapsed back down to Chinese prices within a time frame of a few months. With this in mind, it would seem as if US Steel's earnings are set for a downgrade. Further, if Chinese steel exports are running at an all-time high, US Steel could report a fall in demand throughout the year as customers turn to cheaper Chinese suppliers. Steel is usually cheaper to produce within China due to lower labor costs.

All in all, this implies that US Steel's earnings could be set for a downgrade. Whatever the case, it's likely that there will be some volatility in earnings going forward. Still, the company has managed to shave about $300 million of the cost base during the past year, equivalent to around $2 per share in earnings.

Not alone
With Chinese steel exports flooding the global marketplace, US Steel's peer, Nucor , is also likely to suffer. Nucor reported consensus-beating earnings in the first quarter due to higher steel prices, mainly a result of US Steel's troubles. Nucor reported net income of $111 million, or $0.35 a share during the first quarter, excluding one-offs; income came in at $0.41, beating consensus of $0.38.

Construction spending within the U.S. expanded 9.1% during the first few months of this year, and US Steel failed to benefit, as cold weather on the Great Lakes slowed delivery of iron ore to its largest mill. There were also accidents during March, which forced the company to close some operations.

Nucor's main business is to melt scrap metal in furnaces to sell to customers, ideal when the price of new steel is high, as it has been within the US during the past few quarters. However, with the supply of steel from China on the rise, and the prospect of depressed steel prices on the horizon, Nucor could see demand slump.

And it seems as if analysts are forecasting a harder time for Nucor ahead. Since January, Wall Street estimates for 2014 earnings have been continually downgraded from around $3 per share to $2.35 -- that's a 22% slump. Things could get a lot worse for Nucor if the influx of new, cheap steel from China continues.

Foolish summary
All in all, Chinese steel demand is falling, but production is rising, and Chinese steel mills are flooding the global marketplace with cheap steel. This is going to impact US Steel's earnings going forward, and it's likely that the company's year, which got off to a bad start, will only get worse. 

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Rupert Hargreaves 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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