Rising Prices in the Face of Falling Demand

Steel demand is down…by a great deal. The world’s steel plants are operating at less than 45% of capacity. This operating rate is one of the lowest ever. Yet, some U.S. stainless steel makers have actually raised prices by 5 to 6% since early May. The price increase does not come because of an increase in demand for stainless steel. That demand is off as well.

How do we explain this phenomenon? The answer lies in the cash costs of the stainless steel companies and their customers. (See Diagnose/Pricing/Company Price Environment on StrategyStreet.com.) There are high levels of fixed cost in the stainless steel business. Many of these costs, though fixed, are cash costs that must be paid to keep the plant running. Heating units cannot be shut down easily. Yet, the cash cost of keeping them operating are high. If the plants cannot cover their cash costs, they will close in short order. But, despite the losses that the stainless steel producers are piling up in this period of very low demand, they have raised their prices to cover their fixed cash cost of operating their plants on lower unit volume. The price increases of 5 or 6% represent the increases in cash revenues the companies need in order to keep their plants operating.

Normally, these plants would have shut down at this level of economic activity. Their places would have been taken by off-shore manufacturers who incur lower cash costs to operate. But conditions have changed. Customers are changing their suppliers, replacing off-shore producers with domestic supply. Now the American manufacturers have a lower cash delivered cost than do the off-shore competitors they are now replacing. We then ask, why would a customer be willing to pay domestic manufacturers 5% more than they were paying before May?

Steel service centers are major customers for stainless steel. These are the companies who are paying the higher prices to the domestic manufacturers today. They are paying these higher prices for three, cash-related, reasons. First, even at today’s low level of demand, there is enough demand to pass along the cost increase. Second, the capital markets are often closed to these service centers. They cannot get the financing that would allow them to purchase the same amount of steel off-shore that they would be able to purchase in a normal market environment. Third, purchasing foreign steel involves a long term exposure to the price of steel and its demand. Steel that a service center orders today from an off-shore producer will not arrive at the service center for months. These service center customers are unwilling to bear the exposure to the potential fall-off in steel demand, and the resulting fall in spot prices, for steel over the next several months.

So, basic cash economics explains the price in today’s domestic stainless steel market. The domestic manufacturers are able to raise their prices by 5% to keep their plants operating at cash break-even. They replace off-shore producers whose delivered cost to the stainless steel service center customers is now higher than those of the domestic manufacturers. (See Diagnose/Pricing/Industry Price Outlook on StrategyStreet.com.)

Posted 7/6/09