Steel is mainly produced through two techniques: blast furnaces and EAFs (electric arc furnaces). While blast furnaces use iron ore pellets as the primary raw material, EAFs mainly use steel scrap. Some steel companies also use DRI (direct reduced iron) as a raw material in EAFs.
Lower capacity utilization rates
U.S. Steel’s Flat-Rolled segment operated at a utilization rate of 66% in 3Q15 as can be seen in the graph above. The utilization rate for the Tubular segment was even worse, which we’ll explore in the coming parts of the series. It’s important to note that a utilization rate of 80% or above is regarded as healthy for blast furnaces.
Higher fixed costs
A blast furnace has high setup costs compared to an EAF. Fixed costs associated with blast furnaces are higher, which severely affects steel companies’ profits during downturns. The reasoning is pretty simple. When production falls, fixed costs are divided among fewer units. This increases the per-unit production cost. When capacity utilization rates are low, as they are currently, the profitability of steelmakers using blast furnaces comes down. On the other hand, steel companies using EAFs to produce steel generally don’t see huge swings in their profits.
Nucor (NUE) and Steel Dynamics (STLD) mainly produce steel with EAFs. However, U.S. Steel (X) produces steel entirely through the traditional blast furnaces. Other steel companies including AK Steel and ArcelorMittal (MT) have a mix of blast furnaces and EAFs. Together, ArcelorMittal and BHP Billiton (BHP) form ~4.7% of the SPDR S&P Global Natural Resources ETF (GNR).
U.S. Steel is in the process of constructing an EAF at its facility in Fairfield Works, Alabama. The construction that began in 2Q15 is expected to complete by 3Q16. EAFs will provide U.S. Steel with operational flexibility, as it’s much easier to adjust production levels with an EAF.
U.S. Steel’s integrated operations are also adding to its woes. We’ll discuss more on this in the next part of the series.