The Shale Gas Boom: Boon or Bust for U.S. Steelmakers?

Nov. 12, 2013
Shale gas plays present significant opportunities to improve profitability for the challenged U.S. steel industry, though producers will need to react more nimbly and strategically than the industry has historically allowed.

The recent and rapid expansion of shale-based plays has both depressed natural gas pricing in the U.S., making it an attractive energy source, and increased domestic demand for steel-based products, due to booming domestic oil and gas production. This is welcome news for steelmakers, who have struggled to remain profitable in light of overcapacity, sluggish domestic demand, increased competition from international imports, and generally depressed commodity prices.

How Big is the Shale Gas Boom, Really?

Though projections of technically recoverable reserves can vary significantly, they are all sizable. Shale plays constitute an estimated one-quarter of current recoverable resources, and are forecast to make up one-half of U.S. natural gas production by 2035, according to the Energy Information Agency’s Annual Energy Outlook 2012. The advancement of hydraulic fracturing is helping shale upset the dynamics of the natural gas markets – driving down U.S. prices from $11 in 2008 to $3 to $4 today.

The long-term impact of shale plays on the U.S. energy supply, however, remains somewhat unclear. Natural gas markets are complex, and are impacted by upstream producers, midstream infrastructure, and various types of customers, not to mention energy substitutes like coal, which have their own market volatility.

In our view, the U.S. gas market is structurally out of balance. North America’s natural gas value chain is highly fragmented, and lacks the regulating mechanisms that exist for oil and other parts of the energy sector: natural gas players tend to make decisions in isolation, and operate on very different time horizons. For example, natural gas producers will adjust production volume on a quasi-quarterly basis, while utility companies and chemical companies need to make investment decisions that will commit them for decades to come.

As discussed in the recent A.T. Kearney paper “U.S. Natural Gas: Growing Pains,” these structural deficiencies are being worked out gradually. We foresee a volatile period until a new equilibrium is reached at $6 to $7 per thousand cubic feet (Mcf), where most if not all remaining players are profitable. Ultimately, this volatility and point of equilibrium will be determined by five fundamental drivers: global GDP growth, global gas supply, energy and environmental policy, oil prices and technology. These drivers have both foreseeable elements and harder to predict “wildcard” aspects, such as market crashes or major environmental incidents.

The Real Impact on Steel

Though natural gas represents only one-third of the steel industry’s total fuel and power consumption, it presents an enormous opportunity to improve profitability for an industry plagued since the 2008 financial crisis. Just as mini-mills revolutionized the industry with electric arc furnaces (EAFs) and slab and strip casting, so may the shale plays be a game changer for those companies poised to take advantage and reap the benefits from a combination of favorable demand and supply side drivers.

Supply: Cheap Energy Alone is Not Enough to Create a Revolution

The steel industry is the largest industrial energy consumer, singlehandedly absorbing about 4% of the world’s energy production. In developed countries, the cost of energy comprises between 15% and 20% of the overall cost of steel production, according to EIA. Cheaper U.S. natural gas is lowering the price of making North American steel, driven by cost reductions in direct and indirect energy, and lower material and feedstock pricing.  

Where natural gas can be substituted further into the steelmaking process, the savings become even more significant. Direct reduced iron (DRI) plants that can use natural gas as a feedstock can produce iron for $82/tonne – 20% cheaper than a traditional blast furnance. Nucor, for example, has plans to build a $750 million gas-fueled plant that produces DRI. This is one of at least five DRI plants currently under consideration or construction

Lower natural gas prices are also causing a massive shift from coal to natural gas power generation in the United States. From 2007 to 2012, electricity generation from coal decreased by 25% while increasing from natural gas plants by 35%. This trend is slated to continue until natural gas prices reach a range from $6.50 to $7, at which point demand will drop and coal’s historical price advantage will regain its footing (see chart). Even so, costs have dropped substantially since 2008, with current rate estimates of $40 per megawatt-hour for U.S. heavy industry on the East Coast – compared to equivalent pricing, as reported by Reuters, of $58 in Europe and $98 in Britain.

Infrastructure still remains a concern for transport and storage to enable more substantial changeover to NG. For example, much of the gas produced from the frenzied drilling activity in North Dakota is not captured because the pipeline infrastructure doesn’t yet exist. There’s the additional factor of liquid natural gas (LNG) exports, which present a crucial element of the natural gas balance and the ultimate equilibrium reached. With a glut of natural gas being produced and very large differences in global gas pricing, LNG export facilities in the U.S. are now a hotly debated topic. Many believe that exporting LNG could be a sizeable contributing factor to natural gas price escalation in the U.S., thus hampering the domestic advantage of low-cost energy. On the other hand, the capital funding, and the permitting and regulatory hurdles required to build these terminals may make this a moot argument for several more years to come.

Top Line Growth: Industrial and Consumer

Cheaper natural gas prices present a major cost advantage to the challenged U.S. industrial sector, whose direct energy use in 2010 included 30.4% natural gas. One need look no further than the previously challenged U.S. chemical industry, now booming because of low natural gas pricing, to see that the industrial sector and the U.S. economy will both benefit from this low cost feedstock and energy source. For example, the fall in natural gas pricing from 2005 to 2010 (approximately $10 per million BTU versus $4 per million BTU) pushed a U.S. trade deficit in basic chemicals of $9.4 billion to a trade surplus of $4.6 billion. Clearly, the U.S. chemicals industry will still be better off even if the price settles at $7, given that it is still substantially below 2005 levels.

NG-enabled top line drivers for the steel industry start with the direct use of steel in OCTG (Oil Country Tubular Goods) and line pipe. This supports the increased drilling activity and the build out of the infrastructure needed to connect the shale plays to the existing network of U.S. pipelines. Approximately $100 billion of capital is expected to be spent on close to 50,000 miles of new or modified pipeline. Second and less directly, the use of steel supports the construction of new property, plant and equipment for the expansion of other industries, such as the chemical industry. Almost $250 billion in capital is expected to be spent on other mid-stream (non-pipeline) and downstream projects over the next 10-12 years. The final major driver is supporting the increased demand for automotive and other consumer durables, as the overall economy is pulled up by its bootstraps because of the superior cost economics of manufacturing in a low-cost energy market.

Steel producers will need to ensure the right production mix in order to capitalize on upstream and/or downstream demand as the economy expands and manufacturing is revitalized; therefore, the effects of shale gas on a steelmaker will vary significantly depending on where it sits (or chooses to sit) in the steel market space.

Seeking Cost Advantages: Short vs. Long-Term Decision Making

In the short term, producers face a number of simple commercial decisions, notably whether they are going to compete for certain demand, (e.g. oil and gas tubular products), where they are going to compete, and how. Similarly, on the cost side, they need to make decisions about maximizing the use of low-cost natural gas wherever possible, and determining whether improvement capital to further exploit potential energy savings is justified while natural gas pricing remains so low.

In the long term, steelmakers must capitalize on cost advantages by optimizing new plant sites and technologies, but they need the foresight to estimate production requirements, given these major capital expenditures. Traditionally, steel plants have been built to exploit the availability of cheap raw materials, located near a strong or growing market to ensure that future demand justifies the initial investment. Therefore, the availability of cheaper gas inputs has led to reinvestment and new investment in steel mills located near shale reserves.Increased demand for steel-related products has producers scrambling to ensure the right mix of production facilities, to take advantage of both increased OCTG and line pipe demand upstream, and all the construction and production steel needed to fuel the “manufacturing renaissance” downstream.

Steelmakers Must Invest for Long-Term Equilibrium

The road to riches and equilibrium for steelmakers will not be a straight one – even with the lower price of natural gas and its effect on electricity pricing, even with the amount of OCTG / LP steel demand generated and the U.S. chemicals boom, or even with a full-blown U.S. manufacturing revival. Steelmakers’ decisions related to the shale boom are less clear than other participants:

  • The shale boom is not simply a windfall for the steel industry, as it is for many chemical producers – steelmakers need to change their processes in order to incorporate natural gas as a feedstock or significant energy source
  • Steel producers cannot quickly react to the shale boom as it unfolds – something that many oil and gas exploration and production firms can do quarter-to-quarter
  • Steelmakers are less able to turn on and off their usage of natural gas, as many power plants are able to with their peak-design gas turbines

Given the longer-term investment horizon of the steel industry,  steel producers must pay keen attention to the natural gas market and resulting supply and demand implications to ensure they invest in the right mix of assets as pricing moves towards the long-term equilibrium range.

Steelmakers Should Tread Carefully

As the complex dynamics of natural gas markets unfold, adjusting to the new glut of supply, the steel industry will need to respond with due care over the coming years. There is the urge to overreact to the shale boom without waiting for energy markets to self-correct. Moreover, the path to equilibrium will likely be anything but smooth, with many volatile bumps and altered forecasts along the way—the current softening of the steel market is a case in point. While no steel producer wants to overlook the home run opportunities, jumping too quickly at seemingly favorable economics in the near term may turn out to be disastrous for such a capital-intensive industry. 

Clearly understanding where and how you want to profit (e.g. supply side, demand side, or both) from the shale boom will be critical. Furthermore, assessing and pressure testing your investment decisions against the implications of various potential future scenarios surrounding the impacted industries will be essential to avoid disaster.

Steve Mehltretter is partner with A.T. Kearney in Toronto. Steve leads A.T. Kearney’s Americas Metals and Mining Practice. He can be reached at [email protected].

Herve Wilczynski is a partner with A.T. Kearney based in Houston. Herve has significant experience in the oil and gas sector. He can be reached at [email protected].

Peter Findlay is a consultant with A.T. Kearney based in Toronto. He can be reached at [email protected].

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