By now, we’re all aware of the Section 232 investigation into steel and aluminum imports. In the weeks and months leading up to the January release of the report and President Trump’s response, there was a sense of muted concern among those in the industry. While some were preparing for the worst, the overwhelming majority we spoke to, frankly, seemed skeptical that the size and scope of the ramifications would be all that impactful.
Now that the dust has settled and we’re a few months removed from the release of the report, we want to:
- Look back at some of the pre-report concerns and what action people did or didn’t take
- Understand what’s happened to oil country tubular goods (OCTG) pricing since the release of the report
- Outline the general consensus regarding prices for the remainder of the year and what the go-forward strategy is
We won’t go into the nuts and bolts of the investigation itself (plenty of reference material on the internet already ), except to provide some clarity on key findings and dates as they pertain to the bullet points above.
The initial tariffs were set on March 8, 2018, and scheduled to go into effect on May 1, 2018 . Tariff levels were set at 25% on steel and 10% on aluminum. Initially, the EU, Canada, Mexico, Australia, Argentina, Brazil, and South Korea were granted temporary exemptions to give them time to negotiate permanent alternatives or exemptions. The United States later reached permanent agreements with South Korea, Argentina, and Brazil. These agreements implemented quotas on steel, as opposed to the tariffs originally proposed. Australia remains exempt from tariffs or quotas at this time. Citing “lack of progress being made” in negotiating alternatives to the original tariff, President Trump revoked exemptions for EU countries, Canada, and Mexico in June 2018.
Last fall, the WTI was climbing upwards through the $50’s. Rig count, although down from it’s early summer peak around 950, was also starting to climb again. Optimism in the industry was muted at least partially by concern over potential repercussions of the 232 decision.
Industry publications, such as the OCTG Situation Report, have reported (through their monthly blog) an inventory buildup, starting last year and continuing on to present day. Despite being admittedly concerned about the 232 investigation and its outcome, there doesn’t seem to be much, if any, panic or preemptive “investment buying” of OCTG. On the contrary, most people we spoke to made the same point: distributors and E&P’s have actually been extremely careful not to over-buy. We only have secondhand reports of E&P’s making large-scale purchases ahead of the decision, but this seems to have been the exception far more than the rule.
So, despite the mixed feelings and concern, why the non-reaction from folks in the E&P space? Our conversations revealed a few underlying assumptions; some were stated explicitly, and some were more of a “read between the lines” kind of deal. People believed:
- No tariffs/quotas would ultimately be handed down by the president.
- Some thought the president’s attempt to justify the action under the guise of “national security” was invalid. This is a fundamental caveat of the 232 investigation, and to date, there’s no precedent for using this rationale in cases involving steel imports.
- The World Trade Organization could successfully lobby against it, or at least successfully challenge a ruling in favor of domestic suppliers.
- The 232 was used as a tool to get other treaties re-negotiated (NAFTA, for instance), and that pending a successful outcome there, the applicable countries would then be exempted from the 232 ruling.
- Even if a tariff/quota system was implemented by the president:
- The only country of origin impacted that would also affect OCTG would be South Korea. And their volumes could be easily supplemented by other foreign sources eager to capture market share or by domestic suppliers who were already ramping up production in anticipation of the ruling.
- The EU, Canada, and Mexico — leading importers, outside of South Korea — would be exempted.
- He would eventually bow to political pressure, even though he may not admit it, and lift the tariff/quota.
March 2018 came and went, and as we now know, we are left with the current 24% tariff on imported steel with one exception. South Korea negotiated a quota that results in them being able to import about 70% of the average of the past three years worth of import tonnage.
Operators we spoke to, as well as OCTG distributors, all reported an almost immediate 10-20% increase in OCTG pricing across the board once the tariffs were announced by the president. While there was initial fear that these prices would continue climbing, this simply did not materialize. OCTG prices seemed to have stabilized, along with the price of HRC Steel.
Figure 1: Domestic HRC Steel and Key 232 Dates (source: quandl.com)
So, what happens next? Well, it’s really a function of two things:
1) Inventory, and
2) Rig count/activity levels.
There does not appear to be any shortage or impending shortage of inventory into 1Q2019. There are a couple of forces at work both domestically and abroad that are ensuring this is so.
- Heavy inventory buildup in late 2017 and early 2018 gave the industry a lot of runway for the year.
- There are a lot of other suppliers (foreign and domestic) eager to make up any shortfalls in an attempt to gain market share.
- Renegotiation of NAFTA is highly likely. As of the writing of this, news outlets are reporting that the renegotiated deal is all but done with Mexico. The hope is that the successful renegotiation of NAFTA will lead to a re-exemption of Canada and Mexico’s exemption statuses, or at least a substantial modification to their statuses. This will open the door for major players — like Tenaris, who relies heavily on those countries — to begin importing at lower costs again.
- Domestic mills, which are currently operating mostly on half-shifts, are thought to be able to ramp up their production very quickly by adding shifts, not necessarily having to re-start shuttered mills, which is also an option.
Another idea that seems to bring a sense of calm to the OCTG is that, for political reasons, these tariffs are unlikely to stick for the long-term. Operators we spoke to cited the coming midterm elections as well as the possibility (however far-fetched it may seem) that the president could get impeached. In that scenario, it’s almost certain that any successor would repeal the 232 ruling. There are a multitude of political scenarios that could lead to, at the least, a modification, if not all-out 232 repeal.
In terms of activity, WTI, and consequently Rig Count, are expected to stay flat or drop through the remainder of the year. OPEC, under pressure to control price, committed to raise production in June, although it did not clarify by how much. Likewise, we’re coming out of the high-demand summer season, and any potential shortfalls in production from unstable producers such as Iran, are expected to be made up for with domestic production. In addition to the above, rig activity generally goes flat or drops slightly at the end of the year as companies begin pushing projects to the next budget year. All of this cumulatively leads to a lower activity landscape for the rest of 2018. And lower activity = lower demand for OCTG.
The combination of a healthy inventory outlook and flat/decreasing rig activity (and with it, demand for OCTG) should apply enough downward pressure on prices that the impact to bottom-line well economics is both minimal and not at risk of changing rapidly or in the near future. Then, to further compound the low price/low risk outlook, many distributors will likely take end-of-year tax avoidance measures by quickly offloading excess inventory, oftentimes at a discount.
Moving into 2019, the outlook becomes foggier, although still optimistic, in my view. Yes, the potential for increased rig activity could drive prices up. However, in the case of South Korea, a covenant of their quota is that they will not sell more than 30% of it in any given quarter. So, they will maintain their ability to influence OCTG prices throughout the year. Given South Korea’s influence, the US’s ability to ramp up production, and other foreign players seeking to gain market share in the US, short of an unexpected run-up in WTI prices, a massive price hike is unlikely, even as we move into spring and summer of 2019.
In summary, there is no sense of panic among E&P’s or distributors. That lack of panic has kept demand (and consequently prices) in check. In turn, the resulting stability is lending itself to a calm OCTG market. It seems to be somewhat of a self-fulfilling prophecy. The underlying vibe throughout all of these discussions was that nobody really expects these tariffs to stick, long-term. Whether it’s President Trump who modifies or removes them, or whether there are much larger political events that drive a repeal, people just aren’t convinced that the tariffs are here to stay.
So, what to do about all this? My thought, based on a multitude of conversations with E&P and supplier representatives, is to maintain the status quo and re-evaluate in a few months. I believe the issue should be revisited, at the earliest, after the dust settles from the midterm elections. By then, we’ll see how NAFTA has played out, what rig activity and WTI are forecasted to do, and whether or not OCTG inventories are beginning to get crunched.
Until then, I believe it should be business as usual.