Chicago, Sunday, March 25, 2007 – The upward trend in domestic steel prices is being spurred by the rise in raw materials costs rather than by demand, a practice potentially damaging to steelmakers' financial health.

The nation's minimills are hiking prices to offset the cost of scrap, their primary feedstock, which has had a 50 percent price increase since January. The integrated mills, including those operated along the lake shore by Mittal Steel USA and U.S. Steel Corp., also are raising prices to neutralize higher energy costs.

Roy Berlin, president and owner of Hammond-based Berlin Metals, said the threat of increased steel prices spurs service centers to order more steel despite already-bloated inventories. If demand continues to lag, inventories will escalate farther above the optimum three-month level and stall future steel orders.

From his steel industry outlook presentation at the Steel Business Briefing conference in Chicago last week, it is apparent steel analyst Charles Bradford agrees that service center hedge-buying often leads to an inventory bubble, such as the one that occurred in early 2005. That bubble caused a significant drop in steel prices and steel producer profits.

"Inventories go up as steel prices go up, inventories go down as steel prices do down," said Michelle Applebaum, managing director of Applebaum Research, during her presentation at the SBB conference.

Service centers are businesses that inventory and distribute metals for industrial customers and perform first-stage processing like sharing, slitting, stamping and sawing on the steel they resell to fabricators and manufacturers.

Centers typically have thousands of customers, while steel mills serve just hundreds. The effect of rising steel prices on the market was illustrated in 2004 when service center overbuying helped drive steel prices up and then down.

As steel prices and surcharges climbed throughout the first eight months of 2004, service centers overbought on the anticipation of shortages and even higher prices. By early 2005, service center inventories were bulging, and they stopped buying while working down their inventories.

Steel prices and steelmakers' profits plummeted before they rebounded as demand rose.

Service center inventory levels were at a 3.7-month level in February, up slightly from January's 3.5 month supply. This was primarily due to the month's shorter delivery time, according to the Metals Service Center Institute. The Institute predicts that at the current rate, inventory liquidation "is likely to last into the second quarter."

The consensus 2007 U.S. economic forecast is for 2.7 percent growth, and even that is being reduced, Bradford said during his presentation. U.S. economic growth is being tempered by the current lag in consumer demand due to higher energy costs, a dip in new housing starts and lower auto sales.

"Steel mills need 3 percent economic growth for there to be steel growth," Bradford said. "Even the non-construction side is weakening."

Bradford predicts steel company earnings to bottom in the first quarter and to improve significantly in the second quarter, but the third quarter is "very cloudy."

"First, we expect lower scrap prices in April/May, which could put some pressure on prices, and some customers are still sitting with excessive inventories and have been talking about reducing their steel buys in April," he said in his Friday steel outlook report. "Secondly, the automakers (the second largest steel user) face labor contract negotiations in the third quarter."