A recycler of steel and a distributor of metal ores, Armco Metals Holdings is in the process of acquiring California-based Draco Resources, which trades, mines, and explores for iron ore. This will diversify Armco Metals to sell iron ore into varied markets beyond China. Armco Metals has already been positioning itself as the largest processor of scrap steel in China, which is a fantastic strategy long term, but short term, it could lead to volatile earnings, and the Draco Resource acquisition significantly decreases that risk. To better understand that, an overview of China’s demand for steel is needed.
Since the mid-1990s, China has successfully adopted a carefully government controlled Keynesian capitalism, and it shows. In 1990, China’s GDP was about $356.9 billion, and as of last year, China’s GDP is around $8.27 trillion. So a country with a population in excess of 1.354 billion people has managed to convert about 63% of its population to middle class in a span of mere decades. This has been done primarily as an export driven manufacturing economy with the United States as the main customer. All you have to do is visit a Wal-Mart and you see that a bulk of the products are manufactured in China by our industries and sent back to America. As a result, we have a huge trade deficit with China as we are buying tons of products from them and they are netting large amounts of U.S. dollars as a result. China cannot convert all those surplus U.S. dollars into Yuan as that will drive their currency up and cause inflation, so instead, they are net buyers of our U.S. Treasury bonds, and as a result, China now owns about $1.2 trillion of our $16 trillion or so of U.S. national debt.
It hasn’t always been a straight line of growth. As we are a huge customer of China, at the beginning of 2009, shortly after the Lehman Brothers collapse and the beginning of our financial crisis, we stopped much of our buying and China’s manufacturing collapsed with a loss of 30 million jobs in China. Nine months after that, the IMF did a study in China and discovered that since the beginning of 2009, China had lost only 3 million jobs. So how on Earth did China managed to create 27 million jobs in only 9 months? Massive infrastructure spending on roads and further on high speed rail, and banks were aggressively encouraged to lend to the real estate sector. With a huge population, China has massive labor surpluses, and to avoid social unrest and political instability, the government has to either absorb that labor surplus or violently suppress it. So, the country has been absorbing the surplus labor by debt-financing infrastructural and fixed-capital formation projects on a very large scale.
Not a democracy, the government of China can probably be best described as one of responsive authoritarianism, as the government heavily polls and surveys the population much the same way as we are heavily polled and surveyed in the United States. There is a constant worry of social unrest, as the country spends more on internal security than on military defense. A busy manufacturing sector has successfully increased prosperity and kept employment high enough to avoid social unrest.
The world’s second largest commodity market is iron ore. Central to the world’s economy, iron ore is the main ingredient for manufacturing steel, and steel represents almost 95% of all the metal consumed in the world: ships, buildings, bridges, cars, household appliances, and so on. What is China’s role in the steel market amid all of China’s fantastic economic growth? China has by far, become the largest producer and user of steel on the planet. Going all the way back to the 1960s, the pricing of steel was primarily determined by secretive agreements between mining companies and steel producers. As China became a powerhouse, they refused to participate in these benchmark deals practices, and forced all quarterly contracts to be linked to the iron ore spot market with hybrid contracts.
Over the past few years, China produced about 680 million tons of steel per year, and if they were cranking out a full capacity, could produce in excess of 850 million metric tons. At most, only 4% of the annual production of steel is exported, and most production is used for consumption, but as infrastructure spending has tapered off, it is known that China has built up a huge excess inventory of conceivably a few hundred million tons of steel. In the short term, there are signs that the current round of economic growth is slowing. There have even been news stories of luxurious ghost cities that have been built that the average Chinese can’t afford to move into, but are attractive hard asset investments of the wealthier Chinese. As Chinese wealthier elites have been screaming at the ruling Chinese Communist Party for tax cuts, and public investments are slackened, it clearly looks like it will be difficult for China to continue to be literally half the world’s global iron ore consumption. In the short term, iron ore prices are expected to soften, as global economists sit and hope China’s slowdown manifest as a soft economic landing and not some hard crash. So far, China’s utter lack of democracy has made for exceptional economic management of their capitalism, so odds favor a soft landing.
More to the point, we need a slackening in demand for iron ore as we appear to be hitting a global resource limit. The Worldwatch Institute has suggested that our planet will run out of iron ore in about 64 years assuming a conservative 2% annualized growth in demand, and the demand from developing countries has been much higher. Indeed it has been suggested by a number of analysts that the easiest to mine areas are already depleted and future mining is getting more complex, costly, and dangerous. Just within the past two years, India’s government appointed Shah Commission has warned that India may run out of iron ore with one decade. Out of economic necessity, India’s government lifted an iron ore mining ban in the state of Goa anyway, though set tight limits on the production.
What does this all mean for Armco Metals Holdings? The company has more than ten years of experience in sourcing and distributing metal and non-ferrous metal ores to the Chinese steel industry and is very well entrenched. They have longstanding relationships with more than 100 medium to small-sized metal producers throughout the People’s Republic of China. The development of business relationships with Brazil, South Korea, and India, as well as the recent acquisition of Draco Resources, has diversified the company away from sole dependence on the current China business cycle. The scrap steel recycling business in China is highly valuable long term as we face a future of resource depletion in the future. All of this places Armco Metals Holdings in a good position for steady, long-term growth.
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