Date March 2018
Approximate net recovery on cost
- March 2018 import levies of 25% on steel and 10% on aluminum cause distress across the manufacturing and consumer industries
- As a result of tariffs on select imports, borrowers may face unexpected cost increases that could compress margins
|25% tariff on steel and 10% on aluminum imports
Canada, Mexico, Argentina, Brazil, South Korea, Australia, and the European Union are initially exempted
|Higher margins for domestic producers and importers from exempted countries||
|Economic advantage for domestic production||
|Ripple effect of higher input prices on downstream products||
|Concentrated impact on some states||
|Retaliatory actions by other countries||
Tariff creates uncertainty across the supply chain: The Trump administration has imposed a 10 percent tariff on all U.S. aluminum imports, and a 25 percent tariff on all steel imports, with the exception of North American Free Trade Agreement (“NAFTA”) partners Canada and Mexico. Initial exemptions have also been extended for the European Union, Australia, Brazil, South Korea, and Argentina. Canada is the leading supplier of imported steel and aluminum to the United States, accounting for 16 percent of imported steel and 41 percent of imported aluminum, per CNBC. Authority for the tariffs comes from a seldom-used law from the 1960s that was designed to protect domestic industries deemed vital to national defense. Section 232 of the Trade Expansion Act of 1962 gives the U.S. president authority to place restrictions on the importation of vital materials if such imports “threaten to impair the national security.” The majority of the impact of the tariff on U.S. aluminum imports will be felt in the physical market; however, the majority of the industry believes that eventually there will be a significant impact on exchange prices as well.
Both the steel and aluminum industries have been under heavy pressure from imports for some time. In recommending tariffs or quotas, the Commerce Department noted that employment in the domestic steel industry has decreased by 35 percent in the past two decades, while the aluminum industry lost almost 60 percent of its jobs between 2013 and 2016. Texas, which is the number one state for steel and aluminum imports, is particularly fearful of the prospect of a trade war brought on by the recent action. The Dallas News notes that a much greater share of Texans work in the energy sector and other industries that rely upon steel and aluminum than in those that actually produce the metals, which carries broader implications for the economic impact. In short, Texas’ and many other states’ globalized economies could be susceptible to any retaliation from abroad.
Aluminum types impact recovery values: Aluminum is produced in a wide variety of forms and alloys. Base aluminum prices are tracked for either billet or scrap, but most aluminum is actually sold and used in a fabricated form, such as sheet and coil, bar stock, extrusions, forgings, and castings, among others. For certain applications, such as aerospace and military, aluminum may be produced in proprietary grades and to conform to industry specifications. As such, while the price of base billet can be tracked daily, the cost and value of fabricated aluminum is more difficult to update and track. In a liquidation, the value of aluminum will be driven by marketplace demand and need, with proprietary forms of aluminum, absent a waiting customer, generating a scrap value. Aluminum products in standard sizes and quantities with materials certifications that are widely used will generate strong recoveries in the secondary marketplace.
Inventory costing and mark-to-market reserves: When a company’s inventory contains commodity-type items, like aluminum, which are subject to frequent price fluctuations, it is imperative to understand the company’s inventory costing methodology. A standard cost approach includes updating inventory costs periodically and, depending on the frequency of the update, can result in the company’s reported cost varying from the market in an inflationary or deflationary environment. A rolling weighted cost approach utilizes an average weighted cost for each purchased item that equates to a rolling perpetual average. This methodology is useful for commodity-type items as a company’s reported cost will remain closer in line with the market, although costs will still trail market prices by a set period. Given the volatility in the aluminum market, lenders should be aware of the target company’s costing methods and should consider incorporating a mark-to-market or lower-of-cost-or-market reserve. A mark-to-market reserve account will adjust the cost basis to market and ensure that an advance rate based on a percentage of cost remains relevant even in a volatile market. As a result of the newly levied tariffs on all U.S. imports, borrowers may face unexpected cost increases that could compress margins. Operators that work on a project basis are most vulnerable as input prices may differ at the time materials are purchased from when the contract price was agreed. Recoveries on existing aluminum inventories, on the other hand, may benefit.
Electrical costs impact profitability: Critical to the refining process of aluminum is the consumption of electricity, and U.S. aluminum producers continue to be impacted by the rising cost of electricity. While cheap natural gas in the U.S. could be a lifeline in the near term, energy prices over the next several decades will have a much more far-reaching impact on the economic feasibility of domestic operations. Currently, the industry is powered 50 percent by coal electricity, and there are significant concerns around how much coal prices will be impacted by the Environmental Protection Agency’s newly tightened emissions regulations at power utilities.
Lower domestic electricity prices also bolster the case for smelter restarts. Electricity costs in the U.S. moved down slightly in 2017 compared with the previous year, a change that improved conditions for aluminum producers. On average, the industrial power rate throughout the U.S. came in at 6.63 cents per kilowatt hour (KWH) as of December 2017, down from 6.67 cents per KWH in December 2016, according to U.S. Energy Information Administration data.
NAFTA restructuring: Steel and aluminum tariffs that will sharply raise the prices of both materials were signed into effect in early March 2018. President Trump signed off on the comprehensive tariffs for all import countries, but excluded NAFTA members Canada and Mexico. Since May 2017, the terms and conditions of the NAFTA agreement have been under discussion for restructuring. The Office of the United States Trade Representative notes that “The new NAFTA must continue to break down barriers to American exports. This includes the elimination of unfair subsidies, market-distorting practices by state owned enterprises, and burdensome restrictions of intellectual property. The new NAFTA will be modernized to reflect 21st century standards and will reflect a fairer deal, addressing America’s persistent trade imbalances in North America. It will ensure that the United States obtains more open, equitable, secure, and reciprocal market access, and that our trade agreement with our two largest export markets is effectively implemented and enforced.”
The Aluminum Association favors investigating ways to “modernize” NAFTA in lieu of scrapping the deal altogether. In a comment sent to U.S. Trade Representative Robert Lighthizer, the association said that its aluminum-company members rely on the “crucial intra-NAFTA trading relationship” and continuing free trade to effectively maintain their supply chains, adding “the negotiations to modernize NAFTA must strengthen and expand opportunities under the agreement, without diminishing its unquestionable benefits generated by the duty-free movement of aluminum and aluminum products throughout North America.” However, the association also voiced concerns that the agreement should provide more safeguards to ensure that aluminum traded among member countries is not sourced elsewhere. It remains to be seen what the new terms will be and how they will ultimately impact trading prices for aluminum going forward.