The current boom in steel profits is at risk from oversupply starting next year, and the market is already discounting something of a slowdown, industry bankers warned Wednesday at a steel conference in Manhattan.

The steel industry "is unique in its ability to destroy capital," James Tumulty, vice president and head of high-yield trading at Raymond James, said at the conference co-sponsored by American Metal Market and World Steel Dynamics.

The industry's proclivity toward overproduction has caused prices to collapse and has resulted in 43 separate steel market meltdowns, destroying company balance sheets in the process, Tumulty said. He warned that irresponsible producers developing new capacity could hurt the industry again.

Tumulty's particular concern was that any new capacity developed would be viewed negatively by investors, as it would likely cause softer prices. Others noted increased capacity coming out of China. The message to producers such as U.S. Steel, Mittal Steel, Commercial Metals and Nucor was clear: Don't flood the market.

Bondholders were crushed by past cycles of boom, then bust, and "if you are shareholders of a steel company that's not making real money in this market, you are in a perilous position," Tumulty said. His point is that the lack of profits at this stage in the economic cycle is a sign of serious problems in a sector in which investors are sitting on big gains since January 2003, even after recent weakness.

The trader didn't spotlight any company in particular, although Wheeling Pittsburgh Steel clearly springs to mind.

Whether the increased steel output will be enough to swamp the market remains an open question, but it looks like the market is already pricing in something of a slowdown for 2007.

"Next year's [price-to-earnings] multiples are higher than this year's, which suggests lower profitability going forward," said Spiro Youakim, managing director of metals and mining banking at Citigroup. A growing company would typically have lower P/E multiples in future years compared to the current period.

"Keep in mind that steel is a cyclical business," said Robert Miller, managing director at Miller Mathis & Co., a New York-based specialty investment bank. "The bottom can look very ugly." He cautioned investors and steel industry managers on the dangers of becoming too exuberant at the top of a business cycle.

Although the cyclicality of the steel business is ever present, the good news is the trend toward consolidation, with the top five steel companies taking a 50% market share by 2011, says Dieter Hoeppli, managing director at UBS Securities.

The mining sector, which has already seen mass consolidation, now trades at six to seven times projected earnings before interest and taxes (EBIT) vs. 4.7 times for the steel industry, Hoeppli notes. He expects multiples to move up as steel companies continue to buy each other, which means higher stock prices for any given level of earnings. It also means that holders of steel company stocks will benefit more when steel prices increase.

It was just such upside potential that Citigroup's Youakim was concerned about losing when he warned producers against hedging. He noted that gold miners had increasingly shied away from the futures market because it capped potential earnings gains when metals prices rose.
Fuzzy futures

Such comments can't be music to the ears of Neil Banks, director of exchange development at the London Metal Exchange (LME). In an interview with TheStreet.com Tuesday evening, he acknowledged that any potential exchange-traded futures contract could be at least 18 months off.

The first part of the LME's plan is to have specialty metals publication Platts develop pricing sources, through which reference data points can be compiled, Banks says. He expects it will take through year-end before anything can be published.

"The biggest challenge is ensuring enough data providers," which would be followed by a further 12 months during which the reference points would be published, he explains. That means that any prospect of a traded steel-hedging product is at least 18 months away, which is probably still too soon for Mittal CEO Lakshmi Mittal.

However, others are more optimistic about the prospects for a steel contract in the short term. "There's enough momentum that the market has now passed the point of no return," said Robert Levin, senior vice president of research at the New York Mercantile Exchange, which is currently investigating the possibility of a steel contract of its own.