UNSUSTAINABLE DEMAND

Is there such a thing as “unsustainably low demand”? Certainly, it’s an idea that has been bandied about during the recession by analysts, metals industry leaders, economists and others. To name just one, Klaus Kleinfeld, president and CEO of Alcoa, suggested during a first-quarter earnings conference call that inventories “have been driven down to a level which we believe is absolutely not sustainable.” Indicating, of course, that there is a level of demand below which, for one reason or another, markets cannot go—a popular notion.

Yet the more accurate concept is that we have passed out of a period of unsustainably high demand into a period that tests our ideas of what low demand really means.

Nearly every commentator that uses the phrase “unsustainably low demand” is unable to define it, except in the most general of terms. It’s far easier to calculate unsustainably low demand for, say, food based on the number of people we need to feed and the type of diet we expect them to eat. But for metals? Not so easy.

Let’s consider one metals consumer, the automotive market. Kim Korth, president and owner of management consulting company IRN Inc. in Grand Rapids, Michigan, says first-quarter U.S. production at the rate of 8.5 million vehicles annually represents nearly a 50% year-over-year decline. “In the second half of the year we have to see an uptick in the production numbers because that’s just not sustainable,” Korth says.

The simple formula for calculating absolute rock-bottom auto demand is linked to the scrap rate, which amounts to roughly 14 million vehicles a year in North America. “With roughly 250 million vehicles in the U.S. vehicle population, an average lifespan of 8.8 years for those vehicles and a scrap rate of 5.5% in 2008, that leaves an average of 14 million autos scrapped per year,” Korth says. Even if you assume there are some cars that won’t be replaced, “Most analysts believe that sales will be in the 13 million- to 15 million-unit range in the future, compared to the 16 million to 17 million we enjoyed over the past eight years. With annualized auto sales running at less than 10 million since December, an uptick in auto sales is almost inevitable,” says Korth.

But wait. The standard formula doesn’t compute if there are substantial changes in consumer buying habits, and there have been. In metals terms, it also doesn’t consider whether the amounts of metal used in a vehicle are changing. Automotive industry research company R.L. Polk & Co. estimates that the average length of auto ownership has increased to 56.3 months as of last year from 49 months six years ago. Polk also figures that 70% of consumers are likely to consider used versus new for their next auto purchase. In addition, federal climate-change legislation could change significantly the materials used to produce new autos, as well as their average lifespan.

Under these circumstances, what’s a reasonable estimate for “unsustainably low” consumer automotive demand? Or how about Kleinfeld’s first-quarter suggestion that the then 24% decline in service center aluminum inventories was unsustainably low? Since that time, shipping levels have declined, and steel and aluminum inventories are lower. What was “unsustainably low” yesterday might not be “unsustainably low” today.

A similar situation has played out in appliances, where anticipated demand includes such factors as residential construction, replacement of tired old machines and other, less significant factors, such as institutional buying. In today’s marketplace, even those calculations won’t work because housing has plunged to post-war lows, and many worn appliances aren’t being replaced, says Whirlpool Inc.

“The unemployment rate is at 9.4% [as of early June] and is expected to reach 10%,” says Larry Soehrman, vice president of materials management, Chicago Tube and Iron Co. “People in that situation have reduced their spending and are probably buying only necessities.”

So when it comes to how low demand can go, today’s safe estimate is that it can always decline even more. In aerospace, for example, there is nothing to prevent lower order rates, says Richard Aboulafia, vice president of analysis at research company Teal Group in Fairfax, Virginia. For construction materials, “The level of funding for state and local construction, even with [federal] stimulus [money], will not be nearly enough to sustain all contractors because it won’t sustain current levels of infrastructure spending,” says Ken Simonson, chief economist for the Associated General Contractors of America. “There is no guaranteed minimum higher than zero for infrastructure.”

For autos, “the only thing to safely say is that production rates now are under [the long-term trend] or even conservative estimates for sales in the next two or three years,” says Parks Dodd, president, Aluminomics LLC in Atlanta, Georgia. “I wouldn’t say unsustainable, though.”

Nobody knows how low aluminum demand can fall, says Dodd. On the other hand, he says, demand before the recession hit full force was even less sustainable as it was too high.

“You could look back and say that demand was unsustainably high for a while,” Dodd says. “Everyone knew when housing starts got to be above 1.6 million per year. What no one anticipated was that it would fall to 500,000. The same thing could be said for cars and light trucks. When production and sales were running that high, something had to give.”

We had a period of unusually easy credit, which created a situation of too much money based in credit chasing too many goods for far too long, he says. That makes comparisons based on the last five or six years of demand prone to great error.

“You have to look over the last 20 years,” says Dodd. “Even then, since the recession in 1990 to 1991, we’ve been going up. So we’re entering a period where the norm is going to be lower than what we’re used to in the last 20 years.”

The good news is that we are unlikely to reenter unsustainably high demand any time soon. Korth predicts that auto sales will eventually return to 14 million to 15 million a year, short of the breakneck 17 million-vehicle record.

The same goes for Boeing orders, which set a record high in 2007, and new home starts, which hit 1.9 million units in 2004 but fell to 532,000 in May.