HOW WASHINGTON CREATED AND SOLVED THE GREAT TRANSFORMER SHORTAGE
You can learn a lot about big things by zooming in on (relatively) small things. I found the recent Great Transformer Panic shows how the political economy of energy works through the Washington influence machine.
The cool kids in the power business have known about the problems with procuring distribution and transmission transformers for about four years. It is only in the past few months, though, that it has become a high profile inside-the-Beltway process issue. And now, thanks to the magic of regulation rewriting, serious money grant approvals, trade preferences and press releasing, The Great Transformer Shortage is being solved. At a price yet to be fully determined.
You might have thought that a well understood technology such as utility-scale transformers, which are widely available through a competitive international trade, would not be subject to supply/demand hiccups and pricing drama. And there have not been any transformer shortages or shocking (sorry) price increases in China, Russia, or the countries they supply. There are delays and price increases in the European market, but the big issues have arisen in the US, starting during the Covid pandemic and continuing even after other supply chain problems have been resolved.
Independent power developers, utilities, home builders, manufacturers, data center owners, and any others who needed a new or upgraded connection to the power grid were out of luck. They were told by official experts such as NREL that lead times for transformers were stretching up to two years, a fourfold increase on pre-2022 schedules, and that prices had been increasing by four to nine times in the three years since the pandemic.
Following their consultants’ advice, the transformer-hungry buyers had formed an industry consortium last year to petition the Biden Administration for relief. Otherwise, they warned, the electrification revolution, decarbonization, EV adoption and the other goals of the Inflation Reduction Act would be at risk.
The key problem, it seemed, was a lack of grain oriented silicon steel used for transformer coils. There is only one US producer, AK Steel, a subsidiary of Cleveland Cliffs. And to make the situation worse, greenies in the Department of Energy were going to require that buyers of new distribution transformers should be pushed to use coils make of a newer, more energy-efficient material called amorphous steel.
There was only one small domestic producer of amorphous steel, unfortunately, and Cleveland Cliffs made noises about shutting down its electrical steel finishing plant in Pennsylvania, which would cut UAW union jobs…
All bad. Confusion and suspense about whether to order, expand or shut down facilities, much shuttling between K Street lobbyists and Capitol Hill. On top of this, Nippon Steel made a bid for US Steel, which annoyed Cleveland Cliffs (the only US bidder), the steel union people, Rust Belt senators, the White House and Donald Trump (U.S. Steel Takeover).
The Wall Street Journal and libertarian energy economists put in their two cents of free-market opinions, which really annoyed the politicos, unions, and Cliffs.
Ta-da! President Biden went out and made several strong statements that support Cleveland Cliffs’ bid for US Steel. Coincidentally, Cliffs was just awarded a grant of up to $75 million to electrify its grain oriented electrical steel plant (GOES) in Lyndora, (swing state) Pennsylvania (DOE Industrial Demonstration Program).
And—more magic! On April 4 the Department of Energy finalized its energy efficiency standards for distribution transformers. After a “robust engagement process” the DOE reined in its amorphous steel dream and affirmed that the standards can primarily be me with American made GOES, with some demand left over for the amorphous steel people.
If by any chance this cost-plus way of doing things should lead to overcapacity in the electrical steel and transformer businesses, then there can be “backup” procurement under the Defense Production Act to sop up the extra stuff. As for Nippon Steel’s bid for US Steel, well, the bond market analysts already think it’s been sunk (see CreditSights comments in the footnote below).
I think there’s more politicking, legal fees, union endorsements and bureaucratic scheming to come in the US Steel-Cliffs-Nippon Steel triangle. I’ll be following up soon on how the deal, the politics and the fees could shake out.
Oh, also it’s true that this means power will be even cheaper in China, Russia, India, Indonesia and other competitive parts of the world. So more political fixes will be necessary in election cycles to come.
Those won’t come cheap either…
Creditsights:
· The $15 bn acquisition of US Steel by Nippon Steel is facing significant challenges, with opposition from the United Steelworkers, President Biden, former President Trump, and numerous politicians from key states.
· With the Nippon/US Steel transaction in jeopardy, investors are pondering whether Cleveland-Cliffs will make another bid and what the post-transaction credit profile might look like.
· We believe CLF will likely make a renewed offer for X and aim for a conservative financing approach for the acquisition and quickly delever through asset sales.
· Using conservative assumptions, we project the PF net leverage for the combined entity at 2.4x, assuming a purchase of X by CLF at $54/share on a 50/50 cash/stock basis, then decreasing to 1.5x post-sale of Big River Steel at its replacement cost.
· We maintain our O/P on CLF and U/P on X.
The end of the world moves a little further away with the re-appearance of Dizard.
Mr. Dizard great to see your insights again. They are needed now more than ever to filter out the political B.S. that has infected the business news.