The elements of steel: Can China build big U.S. cars?

Can China afford to expand its production of big cars?

It certainly is trying. Chinese carmaker Zhongxing, which makes pickup trucks and sports utility vehicles, is in talks with General Motors about a joint venture or equity stake, Reuters reported earlier this week. Earlier, speculation held that a Chinese buyer would appear for GM's Hummer brand of fuel-glutton SUVs.

But it's not easy to expand into the business of building big cars. For one thing, China has to consider its production limits. The country is importing so much steel that big iron-ore producers including Vale are actually raising prices to limit the country's demand. The iron-ore industry is already stretched to its limit by demands from China's steelmaking industry. "The world's mineral resources are becoming more difficult to get to market," said one investment banker familiar with the sector. "The supply side is becoming very scarce and concentrated. Between BHP, Rio and CVRD, your supplier base has tremendous leverage over you."

In fact, it was those concerns that helped fuel Cleveland Cliffs' now-challenged $8.3 billion acquisition of metallurgical coal miner Alpha last week. Metcoal, as it is known, is used primarily to make coke, a key component in steelmaking. Iron ore producers are mining more than they can handle, and steelmakers are producing more steel than they can handle, largely because the demand from China is insatiable. In fact, China was the largest offshore supplier of finished steel imports, with 4.58 million net tons, according to the American Iron and Steel Institute. In fact, two prominent mining executives told Deal Journal that they are raising prices on iron ore most to try to slow down China's demand for its steelmaking industry. At the same time, metcoal prices have been rising along with demand for steel.

That means that steelmakers are rushing to buy up metcoal companies before they get a replay of the pricing on iron ore. "Owning both the iron and metcoal is important. If the prices run up so much that it really runs up your steel margin, it's a problem," said this investment banker, who predicted a "feeding frenzy." The problem is, there aren’t too many. Many of them are also privately owned, which means their earnings and profitability are not common knowledge. Last year, Cleveland Cliffs bought up metcoal miner PinnOaks for $450 million in cash. There's more to come. Bankers say it is logical to look at other major metcoal producers like Alabama-based Walter Industries Inc., West Va.-based Bluestone Industries, Massey Energy Company, There are also metallurgical coal miners in Canada, including Toronto Stock Exchange-listed Grand Cache.

Who could buy these companies? A banker campaigns for the usual suspects: ArcelorMittal, Xstrata and CVRD to start.

But, unless China jumps into the game, the country risks being left out and its steel industry will suffer from rising prices in both iron ore and metcoal. The industry already needs to improve its reputation: In 2007, some U.S. steelmakers were concerned about the quality of Chinese steel. Given that China is potentially facing another crunch for the elements of steel, Chinese carmakers may want to tread carefully before investing in big American cars.