Looking for a relatively safe bet in a volatile equities market? Some analysts think steel stocks might be worth a look.

Wall Street analysts are becoming more and more bullish on U.S. steel producers, either increasing their buy ratings or their earnings estimates with prices per ton climbing dramatically since October. The average price of one ton of steel jumped from $545 in December to $665 in February and is already being quoted as high as $800 for May orders.

Indeed, the Standard & Poor's Steel index was up nearly 4% year-to-date through mid-March, vs. a 12% decline in the S&P 500-stock index.

Some fund managers, too, are bulking up on more shares of companies such as U.S. Steel (X), Nucor (NUE), and Commercial Metals (CMC), whose gross margins are more than keeping pace with rising raw material costs due to price hikes.

That the industry is able to hike prices and boost its margins with the economy on the brink of recession seems counterintuitive, to say the least. What's wrong with this picture?

Nothing, say analysts. It's simply the law of supply and demand at work. The steel industry has structural capacity shortage in North America of about 30 million to 40 million tons a year. Imports from foreign steel producers are less likely to make up that shortfall, due to a weaker U.S. dollar and rising freight costs.

Inventories Aren't Climbing as Usual

Low-cost producers from Brazil, Russia, and India would typically be the most logical exporters, but there are multiple reasons why new capacity isn't being added there, from a scarcity of capital due to political risk in Brazil to government bureaucracy and local opposition in India.

Most steel imports are coming from China, which has excess production capacity, but those imports are down an estimated 50% in the past six months. Chinese producers, already burdened by freight costs that can reach more than $150 a ton, now have an added disincentive to export their steel—an export tax imposed by the government in December.

Weaker Dollar Is a Plus

While U.S. prices have tended to be below the average global price, steel imports have generally come in at discounts to U.S. prices, says Richard McLaughlin, a consultant to the steel industry and managing director of the strategy consulting division of Hatch Associates Consultants in Pittsburgh. That's partly because customers aren't confident about the quality of the steel and also because they are being compensated for taking on the added risk of owning the metal during the four to six months it takes to arrive from offshore suppliers, he says.

But it would be a mistake to think that U.S. producers are taking market share away from foreign producers in any material way, McLaughlin says. Domestic steel manufacturers are operating at about 87% capacity, he estimates.

M&A as Slump Protection

In the flat-rolled segment, which primarily supplies the automotive and appliance industries, U.S. Steel, Nucor, and Luxembourg-based Arcelor Mittal (MT), which has a big U.S. division, now control more than two-thirds of domestic production capacity, McLaughlin says. "When you have that kind of concentration, it's easier to be more disciplined about pricing. That's not going away."

Besides being a key driver of pricing power, industry consolidation has also been the favored tool for producers to position themselves for economic slumps. Being larger allows producers to more readily absorb excess capacity and cut production if necessary.

Raising Second-Quarter Forecasts

Analyst Michael Gambardella at JPMorgan says that over the next several quarters he prefers mini-mills such as Nucor, which should face lighter energy costs than the integrated manufacturers. (JPMorgan or its affiliates received compensation for investment banking services from Nucor within the past year and expects to seek compensation for these services from Nucor in the next three months.)

The mini-mill portion of the industry, which includes Nucor, has always made a lot of money due to lower costs overall, says Eric Klenz, vice-president of institutional banking at KeyBanc Capital Markets in Cleveland. "They're newer, the plant layouts are better, and they have a more efficient process," he says. And because they use scrap metal, whose prices haven't risen as fast as those of iron ore and metallurgical coal, they do well when other raw material and natural gas prices are high.

And metal spreads could easily head even higher as mills have announced several price hikes for hot rolled sheet through May that will take them 63% above last August's lows, Gambardella wrote in his Mar. 17 note. He also expects all carbon steel companies to significantly raise their second-quarter profit forecasts when they report first-quarter results.

Nucor shares are up 19% since the beginning of the year, while Commercial Metals shares have stayed fairly flat year-to-date. U.S. Steel shares are up less than 1% since Jan. 2 but have recovered from a low of $92 in early February.

The U.S. steel industry faces a bigger potential threat over the longer term. It would make sense for China, whose main advantage is cheap labor, to shift over time from exporting steel products for manufacturers to exporting finished goods containing steel such as paper clips, nails, and cars, which contain more labor per unit, says McLaughlin. "That will erode our steel [finished goods] markets," but that won't happen in the next few years, he says.

Currently there's about 5 million tons of additional capacity being built in the U.S., but most of that will be in a finishing plant that the German manufacturer Thyssen is building in Alabama. That plant will have guaranteed supply of slab from Brazil, where Thyssen has a joint venture with Brazilian iron ore producer Vale (RIO).

If freight rates moderate and the dollar strengthens, you can expect to see exports from low-cost regions pick up. The extent to which additional capacity gets built in the U.S. will depend on how long the dollar stays weak and how high freight rates go, says McLaughlin.