ey global steel 2014

8/10/2019 EY Global Steel 2014

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Global steel 2014Planning to profit from opportunity:preparing for future demand


2/44Contributors

Pierre MangersExecutive Director

Tel: +61 8 94 29 22 16

pierre.m angers@ lu.ey.com

Angie BeifusSteel A nalyst, M ining & M etals

Tel: +61 2 92 48 40 32

angie.beifus@ au.ey.com

Amit AggarwalSteel A nalyst, M ining & M etals

Tel: +91 1 24 61 9 2 46 4

am it.aggarwal@ in.ey.com

Anjani AgrawalGlobal Steel Leader

Tel: +91 982 06 1 414 1

anjani.agraw al@ in.ey.com

Michael ElliottGlobal M ining & M etals Leader

Tel: +61 2 9 24 8 4 58 8

m ichael.elliott@ au.ey.com

Bob StallPartner

Tel: +1 40 4 8 17 54 74

robert.stall@ ey.com

Special thanks to Manoj Chauhan

and Subhashish Sarkar, steel analysts,

for their contribution.


3/44Contents

Executive summary 01

Steel in the global economy 03

Global econom ic update 03

Global supply and dem and 04

Global outlook for steel 06

Spotlight Q&A wit h Mechel andTata Steel Group 09

Planning to profit from opportunity 11

Succeeding despite challenges 11

Capital dilem m a 12

Raw m aterial strategy finding opportunityin volatility 16

M anaging risks related to steel derivatives 21

Preparing for future steel demand 23

Steel dem and and com petitiveness 23

Tapping into high-grow th sectors 26

Infrastructure and construction 27

Autom otive 31

O il and gas 35 Geographic outlook for steel dem and 39


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Executive

sum m ary

Excess capacity is the biggest threat tothe sector

W hile there are signs that the outlook for dem and is slow ly

im proving, excess capacity rem ains the biggest threat to the steel

sector. The sector is straining under the relentless pressure caused

by years of excess steelm aking capacity and low m argins.

W hile som e capacity is expected to be rem oved over the next

decade, the announced addition of capacity by steelm akers out

to 2020 show s that investm ent is still alive and w ell.

To counteract the investm ent in new steelm aking capacity, w e

estim ate that about 300 m illion tonnes of steelm aking capacity

needs to be closed for the industrys profit m argin to reach a

sustainable level, and raise the capacity utilization rate for the

sector globally, from below 80% to m ore than 8 5%.

Perm anent shutdow n of capacity is the only real solution to bring

balance to the m arket but in the short term it is difficult to see

this happening given state participation in m any countries and

additional political incentive to retain em ploym ent, regardless ofprofitability.

The overall net effect, how ever, has been an increase in steel

m aking capacity despite the C hinese G overnm ent m andating

80 m illion tonnes of capacity to be rem oved by 2018. W ith

restructuring and consolidation in the Chinese m arket, a hand-

full of large Chinese steel players w ill em erge, leading to global

com petition intensifying.

Steel producers should test the

vulnerability of their business m odels

and the resilience of their strategies to

ensure sustainable grow th.

Anjani Agrawal

Global Steel Leader

0

500

1,00 0

1,50 0

2,00 0

2,50 0

20

03

20

0

4

20

05

20

06

20

07

20

08

20

09

2010

2011

2012

2013

2014f

m

illiontonn

es

Total capacity Production Consum ption

Global steelmaking total capacity, production and consumption

Source: W orld Steel A ssociation, BREE and Initiating on Indian Steel Industry: SteelSupport for Superiors Returns,M etals & M ining, Jefferies, 2 O ctober 2013.

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Global steel 2014


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Increased marketcompet it ion will transformthe market

Steelm akers are addressing m yriad

challenges such as volatility, shifting

dem and centers, com plex supply chains,

productivity and cost efficiency. A s

steelm akers increase their ability to survive

in tough tim es, w e w ill see increased

m arket com petition in nearly all products

especially as there is a focus shift to high-

value, higher m argin steel products.

Increasing m arket com petition w ill also

result from the flatter m arginal cost curve

in the sector. W e believe about 85% of

hot-rolled coil (H RC) production is w ithin

U S$ 100/tonne of the m arginal producer

and 46% is w ithin U S$ 50/tonne. W ith

little difference betw een the positions of

steelm akers along the cost curve, sm all

changes in the operating environm ent,

such as increased productivity or changes

in cost of capital, can produce sw ift

changes in positions, com petitiveness and

ultim ately survival. Steel com panies w hom onitor and constantly create new sources

of value are likely to be m ore successful.

A s a highly geared sector w ith lim ited

access to capital, there w ill be increased

pressure for 10% to 1 5% of steelm aking

capacity to close over the next tw o to three

years. The knock-on effect w ill be:

An increase in M &A activity as stronger

operators acquire their w eaker

com petitors w ith the aim of rationalizing

the sector

Early refinancing as steel com panies

seek to take advantage of low interest

rates ahead of potential rate rises

Portfolio optim ization as steelm akers

assess their assets for value creation

The com plex dilem m a of w here to

allocate capital w hether capital should

be invested upstream for raw m aterial

security or dow nstream to capture a

greater share of the value chain

The coking coal and iron ore m arkets arelikely to rem ain volatile w ith an elem ent

of uncertainty despite forecasts for a

surplus m arket with low er prices. These

m arkets are highly concentrated and

their global trade is dom inated by a fewplayers. As a result, production can be

quickly reduced to alter m arket balance

and affect prices. W hile steelm akers have

largely responded to the challenge of raw

m aterial volatility and security of supply

by vertically integrating their operations,

steel consum ers appear to be using steel

derivatives to m itigate this challenge. W e

are seeing the use offinancial instrum ents

increasingly being adopted by A sian

steel producers, including C hinese and

South Korean steel m ills. H ow ever,

overall steelm akers still have the low est

participation rate in steel derivatives.

Preparing for demands ofthe future

The speed and degree of changes in the

global econom y and the increasingly

com plex interplay of factors influencing

a m ore globally integrated steel business

m ake horizon w atching essential.

To succeed, steelm akers m ust determ ine

how to optim ize and create a new product

m ix and decide w hether they are prepared

to take the plunge to invest in new

geographic m arkets.

A s dem and continues to shift to developing

nations, the steel sector is directed

tow ard China, w ith som e focus on B razil,

Russia and India. A s A frica becom es

increasingly urbanized, it m ay be that the

future scram ble for A frican dem and could

com pletely shift the landscape in years

to com e.

There are signs of econom ic im provem entand dem and grow th in m ost steel m arkets:

Infrastructure and construction

U rbanization and a grow ing m iddle class

continue to be global trends driving steel

dem and in construction and real estate.

Increasing investm ent in construction and

infrastructure led to an 8 % y-o-y increase in

global dem and for long products in 2 013.

The A sian construction m arket rem ains

the m ain driver of grow th in this steel

subsector capturing alm ost 40 % of total

construction spending.

Automotive There w ill be increasing

steel dem and from the autom otive sectorin both em erging and developed regions.

The U S, Brazil, Japan and C hina are the

hotspots in the autom otive sector w ith

calculated annual grow th of betw een

5% to 11% forecast to 2016. Despite

threats from other m aterials, steel still

accounts for nearly 7 0% of the m aterials

used in a passenger car so there is am ple

opportunity for steelm akers to capture

m arket share w ith value-added products,

such as AH SS.

Oil and gas Looking upstream , the oiland gas sector w ill continue to experience

significant capital investm ent over

the next few years, an annual average

spend of US$ 657b, w hich should drive

dem and for prem ium oil country tubular

goods (O CTGs), particularly for use in

unconventional projects. In addition, there

is substantial investm ent forecast into

other parts of the oil and gas value chain,

e.g., distribution pipelines and refineries.

Is 2014 the turning point

for steel?Success for steelm akers w ill increasingly

depend on being agile and nim ble in

responding to m arket opportunities that

provide better m argins.

In last yearsGlobal Steel 20 13 : a new

world, a new strategy,w e questioned

w hether 2013 w as the bottom of the

m arket. The expectation of significant

im provem ent in 2 013 did not eventuate as

excess capacity continued to w eigh on the

sector and, w ith the exception of China,steel dem and did not m eet expectations.

There w ere, how ever, signs of grow th w ith

price trends and financial results reflecting

stable or im proving m argins for steel.

W ith a slightly stronger outlook for 2014

com pared w ith 2 013, and the prom ise of

further progress in 2 015 and beyond, the

steel sector is focusing ahead to plan and

profit from the opportunities and prepare

for dem ands of the future. This change

w ill not be im m ediate and the centers

of dem and w ill vary. N evertheless, the

steel sector is expected to gradually gain

m om entum as the decade unfolds, w ith

optim ism about w hat lies ahead.

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Global steel 2014


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1. M odest Eurozone recovery on track as Q 4 GDP grow th im proves to 0 .3% q/q,

IH S Global Insight, 5 M arch 20 14.

2.Eurozone Report ,EY, Decem ber 20 13.

Steel in theglobal economy

Developed markets looking stronger

In 2013, the econom ic environm ent im proved in developed m arkets, w ith grow th in the

EU , the U S and Japan.

The outlook for the EU im proved in the latter half of 2013, w ith higher levels of

em ploym ent, rising GDP and im proved access to capital. The G DP continued to increase,

although only by 0 .3% y-o-y, in the last quarter of 20 13. The region is expected to seea gradual recovery backed by an accom m odating m onetary policy, low inflation and

im proving consum er and business sentim ent.1

In the U S, corporate earnings, em ploym ent grow th and credit availability are im proving.

GDP grew at 3.2% y-o-y despite the drag caused by the shutdow n of the Federal

Governm ent during the quarter. A com bination of im proving household finances, stronger

housing m arket and im proved com petitiveness w ill accelerate U S grow th to an annualized

rate in excess of 3% from the second quarter of 2014 onw ard.2

In Japan, strong export grow th, rising consum er spending and a rebound in business

investm ent led to recovery from the 2012 recession. A hike in the consum ption tax

rate to 8% in 2014 and 10% in 2 015 should help in achieving fiscal stability, but not

Global economicupdateAlthough there was a slightimprovement in the economiesof developed markets in 2013,it was offset by slower growthin emerging economies. Overall,the global economic outlook ispositive with industrial productionforecast t o grow by 4%in 2014.

A fter a period of sustained w eakness and uncertainty, the global econom y continues

along the road to recovery and m ay be on the verge of acceleration. A t the end of 2013,global industrial production indicators show ed a definite upsw ing in sentim ent, w ith 3 %

m onth-on-m onth grow th. This grow th is expected to continue into 2014, w ith forecast

grow th of about 4% com pared w ith 1.9% in 2013.

World industrial production growth continues through tail end of 2013 (%y-o-y)

Source: Global Insight (*projected num bers)

0

1

2

3

4

5

S ep 13 O ct1 3 N o v1 3 D ec1 3 J an 14 Feb 14 2 0 12 2 0 13 2 0 14 2 0 15

3 .1 3 .1 3.2 3.4 3.5

4 .1*

1.8 1.9

3.9*

4 .7 *

Global steel 2014

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4. Short Range O utlook,WorldSteel,O ctober 20 13 .3. Japan Econom ic forecast sum m ary,O EC D, N ovem ber 20 13.

Excess capacity rem ains the biggest threat to the steel sector. The sector needs to

restructure to regain profitability but w ith high debt and reduced profitability, theoptions for consolidation are lim ited. Perm anent shutdow n of high-cost capacityis the only real solution to bring balance to the m arket. Both corporate and

governm ent leadership is necessary to m ake this happen.

Michael ElliottGlobal M ining & M etals LeaderEY, A ustralia

necessarily grow th, in the country. Japans quantitative and

qualitative m onetary easingshould continue until the infl

ationtarget has been m et and GDP grow th achieves a consistent

im provem ent.3

Emerging markets muted growth

Em erging m arkets show ed signs of slow er grow th in 2013 as a

result of low er com m odity prices, w eak dem and from developed

countries and tighter financial conditions. This slow dow n is clearly

illustrated by falling m anufacturing PM I data from em erging

m arkets w here a slight contraction is particularly evident from

M ay 2013 onw ard. In stark contrast, there are clear signs of

expansion in the EU and the U S.

The governm ents of em erging econom ies are im plem entingstructural reform s to rebalance their econom ies. The Chinese

Governm ent, for exam ple, is shifting to a consum ption-based

econom y, w hereas the Brazilian and the Indian Governm ents are

rem oving barriers to investm ent.

Sep-12

O

ct-12

N

ov-12

D

ec-12

Jan-13

Feb-13

M

ar-13

A

pr-13

M

ay-13

Jun-13

Jul-13

A

ug-13

Sep-13

O

ct-13

N

ov-13

D

ec-13

Jan-14

China 48 50 51 52 52 50 52 50 50 48 48 50 51 50 51 50 49

Brazil 50 50 52 51 52 53 52 51 50 50 49 49 50 50 50 51 50

India 53 53 54 55 53 54 52 51 50 50 50 49 50 50 51 48 49

Indonesia 51 52 52 51 50 51 51 52 52 51 51 49 50 51 50 50 51

M exico 54 56 56 57 55 53 52 52 52 51 50 51 50 50 52 52 54

Russia 52 53 52 53 52 52 51 51 50 52 49 49 49 53 49 49 48

U S 52 52 50 50 53 54 51 51 49 51 55 56 56 56 57 56 56

Eurozone 46 45 46 46 48 48 46 47 48 49 50 51 51 51 52 52 53

Japan 48 46 46 45 47 48 50 51 51 52 50 52 52 54 55 55 56

Manufacturing PMI data indicates a contraction in economic growth across emerging markets (below 50 indicates a contraction)

Source: M arkit Econom ics, H SB C, Bloom berg

Global supply and demandGlobal steel dem and increased by an estim ated 3 .2% in 2013 ascom pared to 2 012, largely due to increased infrastructure and

construction activity, especially in A sia.

China w as the clear driver of global steel dem and, recording

6% grow th in 2 013 com pared w ith 2 .9% in 2 012. In the rest of

the w orld, how ever, dem and for steel in 2013 failed to m eet

expectations and w as low er than previously forecast. Despite

structural issues and volatile financial m arkets in em erging

m arkets, the m ajority of dem and (apparent steel use) w as still

propelled by these econom ies (+4.9%), w hereas dem and in the

EU continued to contract (3.8%). There w as, how ever, a slight

increase in apparent steel usage in N orth A m erica (+0.2%).4

4

Global steel 2014


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6. M ordashov urges joint action to reduce excess capacity,Steel Business Brief ing,

24 Jan uary 2014, via Factiva.

7. State Council urges to cut 80 m ton s of steel capacity in 5 years,CCICED, cciced.

net/encciced/new scenter/latestnew s/201310 /t2013 1025_2 622 45.htm l,

25 O ctober 201 3.

8. Beijing collects detailed steel capacity-cut plans,Steel Business Briefing,

27 Jan uary 2014, via Factiva.

5. Global Steel: Steeling for oversupply,M organ Stanley ,22 M ay 2013.

Steel (million tonnes) World China India J apan US EU 27

2013 2014e 2013 2014e 2013 2014e 2013 2014e 2013 2014e 2013 2014e

Production 1,607 1,636 775 802 81 84 111 111 87 88 167 163

Consum ption (estim ate) 1,586 1,629 729 751 79 83 70 70 103 104 153 156

Surplus (deficit) 21 7 46 51 2 1 41 41 -16 -16 14 7

Oversupply is likely to continue in 2014

W orld W orld - excluding China BRIC - excluding China China

0

1

2

3

4

5

6

7

%

grow

th

2013 forecast (Oct12) 2013 estim ate (Oct13)

3.

0

6.

0

3.

1

4.

9

2.

9

4.

6

3.

3

3.

1

3.

2

2014 forecast (O ct13)

3.

5

3.

3

0.

7

Forecast apparent steel usage fails to eventuate in 2013

(with the exception of China)

Source: W orld Steel A ssociation

China Crude steel capacity Outdated capacity closure Net capacity addition

2010 756 41

2011 820 32 32

2012 950 11 119

2013e 1,025 10 65

2014f 1,050 20 20

Chinese net capacity additions 201014 (million tonnes)

Source: EY, M acquarie Research, Deutsche B ank, Steel Business Briefing8

Source: Bureau of Resources and Energy Econom ics ; W orldSteel

Global steel production in 2013 continued to increase by 3.5% to

1,607 m illion tonnes despite tepid dem and grow th in m ost parts

of the w orld. The m ost notable increase in production w as in

China w here at least 58 new furnaces have com e online, adding

80 m illion tonnes of annual capacity (about 8% of an existing 9 70

m illion tonnes). Steel production in Japan has also increased by

3.1% to 1 10.6 m illion tonnes. Production in som e countries did

decline in 2 013, w ith a 4.4%, 2% and 1 % fall in South Korea, the

U S and B razil, respectively, and w ith Europe dropping by about

2%. Capacity utilization in the industry averaged 78.1% in 2013

up from 76.2% during 2 012.

Despite 5 0 m illion tonnes of crude steel capacity being rem oved

from the global m arket (excluding China) in 2012, global

overcapacity w as estim ated at 33 4 m illion tonnes.5W hile som e

capacity is expected to be rem oved over the next decade, theannounced addition of capacity by steelm akers out to 2 020

show s that investm ent is still increasing. In fact, about 300 m illion

tonnes of steelm aking capacity needs to be closed over the next

decade for the industrys profit m argin to reach a sustainable

level. That would raise the industrys capacity utilization rate from

below 80 % to m ore than 85% .6

Sustained overproduction is likely to continue im pacting the global

m arket in 2014, but the im pact w ill vary from region to region.

H igh rates of overproduction com bined w ith volatile raw

m aterial prices have adversely affected the profitability of

Chinese steelm akers. This has seen the C hinese Governm ent

m aking attem pts to restructure the steel industry to increase itsefficiency and rem ove som e excess capacity. In O ctober 2013,

the Chinese G overnm ent issued a guideline requiring that steel

capacity in C hina should be reduced by 8 0 m illion tonnes by

2018.7In addition, m ore than 15 m illion tonnes of obsolete

capacity operating w ith old technologies should be replaced by

new technologies or closed before the end of 2015. Regional

governm ents in China have been slow to close steel m ills,

as it w ould rem ove sources of em ploym ent and other fiscal

benefits. W hile som e capacity has been closed, the overall net

effect to date has how ever been an increase in steelm aking

capacity in China. A necdotally, it would appear that som e C hinese

steel m ills are upgrading to new technology to avoid shutdow n,

thereby increasing the am ount of investm ent at risk. A ctualfigures on just how m uch upgrading is taking place are yet to be

announced.

Global steel 2014

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9. Short Range O utlook,W orldSteel, O ctober 2013.

10. Short Range O utlook,W orldSteel,O ctober 20 13 .

Global out look for steelIn 2 014, global dem and is forecast to grow faster at about 3.3%.

H ow ever, m ore dem and grow th is expected to com e from outside

of China as the Chinese Governm ent pushes through econom ic

restructuring w ith a focus on private consum ption.9

W ith the exception of China, global supply and dem and for steel

w ill largely follow econom ic grow th recovery around the w orld.

In China, national m andates to rationalize capacity w ill have an

effect on supply and as the Chinese econom y m oves to a m ore

consum er-driven m odel, steel consum ption is expected

to m oderate.

The short-term estim ates by W orld Steel A ssociation for globalsteel dem and are sim ilar on an overall basis, w ith som e m ore

positive view s for grow th in the U S, the EU, Brazil and R ussia but a

relatively low er expectation for Asian countries.10

Outlook for steel and economic growth in 2014 mapped against the location of major steel markets

Source: IH S G lobal Insight, BREE

US

2.7 1 .1 1

European Union

1.5 -2 .4 2 .0

Brazil

2 .4 5 .9 3 .6

Russia

2 .5 1 .4 0

China

8 3 .5 3 .0

Japan

1 .4 0 0

South Korea

3.6 1 .5 1 .8

GDPgrowt h (%)

Steelproductiongrowt h (%)

Steeldemandgrowth (%)

India

5.4 3 .7 5 .1

Grow th in the C hinese econom y continues to be a determ iningfactor for the global steel m arket in the m edium -to-long term .

A s China seeks to restrain investm ent activity, rebalancing and

deleveraging, current forecasts for 2014 are for low er grow th

rates in production and dem and w ith the rem oval of excess

capacity. H ow ever, if urbanization projects continue, accom panied

by a strong dom estic econom y and a grow ing m iddle class, the

dem and for steel w ill continue to stim ulate. It w ill also shift the

product range as m ore sophisticated consum er products, such

as autom obiles and hom e appliances, are sought after. This w ill

benefit steelm akers w ith high-end, value-added products.

Tw o factors m ay cause m ore rapid restructuring of the Chinese

steel sector:

The excessive levels of debt m ay allow Chinese policy banks to

stop funding losses as a catalyst to restructure.

The use of steel stockpiles to collateralize debt to be used for

speculation is expected to be unw ound.

6

Global steel 2014


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40

14 0

24 0

34 0

44 0

54 0

64 0

74 0

84 0

94 0

M

illiontonnes

2 00 8 2 00 9 2 01 0 2 01 1 2 01 2 2 01 3e 2 01 4e 2 01 5e

Production-m t Dom estic dem and-m t Production grow th (%)

Dem and grow th (%)

0%

2%

4%

6%

8%

10 %

12 %

14 %

16 %

Chinese steel supply and demand

Source: N BS, M acquarie Research, Septem ber 2013

Steel dem and in Europe and the U S is likely to im prove during

201415. In Europe, it is expected to increase by a robust 2%

in 201411 on the back of investm ent in the infrastructure and

m anufacturing sectors. A lthough the grow th m ay be insufficient

to absorb the capacity overhang, the sw itch from decline to

m arginal grow th can be im portant for industry m argins and

overall sentim ent.

U S steel dem and is also expected to im prove on the back of

residential construction, grow ing autom otive production and

energy investm ents. O ther regions to experience faster steel

dem and grow th w ill be India, Brazil, Russia and M EN A (the M iddle

East and N orth A frica).

11. Short Range O utlook,W orldSteel, O ctober 20 13.

Cost and competitivenessW hile steelm akers are m ost threatened by excess capacity as they

strive to m aintain their profitability, they are also exposed to cost-

related threats:

The increasing age of steel m ills and the deferral of required

m aintenance w ill see a sharp increase in future repair and

m aintenance costs.

W ith econom ic recovery, labor costs are rising faster than steel

dem and.

Productivity w ill continue to fall as steel plants age or are run at

less-than-optim al capacity.

Historic low interest rates, prevailing in m ost m arkets, are not

sustainable, w ith future interest burden set to be significant for

the already highly geared steel sector.

Little com fort can be taken that this w ill hit m arginal producers

first. Steel producers from the C om m onw ealth of Independent

States (CIS) and a few from India have typically occupied the

bottom of the cost curve because of their integrated m ining

operations; w hereas steel producers from China, Japan and South

Korea w ho procure iron ore and coking coal at m arket prices have

typically occupied the top end of the cost curve.

There has been a continualflattening of the m arginal cost curve

prim arily due to w eakening of raw m aterial prices, w hich has

pushed dow n the top end of the cost curve. H ow ever, cost inflation

has been higher in em erging m arkets, w hich has pulled up the

low end of the cost curve. W e believe about 85% of hot-rolled

coil (H RC) production is w ithin U S$100/tonne of the m arginal

producer and 4 6% is w ithin U S$ 50/tonne. Due to a flatter cost

curve, the position of the m arginal producer can quickly change.

Factors, such as increased efficiency in operations and changes

in cost of capital and currency m ovem ent due to global m onetary

policy changes, can quickly shift the position of a steel producer

on either side of the m arginal cost of production. A flatter cost

curve thus prom otes increased com petition and delays production

cutbacks even w hen the price falls below the m arginal cost ofthe high-cost producer. H ow ever, a flat m arginal cost curve also

suggests that steel prices m ay be approaching the bottom .

Global steel 2014

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Restructuring the sectorTo date, the industrys response to overcapacity has sim ply been a

short-term m easure m aintaining m argins through cost reduction

and focusing on high-end products, rather than a fundam ental

solution. Further, it is only steelm akers with any real scale w ho

can im plem ent these m easures. Dealing w ith excess capacity

globally m ay be a larger problem than sim ply rem oving it. O ther

challenges m ay include the w rong type of steel being produced

to m eet new dem and, incorrect m anufacturing processes or steel

being produced in the w rong locations.

In addition, during this period of inconsistent dem and grow th,

as profitability returns, producers tend to utilize excess capacity

im pacting the dem andsupply balance, thereby causing m arginsto dilute again. This vicious cycle is a structural problem that

needs to be addressed by the industry especially as, w ith steel

dem and averaging 3% to 4 % for the rest of this decade, the

solution for increasing profitability in the steel sector is unlikely to

be dem and-led.

Given labor law s, environm ental costs and perm anent loss of

the option value of the plants, it is unlikely that there w ill be

perm anent rem oval of any m eaningful steel capacity. Those steel

m ills that have state participation or are outright ow ned by the

state have an additional political incentive to retain em ploym ent,

regardless of profitability. This m ay largely be due to the steel

industry being an integral part of the econom y for m anydeveloping countries. M organ Stanley estim ates that to rem ove

over 300 m illion tonnes of capacity could m ean the loss of over

1 m illion jobs globally.12

In other industries that have the required global restructuring,

it has usually been achieved through consolidation w here a

num ber of m ajor players acquire sm aller producers and begin to

close inefficient capacity w ith the highest cost. This has occurred

in the oil refining, autom otive and photovoltaic industries over the

past decade and a half.

A lternatively, if no larger players are capable of undertaking

the necessary consolidation, all producers will bleed until the

w eakest are forced to close as funding of ongoing losses becom es

im possible. This has m ore been the pattern of the airline, furniture

and alum inium sm elting sectors.

12. Steeling for oversupply,M organ Stanley, 22 M ay 2013.

H igh debt levels and little to no positive cashfl

ow lim it the abilityof the sector to use consolidation to heal itself. H ow ever, as steel

rem ains a strategic sector in m any econom ies, the possibility

of state-backed support to prom ote consolidation is still there.

O therw ise, it is survival of the fittest.

So w hile the outlook for 2014 is slightly im proved from 2013,

the sector is in a fragile state and any additional econom ic shocks

w ill have an adverse im pact on steelm akers. W ith high gearing,

the lack of availability of fresh capital for m any, the possibility

of continued loss-m aking and the pressure to attain sustainable

environm ental, energy and econom ic efficiency goals, there w ill

be pressure for 10% to 15% of steelm aking capacity to close over

the next tw o to three years.

A n increase in M &A activity w ill be a product of outright m ill

closures as stronger operators acquire and restructure the

w eak to gain benefits from rationalization, and steel com panies

rationalize their portfolio in an attem pt to repair balance sheets

and adhere to national m andates, such as those in China.

N ot all assets put up for sale w illfind buyers, although som e new

entrants to the sector are expected to be driven by low er asset

valuations. Capital m arkets are expected to rem ain tight, if not

closed to m ajor equity raisings, m aking A rcelorM ittals decision

in early 2 013 to raise U S$3.5b for debt reductions appear

very tim ely.

The next tw o years w ill be particularly challenging for the steelsector. A ll steelm akers are m axim izing their cost-cutting and

productivity enhancem ent efforts and seeking to focus on high-

end value-added products. This is going to significantly increase

m arket com petition in nearly all products. Consolidation in

China and its grow ing dem and for high-end products present

a good business opportunity for steelm akers, particularly for

those w ith access to the Chinese m arket. Som e regions w ith

com petitive advantages of high long-term dem and grow th backed

by econom ical resource availability w ill also offer new er grow th

opportunities for global steel players w ho have the ability to

em brace a degree of risk.

O ne thing is for certain, how ever, and that is steelm akers w ill

have to live through a sustained period of volatility in the short-to-

m edium term .

Steel producers can either chose to accept this volatility and

express to the m arket that they are the sam e as everyone else,

or seek to tam e volatility by increasing the flexibility of production

or hedging strategies to protect them selves from this volatility.

W hile the outlook for 2014 is slightly better than 2013 and 2015 holds the prom ise of even greater

im provem ent the sector is in a w eak position and any further econom ic shocks w ill have an extrem ely

negative im pact on steelm akers.

Angie BeifusSteel A nalyst

EY, Australia

8

Global steel 2014


12/44

Q&A with Mechel and Tata Steel GroupTheir perspective on challenges in the global steel sector, the future of demand and the outlook

Apart from the current economic

challenges, what are the other major

challenges faced by the steelmaking

industry?

The m odern steelm aking industrys m ain

challenge is that of global im balance as

excessive supply sees dem and centers shift

from econom ically developed countries

to developing ones. A nother problem ,

w hich em erged from the m ining and

steelm aking sector, is the decline in profit

m argins in dow nstream processing. This

is due to excessive supply and low rates of

consolidation in steelm aking, as com pared

w ith the raw m aterials sector.

A regional risk that com es to m ind isthe lack of transparency in the Chinese

steelm aking industry. Right now , no one

know s precisely how m any plants there are

in C hina and w hat their total production

capacity is. If Chinas internal dem and is

not on par w ith supply, theres a risk of

Chinese producers expanding into the

export m arket and this could cause a

global m arket collapse.

In a num ber of countries, inefficient

producers are able to continue operating

because they receive direct or indirect

state aid this also im pacts the supply and

dem and balance.

A s for Russia, our top challenge apart

from the issues Ive already raised is

the continued increase in tariffs of natural

m onopolies, such as railw ay transit

or electricity.

Oleg KorzhovChief Executive O fficer, M echel

How much of a major challenge is

excessive production for the industry?

This is indeed a very serious problem

particularly as m ost of the industrys newprojects w ere built thanks to loans, and

producers are forced to keep them on full

load to repay those loans.

For exam ple, in Russia, dem and for long

construction steel rolls totals 10.2 m illion

tonnes a year but existing production

capacity is estim ated at about 14.7 m illion

tonnes. This m eans the dom estic m arket

cannot absorb m ore than 70% of the

current capacity, leaving the additional

capacity in need of a hom e.

At the sam e tim e, new projects w ith a totalproduction capacity of 7 m illion tonnes are

due for com pletion by 2018, w ith nearly 3

m illion tonnes already launched in 2013.

Even w ith optim istic grow th forecasts,

such volum es w ill lead to a load decrease

below current levels.

How do steelmakers cope with these

challenges?

M echel has three w ays of dealing

w ith them .

First, w e attem pt to dispose of non-corebusinesses and halt inefficient facilities.

H ow ever, w e are not alone in this; the

sam e processes are underw ay across

Russia, Europe and other countries.

China is a case in point. A ccording to an

officially announced program for reducing

inefficient facilities, betw een 2011 and

2015, China plans to halt steelm aking

facilities im pacting 6 0 m illion tonnes in

the H ebei province, 6.7 m illion tonnes of

steel and 1 8 m illion tonnes of coke in the

Shanxi province, and 21.1 m illion tonnes

of pig iron and 22.6 m illion tonnes of steel

in the Shandong province. It also plans to

reduce the total steelm aking capacity in

the Tianjin province to 20 m illion tonnes.

Second, w e focus our investm ent activity

on the m ost efficient products. For M echel,

these are coking coal and highly profitable

steel products w ith high added value.

Third, w e reorganize our sales system to

gain direct access to end custom ers by

developing our ow n sales netw ork, w hich

m eans w e dont have to share our profits

w ith traders.What do you think is the driving force for

high steel demand from the point of both

the region and the end customer?

Currently, state aid is the m ain driver of

grow th. This is essentially about pouring

m oney into national econom ies the U S

policy of quantitative easing is a case

in point.

H ow ever, such m easures lose efficiency

w ith each passing year. O nly w ith a change

in the econom ic grow th m odel and the

em ergence of radically new industries w ill

the situation alter to any degree. So far,

w e see no reasons for, or signs of, such

a change, but nor could anyone have

predicted 30 years ago just how im portant

inform ation technologies w ould becom e.

Mechels perspective

Global steel 2014

9


13/44

Iron ore and coking coal prices were

volatile during the past year. How

will this affect steel prices and what is

your prognosis for steelmakers

profit margin?

To be fair, iron ore and coal prices have

rem ained w ithin a range over the last few

quarters com pared to the volatility seen

last year. There are no triggers to push

raw m aterial prices too far out of range;

they are likely to rem ain w ithin U S$20 to

U S$ 25 of w here they are today.

W hile som e significant m ining capacity is

set to com e online soon, m any greenfield

projects are being delayed or deferred as

m iners are now conserving m ore capital.Infrastructure for m ining has becom e

difficult, costly and very capital intensive.

A s a result, w hile m iners are focusing on

the cost of production, free on board (FO B)

costs m ay rise because of infrastructure

costs. O n the steel m argin front, w e expect

a relatively flat spread betw een steel

prices and raw m aterial prices. H ow ever,

com panies need to curb inflation-related

costs, such as w ages and energy, to keep

m argins intact. Fixed costs are sticky and

have sensitivity issues. So, m anaging

fixed costs and producing differentiatedproducts could be the m ost critical factors

for the steel industry in the next tw o to

three years, especially w here dem and

contraction is high.

In light of this volatility, do you plan to

use steel futures and hedging against

risks in prices for raw materials and

downstream products?

Steel has not m oved in the sam e w ay as

alum inium because the steel product range

is not as standard. The LM E launch of

billets w as not hugely successful. H ow ever,

iron ore hedging could pick up if volum es

rise there are som e C hinese exchanges

that have started trading in iron ore.

The industry w ants to m ove in the

direction of hedging but there are som e

inherent risks. A lthough hedging is good

for standard products, it is not as useful

for differentiated prem ium productm anufacturers because it rem oves the

differentiation on product prem ium .

Custom ers w ill w ant m ore stable prices.

W e need to see how w e can put a fair but

consistent m echanism in place.

Speaking about economic hedging and

backward integration in steel, some

studies suggest that vertical integration

provides more stable EBITDA but there

is no evidence of it enhancing overall

enterprise value. Do you have any views

on this?

It depends on the value point at w hich you

integrate raw m aterials. If you buy at the

peak of the cycle, you can erode value and

even cash flow s. In developing greenfield

or early stage projects, the chances of

m aking m oney are higher. In term s of

infrastructure, a m iner w ould prefer to be

a rent payer rather than having to ow n and

develop it. If this can be addressed, then

value w ill rem ain, both from cash flow and

econom ic hedge perspective.

Do you think that China is entering a

new phase of slower economic growth or

simply pausing for breath?

M y view is that China is at an inflectionpoint at which it w ill begin to show m ore

m aturity in the steel cycle. The C hinese

steel m odel is m ore classical than Indias

hybrid betw een infrastructure and

consum ption. China w ill gradually m ature

into a grow th trajectory that could be

low er than historical averages of the last

decade, but w ill add m ore quality and

sustainability to its grow th. Its recent

policy m easures are a step in the

right direction.

What do you think will be the impactof consolidation on the Chinese steel

industry?

In a w ay, the C hinese steel industry is also

a converter of raw m aterials into steel.

Consolidation is a plus it will enable

the Chinese steel industry to be m ore

com petitive by cutting overhead costs, and

ensuring good use of capital, and it should

see m ore spend on R &D. It w ill also put the

rest of the global steel industry on alert to

find w ays to rem ain com petitive.

A t this point, Europe is restructuring tosurvive. The context is not the im pact of

China but rather a contraction in regional

European dem and and its higher cost

base. The rise of the steel industry in

China has raised the floor on raw m aterial

prices globally.

Koushik ChatterjeeGroup Executive D irector

Finance & Corporate,

Tata Steel Group

EY would like to thank these participants for sharing their views with us.

Tata Steel Groups perspective

10

Global steel 2014


14/44

Planning toprofit fromopportunity

Succeedingdespite challengesSucceeding in the face of ongoingmyriad challenges requireseffective strategies and efficientexecution to gain raw mater ialssecurity; manage price volatilit y;improve cost competitiveness;manage cash flows; respondto weak demand; innovate newproducts or applicat ions toatt ract new customers; optimizeproduct portfolios to expandmarket access; lead to geographicexpansion; and achieve growthaligned with diverse stakeholdersexpectations.

Despite some optimism forsteelmakers, todays tougheconomic conditions have led to areassessment of r isks, strategies

and operations at each stage ofthe steel value chain.

Capital

dilem m a

Future

dem and

Raw m aterial

strategy

Access to capital lim itedfunding options

Allocation of capital

optim izing value

Raw m aterial outlook

Financial instrum ents form argin protection

Tapping into high-grow th

sectors Geographic outlook for

steel dem and

Global steel 2014

11


15/44

A return to positive cash flow s is encouraging for the sector, particularly w ithreference to its ability to service and refinance existing debt facilities. H ow ever,

w ith higher interest rates m ooted, tightening credit conditions rem ains a risk forthose that havent yet refinanced their balance sheets.

Lee DownhamGlobal M ining & M etals Transactions Leader

EY, U K

Capital dilemmaAccess to capital limited fundingoptions

Gearing in the steel sector is high, particularly com pared w ith

other sectors, and tight m argins have reduced serviceability.

A s a result, a num ber of steelm akers experienced credit

dow ngrades during 2013. H ow ever, an analysis of the top 50

steelm akers by m arket capitalization show s that levered free cash

flow (FCF) returns have returned to positive and this w ill increase

the ability of the top steelm akers to service their debt in the

short term .

There are also early signs of som e inherent risks to com e, w ith

2014 set to bring a shift in the interest rate cycle and, w ith it,

higher funding costs for issuers. Critical to the year ahead is

how the m arkets deal w ith the tim etable for the tapering of

quantitative easing. This im pact w ill likely be felt beyond the U S

m arkets, w ith em erging m arkets having already seen significant

outflow s in 2 013 and A sian investors fearing tighter borrow ing

conditions.13As a result, there is a risk that access to funding

for steelm akers w ill be difficult particularly for those either in

N et debt Lev FCF/net debt

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10 %

12 %

0

50

2009 2010 2011 2012 2013

10 0

15 0

20 0

25 0

U

S$

billion

Note: 20 13 based on S&P calculation of the last 12 m onth s.

Source: EY analysis, S& P Capital IQ

Levered FCF returns to positive territory in 2013

for top 50 steelmakers

14. 2014 O utlook: W estern European Steel,Fitch Ratings,29 Novem ber 2013.

15. Ibid.

16. Finlands O utokum pu announces m ajor financing plan, divests assets,

Reuters News,30 Novem ber 2013.

13. Fitch Street View : A sian Investors Fear Corp Liquidity D rain on Fed Tapering,

Fitch Ratings,17 N ovem ber 201 3.

developed m arkets w ith high gearing or w ith a high exposure to

volatile em erging m arkets. There w ill also be thefl

ow -on effectfrom steel end consum ers, w ho especially rely on bank funding

for their operations.14H igher interest rates could also im pact

steel dem and for consum er goods, such as US cars and hom e

construction.

Som e credit ratings agencies have dow ngraded several of the

m ajor European steelm akers, reflecting the m ore challenging

outlook for European steel m arkets in 2014, and an anticipated

slow er rate of im provem ent in their credit ratings over the next

tw o to three years.15

In particular, several Scandinavian steelm akers have struggled

w ith liquidity in 2013. H ow ever, actions taken by com panies

to respond to this risk deleveraging through non-coredivestm ents, cost cutting, capacity cutbacks and productivity

im provem ents w ill begin to have an effect on shoring up credit

ratings. For exam ple, Finnish steelm aker Outokum pu is shoring

up its finances w ith a rights issue of 650m . Further, O utokum pu

w ill divest assets back to ThyssenKrupp. This w ill partly reverse

O utokum pus 2012 acquisition of Thyssenkrupps stainless steel

business, Inoxum .16

A s revenue rem ains eitherflat or negative, conservation is taking

hold and cash flow s are w eak. In this environm ent, borrow ing only

stresses the balance sheet and challenges credit ratings. Further,

issuing equity dilutes shares, creates m ore dividends and saps the

corporation of its earnings pow er.Steelm akers w ere, how ever, active in the capital m arkets,

raising m ore capital in 2013 than the previous year. H ow ever,

w hen com pared to 2011, capital raising rem ains m uted. There

have been an increased num ber of follow -on equity issues as

steelm akers seek to restore their balance sheets, w ith 34% of

all global m ining and m etal secondary equity raisings being

undertaken by steelm akers. W e expect further deleveraging to

be predom inantly achieved through internal cash generation or

continued divestm ent of non-core assets, w ith dilutive equity

issues likely to be an unpopular choice in an environm ent of

depressed share prices.

12

Global steel 2014


16/44

Follow -on activity increased by 217% in 2013. This included state

privatizations, such as the partial stake sale of the Steel Authority

of India. ArcelorM ittal issued a com bined offering of ordinary

shares (U S$1.75b) and m andatory convertible subordinated notes

(US$2.25b) in January 2013, accounting for the lions share of

this increase. Equity offerings appear to be largely concentrated

in Europe. A reduction in w orking capital also appears to be one

of the big sources of cash flow in Europe. Chinas steel industry

reportedly has a debt ratio of about 70%, m aking steel com paniesm ore susceptible to bankruptcy fears in the current dem and

environm ent.17In India, there have been a num ber of debt

restructurings, essentially to extend the tenure for tiding over

current cash flow challenges.

In the first half of 2014, w e m ay see early refinancing as

steelm akers attem pt to take advantage of low interest rates ahead

of potential rate rises. Continued m arket volatility m ay lim it the

scope of steelm akers to issue bonds on the favorable term s of

recent years. Pockets of confidence and yield seeking w ill continue

but investors are likely to seek safety in investm ent-grade nam es.

A lternatively, greater com pensation on higher-risk, high-yield

steel issues w ill be sought in the form of higher coupons,

particularly given the sectors exposure to em erging m arkets.

2011 2012 Change 2013

US$m U S$m % U S$m% change from

2012

% change 2013

as com pared

to 20 11

IPO s 383 172 -123%

Follow -ons (equity) 13,561 2,856 -375% 9,051 217% -33%

Convertibles 459 163 -181% 2,774 1599% 504%

Bonds 30,418 22,877 -33% 19,835 -13% -35%

Loans 53,571 19,662 -172% 31,248 59% -42%

Total 98,392 45,730 -115% 62,908 38% -36%

Capital raising by steelmakers 201113

Source:M&A and capital raising in mining & m etals, EY, 20 14

17. Chinas debt-laden steel industry on the brink of bankruptcy,International

Business Times,29 A ugust 2013, http://w w w.ibtim es.com /chinas-debt-laden-steel-

industry-brink-bankruptcy-1401415.

Global steel 2014

13


17/44

In 2 014, steelm akers w ill face the increasingly com plex dilem m a between their decision to continue investing

capital in upstream raw m aterials security or into dow nstream operations to expand product offerings to gain

m arket share or capture a greater share of the dow nstream value chain.

Bob StallPartner, Transactions

EY, U S

Capital allocation optimizing valueRising pressure to service debt w ill see an increased exam ination

of asset portfolios in the steel sector. The burning platform of non-

core divestm ents to release cash rem ains critical, particularly in

light of negative free cash flow s for m ost of the sector. H ow ever,

a focus on extracting m axim um value from the sectors existing

portfolios of assets rem ains im portant.

O ver the last few years, the value chain in the m ining and m etals

m arket for the steel industry has transform ed, w ith upstream

having been able to retain proportionately the larger share of the

value. The reasons include degree of consolidation of the m ining,

steel and dow nstream product segm ents. H ow ever, m argin

opportunities also evolve dow nstream in value-added productsegm ents or by creating new product segm ents w ith a long-term

econom ic life cycle. Successful players w ill optim ize through

re-allocation of capital w ithin portfolios to those com ponents

m ost aligned w ith their strategy. Despite a globalizing trend in the

steel industry, the drivers of success m ay be different in different

m arkets, creating dem and for capital over varying investm ent

horizons, scales and risk-rew ard ratios. Decisions w ill have to

be m ade about how to allocate capital betw een upstream or

dow nstream operations and to sectors and geographies in order

to achieve the highest return on investm ent and m axim ize long-

term shareholder value.

To have any hope of m eeting their capital needs, steelm akersm ust extract as m uch value as possible from every capital dollar

invested. W hile all sector participants are sim ilarly affected as

the steel cost curve is fairly flat, best-in-class capital allocation

processes are im portant to survival and success.

Allocating capital upstream

M any steelm akers have responded to the challenge of raw

m aterials security and m argin volatility by m aking acquisitions or

investing upstream to access raw m aterial resources on a long-

term basis. In an environm ent w here value appeared to have

m oved upstream in the business, this has been quite a com m on

trend. Captive access to iron ore and coal does provide stability to

aggregated cash flow stream s, and hence builds the confidence ofcapital providers and leads to better ratings in several m arkets.

H ow ever, this approach has been losing its attractiveness of late

in m ost situations. A dm ittedly, there are risks associated w ith this

strategy, nam ely overpaying for scarce resources w hile com peting

w ith m ining com panies, lack of operational experience of m ining

business and additional capital allocation required for building

infrastructure. The strategy, inherently, also assum es that raw

m aterials prices w ill continue to increase.

Average EV/EBITDA 200913 vs. raw material self-sufficiency

POSCO

NSSM Gerdau

China Steel

Baoshan

NucorThyssenkrupp

Severstal

CS NJFE Tata SteelJSPL

SA IL

H yundai Steel

BaotouCA P

Evraz

U sim inas

Pangang

Voestalpine

Angang

Ternium

Hebei

W uhan

Erdem ir

M M K

JSW

0.0

5.0

10 .0

15 .0

20 .0

25 .0

0 1 2 3 4 5 6 7 8 9 10

A

verageE

V/EB

ITDA

2009-

2013

A rcelorM ittal

N ovolipetskU S Steel

Source: EY analysis, S&P Capital Insight data

14

Global steel 2014


18/44

Average EBITDA margin 200913 vs. raw material self-sufficiency

POSCO

A rcelorM ittal

NSSM

GerdauChina Steel

H yundai Steel

N ucor

NLM K

Thyssenkrupp

Severstal

CS N

JFETata Steel

JSPL

SA ILBaoshan

Baotou

CA P

EvrazU sim inas

Pangang

Voestalpine

Angang

Ternium

Hebei

W uhan

Erdem ir

M M K

US Steel

JSW Steel

0%

5%

10 %

15 %

20 %

25 %

30 %

35 %

40 %

45 %

50 %

0 1 2 3 4 5 6 7 8 9 10

A

verag

eo

pera

tingm

arg

in2

009-

2013

Source: EY analysis, S&P Capital Insight data

Despite these risks, vertical integration rem ains a trend in the

sector as volatile raw m aterial prices for iron ore, m etallurgical

coal and scrap steel continue to exert significant pressure on

steel m argins. This w as evidenced by a couple of large deals in

upstream m ining assets in 2 013, nam ely:

PO SCO and C hina Steel purchased a 15% stake in A rcelorM ittals

Canadian iron ore m ines for US$ 1b and secured long-term

offtake agreem ents. This enabled A rcelorM ittal to extend its

Liberian iron ore assets w hile using the proceeds to pay

off debt.

Evraz secured the rem aining 50% stake in R ussias Raspadskaya

coal m ine for U S$ 964m .

This trend has likew ise been observed in other raw m aterial

assets. For exam ple, N ucor has entered into a long-term , onshore

natural gas w orking-interest drilling program in the U S to hedge

natural gas pricing volatility for its Louisiana-based direct reduced

iron (DRI) plant.18

In EYsGlobal Steel 20 13 : a new world, a new strategyw e

considered the effect of vertical integration on the value of

steelm akers, concluding that raw m aterial self-sufficiency has a

negative correlation w ith the enterprise value of a steelm aker, but

has a positive im pact on its EB ITDA m argins. During 2 013, this

negative correlation in value only becam e m ore pronounced.

U ltim ately, steelm akers m ust ask the question W hat business

am I in?to determ ine w hether they are steel producers, or steel

producers and m iners. If they are both a producer and a m iner,

then the question rem ains as to w hat value they bring to the

portfolio of m ining assets that another m iner does not?

If that second question cannot be answered w ith a clear value

proposition, the m arket w ill put a discount on this part of the

business due to lack of transparency or clarity about the m ining

strategy. In other words, this m ay not be the best use of expensivecapital if these assets could be sold for m ore value rather than

holding them .

18. Form 10-k, N ucor w ebsite, 2012 (accessed via http://w w w.nucor.com /investor/

sec/htm l/?id=8 76 27 96 &sXbrl=1 &com pId=1 07 11 5, 20 D ecem ber 20 13 ).

Global steel 2014

15


19/44

Raw materialst rategy findingopportunity in volat ilityRaw material out look: market surplusesto drive down prices

In 2 013, global seaborne iron ore dem and grew by about 9% y-o-y

on the back of robust Chinese steel production, w hich experienced

approxim ately 7% grow th on 2012 levels and increased to 7 55

m illion tonnes.19The rise in Chinese steel production rates kept

the iron ore price (62 % Fe, CFR N orth C hina) at an elevated level,

w ith prices averaging U S$133 per tonne during the year.

Chinas ability to m eet its dom estic share of iron ore supply m ay

be at its low est w ith grades now below 20% Fe content. At these

levels or low er, it is likely that China can only supply a quarter of

its iron ore requirem ents. H ow ever, the outlook for seaborne iron

ore supply is different (led by Vale, Rio Tinto and Fortescue M etals

Group) w ith grow th expectations of 8.4% per annum from 2013

to 2 018 and w ith expected annual grow th rates of 4.4% in its

dem and during the sam e period.

This w ill result in an oversupplied iron ore m arket, w ith the m arket

balance m oving from a deficit of m ore than 8 % of seabornedem and in 2 013 to a surplus of alm ost 9% by 2018. This is likely

to dislodge an equivalent am ount of m arginal cost production in

China, w ith a resultant dow nw ard pressure on iron ore prices.

Cost escalations during recent years pushed up the m arginal cost

of iron ore, thereby supporting its elevated price levels. H ow ever,

from 2015 onw ard, increased iron ore supply to the m arket w ill

displace the current high-cost production, potentially low ering the

m arginal cost of supply.

The proliferation of the C hinese EA F production route w ill globally change the level playing field of ferrous

m etallic supply m arkets: m ore expensive scrap at the expense of cheaper iron ore.

Pierre MangersExecutive Director

EY, Luxem bourg

Sim ilar to the iron ore m arket, the seaborne coking coal m arketis also expected to run into oversupply. The m arket balance is

expected to grow from a surplus of about 1% of seaborne dem and

in 2013 to a 6 % surplus in 2 017 and back to about 4% by 2018.

The U S w ill continue its status as the sw ing producer, affecting

the m arket balance in the m edium term . H ow ever, the tapering

of quantitative easing is likely to push up the U S dollar, m aking

U S coking coal m ore expensive and therefore less viable in the

seaborne coal m arket.

China w ill rem ain the biggest im porter of coking coal, accounting

for about a quarter of coking coal im ports in 2 018. Coking coal

supply w ill be driven by large-scale expansion in A ustralia. Som e

notable projects in A ustralia include A nglo A m ericans G rosvenor

m ine (5m tpa) and the Jellinbahs Lake V erm ont expansion

(4m tpa). Supply from M ozam bique and M ongolia is also expected

to ram p up; how ever, the tim ing of large-scale expansion from

these regions is highly variable.

A s a result of grow ing surpluses, consensus indicates a sharp fall

in iron ore prices prices are forecast to fall from an average of

U S$133 per tonne to U S$10 0 to U S$11 0 per tonne betw een

2013 and 2 018. Coking coal prices, having experienced steep

declines, are forecast to rise in the m edium term from US$159

per tonne in 2 01 3 to about U S$20 0 per tonne in 2 01 5 and 2 01 6,

but are then expected to gravitate tow ard U S$180 per tonne

by 201 8.

It is w orth noting that the iron ore and coking coal m arkets are

highly concentrated and their global trade is dom inated by a

few m ajor players that can sw iftly reduce production to alter the

m arket balance and affect prices. Prices w ill also be affected by

steel m arket dem and, w hich is driven by the uncertain global

econom ic environm ent. The ensuing uncertain and volatile price

environm ent w ill have a bearing on the steel industrys raw

m aterials sourcing strategy.

19 .Global Metals Playbook: 4Q13 ,Morgan Stanley,7 O ctober 20 13 , via

Thom sonOne.

20. Ibid.

Surpluses in seaborne iron ore and coking coal markets

Source: M organ S tanley20

-10.0%

-5.0%

0.0%

5.0%

10 .0%

0

50 0

1,00 0

1,50 0

2,00 0

2

0

1

3

e

2

0

1

4

e

2

0

1

5

e

2

0

1

6

e

2

0

1

7

e

2

0

1

8

e

Dem and - m illion tonnes (LH S) M arket balance as a percentage of dem and

Iron ore

2

0

1

3

e

2

0

1

4

e

2

0

1

5

e

2

0

1

6

e

2

0

1

7

e

2

0

1

8

e

-5.0%

0.0%

5.0%

10 .0%

0

10 0

20 0

30 0

40 0

M arket balance as a percentage of dem and

Coking coal

Dem and - m illion tonnes (LH S)

16

Global steel 2014


20/44


21/44

Average price movement of steel, iron ore (indexed to 100)

Causes of volatility:

Shorter-term pricing of key raw m aterials

Enhanced risks and uncertainties in global seaborne trade,

supply chain disruptions, socio-political events in new

resource countries, etc.

Econom ic and financial uncertainty in the global econom y

and the increasing inter-linkages betw een developed and

rapid-grow th econom ies

Distressed steel pricing in an oversupplied m arket in a

unconsolidated industry

Volatility in raw material pricesSteelm akers have largely responded to the challenge of raw

m aterial volatility and security of supply by vertically integrating

their operations, w hereas steel consum ers appear to be using

steel derivatives to m itigate this challenge.

Volatile raw m aterial prices m ay not necessarily be negativefor

steelm akers w ho can be sufficiently agile to benefit from falling

raw m aterial prices. H ow ever, historic trends suggest steelm akers

have not fully benefitted from dow nw ard m ovem ent: steel

prices have responded quickly. In the current environm ent of

surplus steel capacity, steelm akersability to pass through cost

escalations has been capped. O n the other hand, a relatively

m ore consolidated raw m aterials industry has been sw ifter in itsopportunistic reactions to dem andsupply im balances. H ence,

steel producers often face m argin squeeze w ithout any protection.

Steelm akers m ay enter into long-term supply agreem ents w ith

m iners, but prices are settled on an ongoing basis.

Steelm akers need to understand their exposure at every stage

of the value chain and im plem ent risk m anagem ent strategies to

efficiently m anage the exposure arising from the tim ing difference

betw een the selling price (of steel) and the purchasing price (of

raw m aterials). This delta im pacts a steelm akers profitability

w hich, in turn, im pacts investorsconfidence in the industry.

Increased price volatility also m akes it m ore difficult to predict

prices, thus im pacting capital projects and financing.

Financial inst ruments

Financial instrum ents have becom e an increasingly im portant

alternative strategy to m anage volatility in steel m arkets, w ith

the recent price setting m echanism m oving aw ay from fixed

contracts. The practice of using financial instrum ents to hedge

both raw m aterial and steel product price risks is not as prevalent

in steel m arkets as it is in other com m odity m arkets, such as base

m etals, oil and agricultural resources. Steelm akers, in general,

have yet to fully em brace the use of derivative instrum ents to

m anage volatile input costs, w hile they rem ain in inventory,

and assist custom ers with pricing certainty. They appear to be

concerned about a num ber of risks, including:

Price divergence risk:it is caused by the divergence betw eenphysical and derivative prices due to econom ic factors affecting

physical com m odities, even if a suitable derivative product is

available.

Basis risk:the financial contracts are for a certain specification

of steel and do not fully reflect the w ide variety of steel

products required by custom ers. The w ide product variety can

also lead to basis risk in steel derivatives, leading to a faulty

hedging strategy.

Liquidity risk:illiquid steel and raw m aterial contracts, unlike

other m ore m ature m arkets, m ake prices m ore prone to

speculation and thus do not fully reflect m arket conditions.

H ow ever, financial instrum ents are increasingly being adopted

by A sian steel producers, including Chinese and South Korean

steel m ills.

0

20

40

60

80

10 0

12 0

14 0

16 0

18 0

20 0

2007 2008 2009 2010 2011 2012 2013e

Iron ore prices Steel prices (H RC )

U

S$m

illion

Source: EY A nalysis; Thom son D atastream

18

Global steel 2014


22/44

26. The financialisationof ferrous m arkets,The Steel Index, 30 M ay 2 013.

27. Strategic insights from W SD January 2014,AIST w ebsite, w w w.aist.org/AIST/aist/AIST/Publications/w sd/14_jan_w sd.pdf, accessed on 28 Decem ber 2 013.

28.China iron ore futures debut briskly, back pricing clout push,Reuters, 18

O ctober 2013, http://w w w.reuters.com /article/20 13/10 /18 /china-ironore-futures-

idUS L3N 0I809 Z2 013 10 18, accessed on 21 Decem ber 20 13.

Iron ore derivatives rem ain the m ost traded and established of allferrous derivatives, w ith steel derivatives being m ost active at the

SH FE. The LM E billets are also w idely follow ed but have relatively

low er volum es than steel derivatives in the SH FE. Liquidity in

scrap derivatives is still building at a m oderate pace, w hereas

coking coal futures are very m uch in the early stage.26Liquidity

in steel derivatives is expected to pick up in the near term , w ith

the hedging of price risk for steel products and steelm akersraw

m aterials set to becom e an alm ost universal activity27by 2016 .

In O ctober 2013, Chinas DCE launched the countrys first iron ore

futures. Som e of Chinas largest steelm akers, such as Baosteel,

A ngang and Shagang, have already show n an interest in these

financial instrum ents.28Since derivative trading is inevitable to

gain m om entum , EY recom m ends that steelm akers:

Understand w hich m arkets and instrum ents are m ost

appropriate for their needs

Determ ine their required level of liquidity for participation

Consider how to m anage their business risks

Understand their risk appetite

Design and im plem ent appropriate governance processes

Decide w hat trading system to use

Have a strategy to access necessary skills

It can be argued that steelm akers are concerned that in a m oretransparent m arket, they m ay lose the pricing pow er of closed-

door price negotiations w ith their custom ers.23W e believe

steelm akersreluctance to accept derivatives are part of the price

evolution. That said, w e also believe the advent of derivatives is

inevitable and thatfirst m overs can take advantage of early stage

opportunities. For exam ple, w hen alum inium w as introduced on

the LM E, it faced sim ilar concerns, but today it is one of the m ost

heavily traded m etals on the LM E.

Steelm akersinitial concerns are being countered by their

custom ersopenness to derivatives. For exam ple, com panies

such as General M otors and Ford M otor Com pany have begun

to use derivative instrum ents as part of their m aterial sourcing

strategy.24

Data from CM E show s that participation in steel derivatives

m arkets is highest am ong m erchants, follow ed by end custom ers

and junior m iners that need to hedge to getfinance. Steel

m ills and m ajor m iners have am ong the low est derivative

adoption rates.25

Prevalence of steel and raw material financial instruments

The m arket has identified the opportunity of using derivatives

for steel and raw m aterials. A s a result, a num ber of hedging

instrum ents have com e into play in recent years, as show n in the

accom panying table.

23. Steel U sers Seek Futures,The Wall Street Jour nal,21 Septem ber 2011 , http://

online.w sj.com /new s/articles/SB 10 00 14 24 05 31 11 90 41 94 60 45 76 58 31 13 70 23 21

85 4, accessed on 2 0 D ecem ber 20 13.24. W hirlpool enters steel futures,SteelOrbis website, 12 M arch 2 01 0, http://

w w w.steelorbis.com /steel-new s/latest-new s/whirlpool-enters-steel-futures-

m arket-51 82 47 .htm , accessed on 21 Decem ber 20 13 .

25. Principal role of a com m odity futures exchange,CM E G roup, 2013.

Global steel 2014

19


23/44

Commodity GradeMarket

platformReference index

Region ofcommodity

delivery

Iron ore DCE Iron Ore Quality Standards

62% Fe Fines

62% Fe Fines

62% Fe Fines

62% Fe Fines

62% Fe Fines

DCE

ICE (O TC)

N Y M EX CM E

N Y M EX CM E

SG X

SM X

DCE settlem ent price

Platts iron ore 62% CFR China

Platts iron ore 62% CFR China

TSI iron ore 62% CFR China

TSI iron ore 62% CFR China

M B iron ore 62 % CFR Q ingdao

DCE w arehouse

CFR China

CFR China

CFR China

CFR China

CFR China

Coking coal A ustralian H CC m id vol

A ustralian prem ium H CC low vol

N Y M EX CM E

N Y M EX CM E

Platts

1) Platts 2) Argus

FO B A ustralia

FO B A ustralia

Steel scrap U S ferrous bushelingTurkish HM S im ports

NYM EX CM EN Y M EX CM E

AM M US M idwestPlatts

M idw est U SCFR Turkey

Steel G lobal B illet

Dom estic US H RC

Billet

Rebar

China dom estic rebar

China dom estic w ire rod

Ingot/Billet

Ingot/Billet

LM E

N Y M EX CM E

N Y M EX CM E

DGCX

SHFE

SHFE

NCDEX

M CX

LM E settlem ent price at expiry

CRU U S M idw est dom estic HRC index

Platts

DGCX settlem ent price at expiry

SH FE settlem ent price at expiry

SH FE settlem ent price at expiry

N CDEX settlem ent price at expiry

M CX settlem ent price at expiry

LM E warehouse

M idw est U S

FO B Black sea

Dubai

W arehouses in C hina

W arehouses in C hina

W arehouses in India

W arehouses in India

Variousfi

nancial instruments available in steel and raw materials

DCE: Dalian com m odity exchange; ICE: Intercontinental exchange; N YM EX : N ew York m ercantile exchan ge; SE: Singapore exchange; SM X: Singapore m ercantile exchange;

LM E: London m etal exchange; DGCX : Dubai gold and com m odity exchange; SH FE: Shanghai futures exchange; N CD EX : N ational Com m odity & Derivatives Exchange; M CX :

M ulti-com m odity exchange of India

Opportunity in volatility

A nother w ay steelm akers and steel consum ers can address volatility is through better collaboration and

com m unication. This w ould require steelm akers to becom e m ore custom er-focused and respond to their

custom ersdesire for price certainty from order to delivery. Steelm akers w ill need to know their custom ers

plans and requirem ents as w ell as their ow n inventory cycles and steel distribution strategy. A derivatives-

based strategy can allow producers to give pricing certainty to their custom ers and build out the cost of this

into the price quoted. This tool m ay indeed becom e a differentiator in attracting and retaining a long-term

custom er w ith a higher degree of m utual trust and confidence.

20

Global steel 2014


24/44

41621

41547

41426

41364

41244

41153

41061

40969

40878

40787

40695

40603

40513

40423

40333

40243

40153

40063

39973

Volum e - m t

SH FE rebar and w ire rod

0

20

40

60

80

10 0

0

5

10

15

20

25

4

1621

4

1547

4

1426

4

1364

4

1244

4

1153

4

1061

4

0969

4

0878

4

0787

4

0695

4

0603

4

0513

4

0423

4

0333

4

0243

4

0153

4

0063

3

9973

Volum e - m t

SG X Ironore swaps

Iron ore and rebar derivative volumes on Shanghai and Singapore exchanges

Source: SG X, SH FE, Thom sonOne

Based on estim ates by the W orld Steel Dynam ics (W SD ), in 2 013,

the traded derivatives volum e of SH FE rebars futures was m ore

than three tim es that of physical consum ption volum e. For other

m ajor global steel contracts such as the U S H RC and LM E billet

contracts the traded derivative volum es are low er than physical

consum ption volum es. The oldest of worlds m ajor steel contracts

the LM E steel billet futures has seen a sharp falling trend in

volum es over the past few years. This is due to a significant

reduction in the supply of steel billets used for physical delivery by

LM E in its m ajor delivery locations. The decreasing liquidity of the

LM E steel billet contracts has led to the CM E hot rolled coil futures

gaining popularity in recent years.33How ever, traded derivatives

volum e rem ains low as com pared to consum ption volum es,

indicating low developm ent of m arket and lim ited liquidity.

33. LM E M etal Inventory H ubs S ign al Steel Billet Contracts Dow nfall, M etalM iner,

http://agm etalm iner.com /20 12/12/07/lm e-m etal-inventory-hubs-signal-steel-billet-

contracts-dow nfall/, accessed on 7 February 20 14.

Title:?

Managing price divergence riskThe principle of hedging price risk w ith futures is based on the

assum ption that futures and spot prices converge since the price

of the derivative should be closely linked to the underlying price.

If prices diverge, the gain or loss in a futures position w ould fail

to offset any m ovem ent in the underlying cash position and the

hedge w ould be ineffective.

The chart below show s the price variation of CM Es Hot-Rolled

Coil (H RC) steel futures against that of physical H RC prices. W e

observe the tw o prices usually diverge rather than converge w iththe price difference in the range of -U S$75/tonne to +$75/tonne

(10% to +13%).

Tw o factors need to be considered in the price discovery process

of the futures:

The relative dom inance of the two m arkets, i.e., in w hich m arket

prices are first determ ined, as this influences price discovery in

the other m arket

The nature and extent of price divergence between the tw om arkets

These factors, or som e variants of them , can be estim ated using

various statistical m odels, such as G arbade and Silber, Gonzalo

and G ranger, Granger causality and the H asbrouck m odel.

Managing basis riskH edging w ith derivatives entails taking a position in a derivative

that w ill offset the price m ovem ent in the underlying com m odity

in the sam e tim e period. H ow ever, the price m ovem ents of the

tw o assets m ay not alw ays occur in this tim e period, especially

if there are m arket or geographic differences. H ence, tim e lag is

also an im portant factor that needs to be taken into account w hen

constructing a hedge.

Steel derivatives are not standardized like those of base m etals,

agricultural products or oil. H ence, a like-for-like derivative m aynot alw ays be available for hedging, m aking the use of a proxy to

hedge necessary. For exam ple, a steelm aker m ay not have an exact

steel derivative to hedge cold-rolled coil (CRC) steel price risk and

m ay have to use CM Es HRC contract, w hich is a related product.

This type of hedging is com m only know n as proxy hedging.

Proxy hedging exposes hedgers to basis risk. This risk can be

m inim ized by using a proxy w ith a high price correlation w ith the

physical com m odity and by m onitoring the correlation throughout

the hedging period to avoid unhedged exposures in case of a

correlation breakdow n. Therefore, regular rebalancing of the

hedge portfolio needs to be done dynam ically in case of

proxy hedging.

Managing liquidity r iskM arket liquidity ensures ease of buying and selling, efficient

price discovery and low er transaction costs. In the global steel

derivatives m arket, this liquidity is still evolving. Because steel

tends to have regional pricing and steel derivatives contracts

currently exist for only a few product m arkets.30

The accom panying graphs show an increasing trend in the

Singapore iron ore contract and a strong liquidity for rebar futures

on the Shanghai Futures Exchange (SH FE). U nsurprisingly, m ost

of the derivatives trading is taking place in China, the largest

producer and consum er of ferrous com m odities.

Daily volum es in excess of 2 m illion tonnes of iron ore are providing

am ple liquidity for m ost steel m ill purchasing. This increase in

liquidity w ill, in turn, attract greater volum es from the m ajor

suppliers w ho are w eary offlooding the derivatives m arkets.

Managing risks related tosteel derivatives

50 0

55 0

60 0

65 0

70 0

75 0

80 0

Jan-

12

A

pr-

12

Ju

l-12

O

ct-

12

Jan-

13

A

pr-

13

Ju

l-13

O

ct-

13

HRC steel futures HRC physical m arket price

U

S$/

M

T

29. H RC Steel Futures - US M idw est Dom estic H ot-Rolled C oil Steel Index Future, H RC

physical m arket price - H RC price of US carbon steel U S or CA origin short tonne

delivery M idw est w arehouse. 30. The financialisationof ferrous m arkets,The Steel Index, 30 M ay 2 013.

Price variation observed in steel market29

Source: Bloom berg

Global steel 2014

21


25/44

Vo

lum

e(

m

illiont

onne

s)

A

pr

09

Ju

l09

O

ct09

Jan

10

A

pr

10

Ju

l10

O

ct10

Jan

11

A

pr

11

Ju

l11

O

ct11

Jan

12

A

pr

12

Ju

l12

O

ct12

Jan

13

A

pr

13

Ju

l13

O

ct13

Jan

14

0

10

20

30

40

50

60

70

80

90

100SH FE rebar and w ire rod

0

5

10

15

20

25

A

pr

09

Ju

l09

O

ct09

Jan

10

A

pr

10

Ju

l10

O

ct10

Jan

11

A

pr

11

Ju

l11

O

ct11

Jan

12

A

pr

12

Ju

l12

O

ct12

Jan

13

A

pr

13

Ju

l13

O

ct13

Jan

14

Vo

lum

e(

m

illiont

onnes

)

SG X iron ore swaps

Iron ore and rebar derivative volumes on Shanghai and Singapore exchanges

Source: SG X, SH FE, Thom sonOne

O n the basis of estim ates by the W orld Steel Dynam ics (W SD), in

2013, the traded derivatives volum e of the SH FE rebars futures

w as m ore than three tim es that of physical consum ption volum e.

For other m ajor global steel contracts, such as the U S H RC and

LM E billet contracts, the traded derivative volum es are low er than

physical consum ption volum es. The w orlds oldest m ajor steel

contracts the LM E steel billet futures have seen a sharp falling

trend in volum es over the past few years. This is due to LM Es

significant reduction in the supply of steel billets used for physical

delivery in its m ajor delivery locations. The decreasing liquidity

of the LM E steel billet contracts has led to the CM E H RC futures

gaining popularity in recent years.31How ever, traded derivatives

volum e rem ains low as com pared w ith consum ption volum es,

indicating low m arket developm ent and lim ited liquidity.

31. LM E M etal Inventory H ubs S ignal Steel Billet Contracts Dow nfall,

MetalMiner website,http://agm etalm iner.com /20 12/12 /07 /lm e-m etal-inventory-

hubs-signal-steel-billet-contracts-dow nfall/, accessed on 7 February 2014.

22

Global steel 2014


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Preparing forfuture steeldemand

Steel demand andcompetitivenessGlobally, we see steel intensitystabilizing as developedmarkets mature and as Chinashifts its economy away frominfrastructure and towardconsumer-led economic growth.The steel intensity curve explainsthe long-term drivers for steeluse both over time and acrosscountries at a point in t ime. Thecurve of steel intensity showsthis decline in peak consumptionas economies mature to a morestable intensity. Chinas steelintensity is forecast to peak atabove 900 million tonnes perannum after 2020.

Countries or sectors m ay enjoy a tem porary boost depending

on econom ic conditions but w ill eventually m ature and stabilizein the long run. Stage 1 of the curve is the m ost steel intensive,

driven by construction and infrastructure dem and. In m any rapid-

grow th m arkets, w hich are still at the bottom of the steel intensity

curve, w e believe steel consum ption w ill continue to be driven

by the grow th of the construction and infrastructure sector in

those regions.

A s previously discussed, In the face of variable dem and, the

industrys flatter cost curve can be both a challenge, and an

opportunity. O ver the last few years, m any steelm akers have

focused on im proving their cost effectiveness, and as a result, the

com petitive landscape has changed. The larger steelm akers have

m ore opportunity to tap into other geographic m arkets, given the

low er freight rates, and several players have increased confidence

to do so.

In addition, steelm akers can increase their com petitiveness

through strong custom er relationships and by tapping into niche,

higher-value m arkets. H ow ever, the com petition in these high-

value steel segm ents is going to intensify as the m ajor players are

already using relationships they have built in these niche m arkets

to drive the continuum of value for their products.

Com m odity steel producers w ill struggle to survive as this

com petition intensifies. Producers with old technology and

high-cost production w ill be driven out of the m arket. In China,

this trend has the potential to transform the industry. Increasedconsolidation of production in the hands of the top producers

w ill bring about better cost m anagem ent, m ore ability to invest

in new technology and research and developm ent. It w ill enable

a stronger negotiation on prices w ith raw m aterial producers

and w ill rem ove distressed selling of steel below m arginal cost.

It w ill also increase the com petitiveness of the larger Chinese

players globally.

Global steel 2014

23


27/44

The survivors in todays steel m arket w ill have a better footprint in term s of

m arket access, a m ore efficient cost curve and better access to raw m aterials,

resulting in m ore efficient value chains. Increasing vertical integration of thesteel value

ey global steel 2014

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