Credit Suisse: Overview of Steel Pipe Industry

A play on global oil capex Global order book strong for three years Pipeline capex is picking up after a few decades. 64 mn tonnes of new pipelines have been planned, which by itself would assure three years worth of orders for line pipe suppliers globally. 70% of new pipeline demand is expected to come from Asia, the Middle East and North America. The American Gas Association estimates 496,000 km of oil and gas pipeline was added in the US in the 1960s: we believe 85,000 km of this would need replacement – effectively adding another year of orders to the industry. Investment in pipelines is linked to global E&P capex, which is highly correlated to oil prices. Given Credit Suisse’s expectation of oil prices remaining at US$90/barrel for 2008-10, we believe pipeline demand will remain robust. We expect pipe manufacturers to be able to pass through raw material cost increases – margin accretive increases may be difficult at this stage.

Indian firms a good way to play global demand Of the ~6.5 mn tonnes of capacity being added globally over the next two years, Indian firms are adding 1.75 mn tonnes, or 27%. Capacity of Indian companies is expected to grow by 42% from FY08E to FY10E. Thus we view Indian companies as a good play on the expected surge in new pipeline demand, as well as pipeline replacement. 70% of planned capacity additions for Indian manufacturers is for HSAW pipes – a reflection of LSAW demand switching to HSAW due to persistently high wide-plate prices. While 19 mn tonnes of plate capacity are coming online and could potentially bring LSAW prices down, we believe demand will be strong enough to keep both LSAW and HSAW capacities well utilised.

Converters have limited downside Pipe manufacturers are basically converters: history suggests 8-12% as the normal range for EBITDA margins. Volumes and prices for raw material (plate/coil) and freight (together 90% of the cost) are tied up soon after the contract is signed with the customer. The quantum of this hedge varies by customer, and typically ranges from 60 to 100%. The risk of overcapacity is slightly lower, as breakeven utilisation is typically a low 20%. Current economics suggest a cash payback of six years for greenfield investment.

Stock picking and valuation We believe stock picking in the current scenario comes down to: 1) volume growth and 2) cost control by vertical integration. All Indian companies are adding capacity, but Welspun and Jindal SAW are expected to see an expansion in EBITDA margins as well. The expansion for Welspun is better quality – coming from vertical integration (plate capacity). Much of Jindal SAW’s margin growth comes from divestment of the US mills. The valuation excesses of the past few quarters have now corrected. Given the macroeconomic uncertainty, we do not expect an expansion in EV/EBITDA multiples, but do not expect them to contract as well, given significant EBITDA growth.

Industry risks: demand, not oversupply Given low breakeven utilisation, steady margins and a relatively short payback period, we believe overcapacity is less of a concern than a lack of demand. Pipeline projects being capital intensive, financing is critical – the disruption in credit markets and the correction in equities could delay projects, and though less likely, create a receivables risk as well. We also worry about incomplete pass through of costs (if the company is not fully hedged), and of potential pricing pressure on HSAW caused by plate capacity addition globally.

Global order book strong for three years Pipeline capex is picking up after a few decades. 64 mn tonnes of new pipelines have been planned, which by itself would assure three years worth of orders for line pipe suppliers globally. 70% of new pipeline demand is expected to come from Asia, the Middle East and North America. The American Gas Association estimates 496,000 km of oil and gas pipeline was added in the US in the 1960s: we believe 85,000 km of this would need replacement – effectively adding another year of orders to the industry. Investment in pipelines is linked to global E&P capex, which is highly correlated to oil prices. Given Credit Suisse’s expectation of oil prices remaining at US$90/barrel for 2008-10, we believe pipeline demand will remain robust. We expect pipe manufacturers to be able to pass through raw material cost increases – margin accretive increases may be difficult at this stage.

New projects assure a three-year order book We believe announced pipeline projects assure at least an order book of three years: 64 mn tonnes of new pipelines are being planned , when global CY10 capacity is expected to be ~21 mn tonnes. 70% of the new pipeline demand is expected to come from Asia, the Middle East and North America.

US replacement demand can add another year According to the American Gas Association (AGA), 496,000 km of oil and gas pipeline was added in the US in the 1960s. The probability of a gas pipe surviving more than 33 years (i.e. until now) is a low 15%, and the probability for oil pipes is only slightly higher at 38%. We therefore estimate that at least 85,000 km of pipeline will be up for replacement in the US. This by itself can generate 21 mn tonnes of pipe demand (rule of thumb: 1km = 250 tonnes) – i.e. another year of orders globally. This is currently not in our estimates, as timing the replacement is tricky, but this adds upside risk to our demand forecasts.

Every oil find needs a terrestrial network of pipes. Pipe demand is therefore linked to new exploration and finds. We note that global oil & gas E&P (exploration & production) capex follows the trend in oil prices . As it shows, investment is picking up after a three-decade lull. Even if the current speculative froth in crude were to come off, oil prices are expected to stabilise at levels much higher than in the past, supporting sustained high E&P capex. The Credit Suisse oil team forecasts WTI oil prices to be

US$90/barrel for 2008-10 and US$75/barrel beyond that. We, therefore, do not foresee any pressure on E&P capex, and by induction, on pipe demand.

Price increases to only offset costs Driven by strong demand and the increasing cost of raw materials, line pipe prices have increased by 70% in the past three years. Of this, 50% has happened in the past three quarters. We expect any further increases to be limited to offsetting the rising plate/coil costs. Plate prices have risen globally due to undersupply and a cost push from increasing iron ore and coking coal prices. Discussion with industry sources suggests margin accretive price increases may be difficult at this stage. We believe rising prices are already pressuring pipeline project budgets: 30-38% of project costs come from line pipes.

Strong volumes for Indian firms Of the ~6.5 mn tonnes of capacity being added globally over the next two years, Indian firms are adding 1.75 mn tonnes, or 27%. Capacity of Indian companies is expected to grow by 42% from FY08E to FY10E. India is thus a good play on the expected surge in pipeline demand. Some 70% of planned capacity additions for Indian manufacturers is for HSAW pipes – a reflection of LSAW demand switching to HSAW due to persistently high wide-plate prices. While 19 mn tonnes of plate capacity are coming online and could potentially bring LSAW prices down, we believe demand will be strong enough to keep both LSAW and HSAW capacities well utilised.

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