Edelweiss: Steel melting away

Moreover, any switch to alternate technologies of production of crude steel (e.g. using scrap) is not feasible in the short term, though some substitution effect will happen. Coking coal spot prices (at USD 330/tonne, down from the peak level of USD 390/tonne) have not moderated as much as other commodities. They are still above FY09 contract prices, giving us confidence that contract prices will not correct by more than 10% next year.

Iron ore and coking coal industries have strong pricing power Iron ore and coking coal have remained above demand destruction level, implied by the historic data since last four years, on account of the following reasons:

  • Consolidated nature of iron ore and coking coal industry.
  • Supply shortage due to slow capacity creep.
  • Supply disruption due to inclement weather.

While iron ore prices have remained beyond safety zone over the past four years and at times in past 25 years, coking coal prices have recently shot up much above the demand destruction point.

Iron ore not in ‘safety zone’ for past four years In 1981-86, global spend on iron ore was ~0.06-0.1% of global GDP, and then dropped down to 0.04-0.06% in 1987-2003. We consider 0.06% as safety zone for iron ore. However, prices have continued to rise thereon.

In 2008, spend on iron ore is expected to be 0.2% of the global GDP. However, due to major exposure of China to sea-borne iron ore market, we expect contract prices to moderate 25% next year, reaching a level of 0.14% of GDP. In CY10/FY11, we expect contract prices to decline by further 20%, to 0.12% of GDP.

Coking coal prices have far exceeded demand destruction level Since 1986, spend on coking coal has remained within 0.03-0.07% of the global GDP, on average. However, with 100% price increase in 2005, it went up to 0.14%, remaining broadly stable thereon. In 2008, with 200% price increase, the spending has however shot up to 0.46% of global GDP, far above the demand destruction level of 0.14%.

We expect coking coal prices to come off 10% in FY10E on fall in global steel consumption, and hence, lesser demand. It was recently reported that a major US producer has settled the majority of 2009 metallurgical coal contracts with buyers of domestic steel makers, at prices above the 2008 benchmark (USD 300 per metric tonne) for Australian hard coking coal. As per the report, low volatile premium coal settled ~USD 300/short tonne (USD 330/tonne) FOB mine. We, however, believe this to be more of an exception than rule, and expect contract prices to ease 10% in FY10. In CY10, we expect coking coal price to moderate 15% Y-o-Y as more supplies come up and demand declines in the developed world.

Global marginal cost for HR coil estimated at ~USD 825/tonne currently Since CY00, world revenue, cost and EBITDA per tonne has grown 6% Y-o-Y on average. Overall, steel players have been able to increase prices, passing on the rise in input costs. In the last four years, steel players have maintained EBITDA/tonne of USD 104-116/tonne on average, despite high cost pressures.

In CY08E, we expect EBITDA/tonne to come at USD 106/tonne, essentially unchanged from the USD 104/tonne level in CY07, due to average world revenue/tonne growing 28% Y-o-Y and average cost/tonne growing 31% Y-o-Y. We have analysed the cost escalation in three regions at the HR coil level – China, Europe, and the US, which together account for ~60% of the global production. The average operating cost of production (at EBITDA level) for HR coils in China, Europe, and the US is expected to be up 58% (to USD 650/tonne), 46% (to USD 789/tonne), and 43% (to USD 785/tonne), respectively, for CY08E. Marginal cost of production is higher, and we estimate it to be USD 825/tonne.

The HR coil cost curve for nearly 65% of the global production during CY00-08E. It is noteworthy that the increase in average operating cost (up to EBITDA level) from CY07 to CY08 is nearly the same as witnessed in CY01-07 across regions. For instance, the increase in HR coil cost in China from CY01-07 was USD 223/tonne. In CY08 alone, the increase is expected at USD 237/tonne.

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