International markets

Supply and demand

2007 was a successful year for the global steel and mining industries. The global economy was strong, recording robust 5.2% growth in real terms. This was to a large extent led by the continuing strength of the emerging economies: China, India, Brazil and, Severstal’s key local market, Russia.
A substantial increase in steel-intensive infrastructure and construction spending was driven by three key factors: strong macroeconomic fundamentals, rising foreign and domestic investments, and a long-standing need to upgrade infrastructure in emerging markets. The global economy was also sustained by high demand for automotive and machine goods.

In Europe, steel-intensive industries enjoyed a good year, while in the US the mortgage and real estate crisis did not have an immediate adverse effect on steel consumption. Despite a decline in residential construction, steel-intensive non-residential construction remained relatively strong, while American manufacturers benefited from a weaker US dollar. However, Steel output and demand in North America was relatively weak throughout the first half of 2007, starting to recover by the end of the year.

Overall, 2007 global steel production increased by 7.5% to over 1.34 billion tonnes. While steel production grew in absolute terms, actual growth rates decreased: in 2006 the rate of steel production growth was 9.1%.

Some analysts are forecasting a shortage of finished steel in 2008 due to a slowdown in Chinese exports and an increase in US imports at a time when global demand will remain strong. Global steel production, excluding China, was up by 3.3%, in line with the expectations of the industrial monitoring agency World Steel Dynamic, which said that the global steel demand will grow by 3.5% annually up to 2015.

The rapid rise in freight costs led to further regionalisation of steel demand and supply, effectively limiting the competitiveness of export sales. This has benefited companies from importing regions such as North America. At the same time, it has not had a significantly negative effect on the profitability of traditional exporters from the CIS and Latin America, due to the sharp increase in domestic demand.

In 2007, for the second consecutive year, China was the world’s leading steel-producer. This was due to Chinese capacity and production rising by 66 million tonnes, or 16%, in 2007 compared to 2006. Russia remained the world’s fifth largest steel producer in 2007, with 72.2 million tonnes of steel (2% growth).

Rates of capital outlay in the global steel industry remained high in 2007, reflecting a strong demand outlook and improved steel industry economics. Overall levels of investments per tonne were almost twice the average level attained in 2000–2003. However, a significant proportion of these capital investments went into reducing costs rather than into increasing capacity. With the exception of China, global capacity increases are not expected to outstrip demand until at least 2010.

Costs and prices

Cost inflation became a material issue for the global steel and mining industry during 2007. The commodity pricing boom and an improved investment climate over the last few years has facilitated a series of sharp rises in the financial inflows into the world’s emerging economies. This has in turn put pressure on domestic inflation and led to a substantial appreciation of local currencies.

The growing deficit of skilled labour was particularly acute in the mining industry given its huge greenfield and brownfield capacity expansions. Steel and mining equipment and spare parts prices also increased, reflecting rising global demand and limited production capacity.

Although raw materials contract prices increased only marginally around the world in 2007, the supply of raw materials was unable to catch up with surging demand in the second half of the year. As a result, spot raw materials prices increased substantially – in certain cases by as much as 70%–150% – compared with 2006 levels. Price increases were acute for all the major raw materials costs of steelmaking, including coking coal, coke, iron ore and steel scrap.

These price upgrades will be reflected in 2008 contract prices for iron ore and coal, contributing to a substantial increase in steelmaking costs in 2008. Price pressure from the raw materials market has highlighted the benefits of vertical integration and increased the level of strategic interest from steelmakers in upstream markets. Vertically integrated steelmakers like Severstal are therefore in a stronger position regarding raw materials prices than those buying their iron ore and coal on the open market.

Prices of hot-rolled flat metal products rose most steeply in Europe and Asia – growth of 15% in 2007. In Russia, prices grew by 7%, while in the US they fell by 9%.

Significant global price increases for long-rolled steel in 2007 were due both to increased demand, and the growth in prices for scrap metal. The rates of price increases were particularly steep in Russia where beams were up by 51%, fixtures by 29%, and rolled wire by 33%.

M&A and valuations

Global consolidation in the steel industry continued in 2007 as steel companies aimed to expand their geographic presence, consolidate supply, and gain access to new markets and customers.

M&A activity was particularly strong in North America where many of the remaining mid-sized companies were acquired by international majors from Europe and emerging markets. There was also a new trend: steel companies became increasingly interested in acquiring raw materials suppliers, including scrap collectors. For example, Nucor and Steel Dynamics, the two leading mini-mill steelmakers in North America, made substantial acquisitions of scrap companies operating in the US market. As further evidence of this trend, Severstal acquired Vtorchermet, a 1.1 million tonnes scrap collector in Russia.

Increases in iron ore, coking coal and other bulk materials prices have prompted more M&A activity in the mining sector. Many leading steel companies made self-sufficiency in raw materials a key strategic priority.

In this climate of continued consolidation, disciplined production behaviour and strong global demand for steel, the steel industry has benefited from increased attention from investors.

The average EV/EBITDA multiple for the major publicly-traded steel companies has increased from less than five in 2006 to just over six in 2007, reflecting increased investor confidence in the long-term sustainability of steelmakers’ earnings.

This increase in multiples was particularly strong for Russian, Latin American and Asian companies as historical discounts were eliminated and higher long-term demand growth rates justified higher valuation. For markets like Russia, with relatively few opportunities to invest directly in infrastructure growth, investments in steel companies were seen as the gateway to the infrastructure and construction boom.

Despite the recent consolidation activity, the steel industry remains much more fragmented than that of its suppliers (particularly iron ore), or its largest customers (such as automotive), or other metallurgic industries, such as Aluminium. Further takeovers, mergers and alliances are inevitable as producers look to integrate horizontally with other mills, and vertically with raw material suppliers and steel distributors, to secure their futures.

Severstal's position in the global industry

In 2007, according to the International Steel Statistics Bureau, Severstal became the world’s 15th largest steel producer by production volumes. Severstal’s Russian Steel division is Russia’s third largest steel company by volume of crude steel production (16.4%), and second in steel products distribution (17.9%).

On the Russian market, which remains the most important to us, we traditionally compete against NLMK and MMK in production and distribution of flat-rolled products.

In the construction, metalware and engineering industries, we compete with Evraz, Oskol Steel Mill and Mechel Steel Group in production and sales of long products. These companies, as well as Ukrainian enterprises, are our principal competitors on the export markets.