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By John Helmer in Moscow

Russian steelmaker makes billion-dollar bid for Fortescue without explanation to the Russian market.

When Victor Rashnikov, owner of Magnitogorsk Metallurgical Combine (MMK), was in London in April, trying to persuade shareholders to buy up to 14% of his shares, he claimed that the steel mill, Russia’s largest, had secured its iron-ore requirements for the next decade, and the decade after that, from Kazakhstan, just 380 kilometres from the plant.

Rashnikov omitted to reveal that he had already spent $130 million buying shares in Fortescue Metals Group, developer of a large new iron-ore deposit in Western Australia’s Pilbara region, several thousand kms from MMK.

Last week, Rashnikov gave surprise notice — to Australia’s financial regulator, but not to MMK shareholders — that he is planning to spend up to another billion dollars on lifting his stake in Fortescue to about 16%. The buyout target, suggested by Australian reports, is a 9.9% shareholding in Fortescue currently owned by Leucadia National Corporation of the US. Rashnikov, the Australian regulatory disclosures revealed, already holds about 5.4% of Fortescue. Crossing the 15% shareholding barrier by a foreign investor requires Australian government permission.

MMK responded through spokesman Yelena Azovtseva that it is “premature to speak about concrete shares and the possibility of participation in this business, as no decisions and arrangements are present on this occasion.” There have been many occasions on which Azovtseva is the last person in the market to be informed by Rashnikov, when he has made his decisions and arrangements.

The explanation for what is going on doesn’t come from Rashnikov. He has never admitted publicly to buying into Fortescue at all, although the evidence suggests in retrospect that he started buying in the second half of 2006. On the contrary, Rashnikov’s recent statements, along with MMK’s strategy releases and investor briefings, emphasize a priority for MMK’s investment spending on domestic iron-ore, coking coal, and other local steelmaking operations. Security for iron-ore is described in these releases as based on domestic supplies — new Russian mines, plus long-term guarantees from Kazakhstan — not on foreign imports.

In Rashnikov’s London share sale prospectus, issued on April 6, 2007, share buyers were told that MMK’s capital expenditure plan to the year 2013 would cost $5.2 billion, with the lion’s share of the money allocated to domestic steelmaking.

In a detailed section on iron-ore supply security, the prospectus reported that the mill is currently consuming about 16 million tonnes of iron ore per year. 73% of the iron-ore requirement was identified from the Sokolovsko-Sarbaiskoye ore-treament combine (SSGPO, Sokolovka for short) in Kazakhstan. 89% of the pellet supplies are also from the same source.

SSGPO is the fourth largest iron-ore producer in Russia, Ukraine and Kazakhstan and has reserves of 3.4 billion tonnes or approximately 100 years at current annual mining rates of 31million tonnes of untreated ore. An attempt by SSGPO, in alliance with independent Russian iron-ore producer Alisher Usmanov, to divert high priced ore supplies to China, and cut off MMK, aborted in mid-2005, when the Kremlin intervened to slap down Usmanov’s ambition. Usmanov, it should also be noted, was also pursued by Andrew Forrest of Fortescue to buy into the Australian project, but Usmanov judged he had better uses for his cash (like spending $150 million buying into Arsenal Football Club in the UK!).

According to the MMK prospectus, the 10-year agreement MMK signed with SSGPO this past March commits about 144 million tonnes for a total contract value of $8.4 billion. That represents a unit price of about $58.33 per tonne. The prospectus assures that “the price payable under this contract is agreed annually on the basis of generally prevailing world FOB prices”. It conceded that “MMK remains exposed to the risk of fluctuations in the price of iron ore on the international markets.”

To hedge against that, Rashnikov claimed, through the prospectus and through his bankers, that directly owned iron-ore reserves MMK currently mines, or intends to mine, amount to 1.5 million tonnes per annum on a current basis; plus 3 million tonnes pa in mine development at present; plus another 5 million tonnes pa from a deposit on the Kursk magnetic anomaly in western Russia, expected to start production in 2013. For these new deposits and reserves, the prospectus reports that MMK had paid licence acquisition fees of less than $40 million. No capital expenditure estimate for the new mines was given.

Subsequently, on September 6, MMK announced it will build an ore-processing plant at the western deposit, known as Prioskolskoye, where it proposes to process 25 million tonnes a year of ore a year. Again, MMK omitted to give the planned cost of this plant. Industry analysts believe to be around $1 billion.

“They do not have an iron ore supply problem”, reported Rob Edwards of Renaissance Capital, one of MMK’s bookrunners in the April share sale.

Morgan Stanley and ABN Amro, other bankers to Rashnikov in London, claimed during the IPO that the SSGPO contracts are governed by UK law, making them even more watertight. MMK will never be threatened with iron ore supply interruptions again, Rashnikov’s men claimed.

The bankers also believed — or so they said at the time — that while MMK was not intending to acquire iron-ore producers at this stage in the iron-ore price cycle, because the asset prices were too high, MMK was accumulating domestic iron-ore licenses for development, if the need and the economics favoured the option.

So why was Rashnikov doing the opposite of what his bankers were claiming? And even if he could justify the profitability of a pure portfolio investment play in Fortescue at the time, why is he contemplating a billion-dollar investment in Australian iron ore, at premium price, now?

Market media have speculated that Rashnikov is aiming at Fortescue to ensure that the long-term price of iron-ore delivered to MMK doesn’t rise above the cost of the Pacific region product shipped out of Australia, and vice versa. The terms of the contract with SSGPO makes this pricing link inescapable, however. And if that’s the case, buying a shareholding stake costing up to billion dollars to hold the iron-ore price down, and lower Fortescue’s profitability to MMK’s advantage, seems an unlikely game — and an expensive one. No iron-ore imports have ever proved cost-effective for delivery to Russia from Australia (or Brazil). So, is Rashnikov betting MMK’s money on transferring its profitability to Fortescue dividends?

At just over 15%, Rashnikov has exposed his current intention, but the stake is too small to give him the management and strategic control of Fortescue he, and other Russian steelmakers, expect when they buy into an asset. If he seeks more than 20% of Fortescue, Rashnikov will be obliged by Australian market rules to make an offer for the remainder. The costs will balloon.

More likely, Rashnikov is buying overseas assets as a political hedge — assets which can preserve his wealth in the event that the Russian presidential election, due in six months, leads to a change in proprietorship in the Russian steel sector. Absoprtion of MMK by another Russian steel group, directed by the Kremlin, has been much rumoured; Rashnikov has been able to head off a variety of takeover plans for years.

But if he suspects that his ability to prevent the Kremlin curtain coming down on his domestic assets is waning, Rashnikov, not MMK, may be the ultimate beneficial owner of the Fortescue shares.

Last week, Rashnikov and MMK’s investor disclosures appeared at odds over another billion-dollar investment project, this one in the US. According to public statements from the company, repeated to Mineweb, MMK is looking at a greenfield site in the US state of Ohio for a new steel mill to produce 1.5 million tonnes per annum of specialty flat steel for automotive applications.

First word of the deal, which Rashnikov says would cost more than $1 billion, came in July, from an Ohio regional official, Lieutenant Governor Ted Strickland. Strickland had visited MMK, and met Rashnikov. Strickland told Ohio media that he was hopeful of drawing MMK into building the new plant in the state, and the Ohio development agency claimed MMK might make an announcement of the plan before year’s end.

MMK has been in talks with US promoters of investment plans before, but nothing has come to fruition. In July MMK refused to confirm the Strickland claims. Then last Thursday, MMK spokesman Yelena Azovtseva, said the location “now depends on how the negotiations will go. Based on their results, the decision will be made. One of the variants is Ohio State.” MMK experts have been in the state, and have selected a site. The reason for the publicity is that MMK is bidding for substantial tax and other incentives from the State. “The key to our positive decision,” Azovtseva said, “will be the packet of privileges and preferences which the US can give us.”

In July, Rashnikov had ignored the US when he said in an interview, published in Moscow, that MMK’s development priority is domestic, and that, offshore, the first greenfield project in line is a steelmill in Turkey. At the time, Rashnikov also issued criticism of Severstal for allowing its investments in North America to dilute the profitability of the group as a whole.

MMK’s spokesman was asked how the proposed auto sheet mill makes commercial sense. “If there were no commercial sense,” she said, “no-one would go there. The US is first of all, a territory of high prices; and second, we are planning to propose a unique product — steel with better quality specs, high-strength sheet.”

There was no clarification of why, two months ago, Rashnikov thought poorly of Severstal’s venture into the US automotive steel business through its acquisition of Rouge Steel in Michigan in 2003; and now is considering paying roughly five times the Rouge acquisition price to build a new plant in Ohio. Severstal’s purchase of the bankrupt Rouge was valued at $215 million. Steel analysts have noted that the plant has had an adverse impact on Severstal’s consolidated financial results ever since.

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