By John Helmer in Moscow
At current prices, old King Coal is a merry old soul in Russia.
In the bad old days, when Boris Yeltsin was in charge of Russia, all you had to do to acquire a steelmill on the cheap was to cut off its gas, electricity, iron-ore, scrap metal, or its coking coal. Adapting Honore de Balzac’s maxim just a little, behind every Russian steel fortune there is a raw material crime. Not because they had read Balzac, the Russian steelmakers came to understand that in order to protect their easily taken assets, they were obliged to insure and control their raw material supplies, especially iron-ore and coal.
The resulting interlocking shareholding schemes, by which most of Russia’s coal mines are controlled, and deter raiders, are very difficult to unravel. It’s a condition even PriceWaterhouseCoopers might call non-transparency. But that was in an economy recovering from the damage Yeltsin did to it. Today’s Russian GDP is growing at a rate of 7%, and while state policy can probably sustain that relatively comfortably, accelerating inflation rates pose problems that President Vladimir Putin was not threatened by. Official inflation is running at 1.2% per month, but the price of hot-rolled steel is up 25% over the past month; cold-rolled steel, 29%.
Will this force a slowdown in output of steel, and trigger worsening product inflation, deteriorating growth? In 2006, Russian steel consumption jumped 18%; the mills, which had excess capacity, lifted output by 7%. In 2007, consumption grew by 25%, against an output gain of just 3%. Sizeable volumes of imports from China, Turkey, and the Ukraine landed in the market to fill the gap. This year, industry experts are forecasting a slower rate of growth of demand, at 10%, while production is forecast to grow at 4%.
For the domestic supply and demand balance, much depends on the rate of state spending on infrastructure, and on the oil and gas companies for drilling and delivering by pipeline. In an early sign of how steelmakers are responding to their shrinking profit margins, the Russian pipemakers report cutting their output and shipments in the first quarter by about 10%.
The conditions have also prompted the pipemakers, on whom the oil, gas, water, and construction industries depend, to apply to the government for protection from these rising costs. Anti-dumping action against competing imports is being reviewed. A steel price-rigging inquiry has been started at the Federal Anti-Monopoly Service. As cost inflation transforms the industrial landscape, other, more draconian government measures are being considered, and not only for the pipemakers. One expedient is higher export duties or quotas to limit the outflow of steel scrap, and reduce its cost to the steel furnaces.
For the time being, all is quiet on the iron-ore and coal front.
Well, for control of costs, perhaps. But a revolutionary change is being considered for the ownership of the Metalloinvest group, Russia’s largest independent iron-ore producer, long associated in public with the name of Alisher Usmanov, but controlled behind the scenes, it is believed, by Gazprom. As Mineweb has already reported, Usmanov is being removed from his core business, and Metalloinvest faces absorption by Norilsk Nickel. The latest on this transaction will follow in a day or two.
But what of the second major ingredient in steelmaking — coking coal? Because of Russia’s significance as a global coal producer, and the way in which coal is tied to steel production ownership, the slightest change wrought by inflation at the consumption end of the steel production chain is about to transmit a shock or two to the coal-face. And that, in turn, is capable of transmitting a shock or two to the global price of coal in trade.
The Russian coal industry is the fifth largest in the world in terms of output, with 2007 production of 314 million tonnes of raw coal (China, US, India, and Australia lead, in that order). Russia also has the second largest coal reserves in the world (after the US), with a 17% share. The country produces both steaming (thermal) and coking coal, and it is self-sufficient in both types on the market for power companies, as well as for steel producers. In 2007, the production of steaming coal amounted to 242 million tonnes, while production of coking coal was at 72.5 million tonnes. Most of this coal is mined in the Kemerovo region of central Siberia, where high-quality coal grades and bedrock labour wages have generated extremely low production costs of $25 per tonne, or less.
As Mineweb has also reported, in order to hold down these costs and raise productivity, the mine proprietors disregard safety, and operate some of the most lethal mines in the world, excepting only China and the Ukraine.
Death is a hidden cost of Russian coal production. Rail freight is more obvious. Because of the distance between the Kemerovo mines and the ports on Russia’s western and eastern seaboards, rail transportation costs are relatively high for delivering coal to export. Nonetheless, export volume of coal last year was 97 million tonnes; that makes Russia the third largest coal exporter in the world (trailing Australia and Indonesia). There is a chance the Russian export volume could grow: when the price of coal goes up, the cost of transportation to port shrinks as a percentage of the overall price, and thus, the Russian commodity becomes more competitive in export markets, reinforced by the rising cost of sea freight for such export competitors as Australia, Indonesia and South Africa. As China turns from becoming a net exporter of coal to an importer, the advantage of price and proximity will reinforce Russia’s global advantage.
The potential availability of new coal reserves in Yakutia (Sakha), relatively close to the Asian export markets, is a reassurance to the country managers in Moscow that rising coal value in international trade will not deplete Russian domestic supplies, and threaten either the steelmakers and their customers (for coking coal), or the electricity generating companies (for steam coal). In the long term, if the Yakut deposits are brought on stream, that won’t happen. But politics and pricing are short-term affairs. If the concessionaires of Russian coal, like Abramovich (Evraz) and Zyuzin (Mechel) think of pocketing the extra share value and capitalization that come from exporting their coal surpluses, while the rest of the coal consuming market suffers, they risk losing their concessions altogether.
Mineweb has reported before on the nervousness of Zyuzin, one of two co-partners in the Mechel group, who decided to hang on to the group, while his longtime associate, Vladimir Iorikh sold out, and headed for Switzerland. For the past year, Zyuzin’s bet on staying put has been rewarded by the market. The New York listed Mechel stock is almost four times the value it was when Zyuzin bought Iorikh out for less than $2 billion. With a current market cap of $22.4 billion, Zyuzin’s stake is now worth about $16 billion. From the perspective of some in Moscow, that is a windfall, which Zyuzin has yet to earn, because he has not invested yet in bringing the coal to the surface.
The question that arises at the Kremlin is whether Zyuzin should be allowed to spin off the Mechel coal assets, and generate an even higher capital value for a new coal company than the assets enjoy inside the Mechel listing. Zyuzin has been negotiating for an answer to that question for months now. For the time being, he is Russia’s wealthiest coal holder.
He might have been challenged for the top spot by Andrei Melnichenko, once the controlling shareholder of the MDM group of companies, and currently co-proprietor of the Siberian Coal Energy Company (SUEK), which is Russia’s largest steam coal producer. It reports production of almost 90 million tonnes (as of 2006), and exports 24 million tonnes. The announcement two months ago of a takeover by Gazprom of SUEK omits capital and equity valuations for the assets to be contributed to what is also described as a joint venture; in time, according to the announcements, this is likely to be listed in London. Since SUEK is closely held by Melnichenko and his partner, Sergei Popov, the value of their stakes in the new company is also unclear.
Russian industry sources report, however, that for its stake of 50% less one share of the newco, SUEK has contributed all of its coal mines and power generating assets, previously valued in the market at up to $12 billion. For 50% plus one share, Gazprom has contributed assets valued independently in the market at about $5 billion. The venture’s announced capitalization is $11.5 billion. The discount Gazprom has obliged Melnichenko to concede, and SUEK to pay, is in the arithmetic.
Notwithstanding the fact that the prices of iron-ore and coking coal are rocketing upwards, Russian steelmakers are largely protected from the worst. The largest of the steel groups, Evraz, is 81% self-sufficient for iron-ore, and 168% self-sufficient for coking coal. The latter figure means that, through its coal mines, Evraz can sell coking coal that is surplus to its needs, on either the domestic or export markets. Severstal is 92% self-sufficient in iron-ore; 73% self-sufficient in coking coal. Novolipetsk Metallurgical Combine is 98% self-sufficient in iron-ore, and though it produces coke in abundance, until it can develop exploration assets into coal mines, it is entirely dependent on other suppliers for its coking coal. Mechel, a specialty steel producer, is 78% self-sufficient in iron-ore; 576% self-sufficient in coking coal. The abundance of coal assets is something the owner of Mechel, Igor Zyuzin, is currently thinking of spinning off as a separately listed shareholding company.
Magnitogorsk (MMK) Russia’s largest stand-alone steel mill, is relatively impoverished for raw materials, with just 20% self-sufficiency for iron-ore. This exposed Victor Rashnikov, MMK’s owner, to the most recent of the raw materials blockades and asset attacks; that came from Alisher Usmanov in the spring of 2005, it was beaten off with support from the Kremlin, and also ArcelorMittal. More recently, Rashnikov is hedging the rising price of his iron-ore supplies by holding a minority shareholding stake in the novice Australian producer, Fortescue Metals Group. FMG is much too far away to deliver iron-ore cost-effectively to MMK’s Siberian mill. But the rising profitability and market capitalization of FMG will offset MMK’s costs. MMK is also dependent on others for its coking coal, with just 15% self-sufficiency.
Steelmaking, iron-ore and coal are strategic in Russian resource policy terms, and it bears remembering how recent are the concessions for their privately owned development. The controlling stakes of Rashnikov (MMK), Zyuzin (Mechel), Abramov and Abramovich (Evraz), Vladimir Lisin (Novolipetsk), and Alexei Mordashov (Severstal) are barely older than a decade. How swiftly this could change is a sensitive point. Usmanov would have been counted one of the major steelmaking concessionaires until last month, when the putative takeover of his assets by Norilsk Nickel was first disclosed.
In a steady-state Russian economy, these concessionaires might relax. But not during a period of accelerating inflation, and political (presidential) transition. One pointer is that the Kremlin intends to designate state developers for fresh resource deposits. This week, it was disclosed that the state-owned diamond miner, Alrosa, has been awarded four iron-ore prospects for development, without a competitive bidding contest. The deposits in the Sakha region, Alrosa’s home base, are classified as holding about 3 billion tonnes of iron-ore.
The ownership of Russian coal leaves portfolio investors without direct access to most of the large producers. Even the latter are dwarfed by the market caps of the global miners – BHP Billiton, Rio Tinto, Xstrata, and Anglo American – or the biggest of the Chinese, China Shenhua Energy, and China Coal Energy, which have been lifted by bubble investing. Just two Russian coking coal companies are publicly listed, and accessible to the investor: Raspadskaya is 80% owned and controlled by Evraz, along with the Raspadskaya management, and has a 20% free float on the Russian market. Belon is 83% owned by a partnership of MMK and Andrei Dobrov, Belon’s founder and chief executive; its free float is just 17%.
Over the past year, Raspadskaya shares have traded between $2.19 and $7.75; they are currently at $8.90, off the year-to-date high of $9.25. In a recent report by Kirill Chuiko of UralSib Bank, this year’s target for the share price is fixed at $12, making an upside of 35%. Belon shares have traded between $37.50 and $180; it is currently at $158, having fallen from the February high of $180. According to Chuiko, there is still 22% upside to his target price for this year of $220. The hesitant trajectories suggest that the investor market is currently nervous about something.
In an initiating report for both, issued on April 14, by UBS in Moscow, analyst Denis Evstratenko proposed equal optimism for the coking coal sector, but less upside in his price targets — $10 for Raspadskaya; $190 for Belon.
However, in none of the recent brokerage reports on Raspadskaya and Belon is there any mention or warning of takeover risk, price regulation, or windfall tax penalties from the state. For the time being, the underlying fundamentals suggest no-one is pushing for this. At least, not while the domestic demand for coking coal is growing more slowly than mine output – 2% for demand per annum to 2011, compared to 7% for output. Since this should mean greater, not less flexibility to export, so long as export prices accelerate faster than domestic Russian prices, the miners’ Ebitda and profit should continue to grow, without attracting trouble. For the time being, domestic coking coal fetches a premium of 18% over exports; it is taking the domestic price at least three months to catch up with the global price.