MILLENNIUM STEEL 2006 18 AUTHOR: Gilles Calis SteelConsult International After decades of poor financial results, the steel industry has realised a structural improvement in its financial performance. As shown in Figure 1.1, 2005 marked the fifth consecutive year of increasing profits, and the third consecutive year of record profits, for the steel industry. Even in Q3 2005, after significant declines in sales prices for finished products, combined earnings of the world’s top 67 listed steel mills were still double those generated during the previous cyclical peak in Q2 2000 (see Figure 1.2). This result is even more impressive in the light of the strong cost increases the steel industry has absorbed in recent years. From 2003, steel mills have had to accept double or triple digit price rises for most of their key input factors: iron ore, coking coal, coke, scrap and energy. As a result, the cost of steel production has surged. The global operating cost of HR coil, for example, has increased from an estimated US$175–250/tonne in 2002 to US$300–420/tonne in 2005. It is not only the average cost of steel production that has increased, but also the difference between high and low cost producers in the world. The cost of raw materials, labour and energy has always varied by region, depending on local availability of resources. Though the markets for iron ore and coal are global, and prices on the local market tend to follow those on the international market, producers in regions with abundant reserves usually have a strategic cost advantage over producers that need to source their supplies from overseas. A considerable number of mills in countries with large reserves of raw materials own part or all of their supply requirements. Examples include Severstal, NLMK and Evrazholding in Russia, CSN in Brazil, SAIL and Tisco in India, US Steel in the USA and several Mittal Steel plants in various parts of the world. Other mills in these countries that do not possess their own mining reserves at least have the benefit of not having to pay export tariffs and costs of seaborne freight. The unprecedented increases in the price of steelmaking input factors have had a major impact on the cost competitiveness of steel mills in different countries and regions. Figure 2 shows the average operating cost of HR coil in 2005, broken down into the main components of raw materials, labour and energy. At the top end of the range, with an estimated production cost of US$420/tonne of HR, are steel producers in Western Europe, Japan and North America, which face cost disadvantages in all three main cost areas. The lowest cost The steel industry has been confronted with unprecedented increases in prices of raw materials, freight and energy in recent years. As a result, the costs of steelmaking have risen around the world. However, the impact has not been equal for all steel manufacturers. Differences in regional cost competitiveness have become more pronounced, to the benefit of mills with access to cheap raw materials and energy. New competitive realities in steel r Figs.1.1/1.2 EBITDA global steel industry/EBITDA global steel industry, index (US$, Q1 2000=100)
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AUTHOR: Gilles CalisSteelConsult International
After decades of poor financial results, the steel industry hasrealised a structural improvement in its financialperformance. As shown in Figure 1.1, 2005 marked the fifthconsecutive year of increasing profits, and the thirdconsecutive year of record profits, for the steel industry. Evenin Q3 2005, after significant declines in sales prices forfinished products, combined earnings of the world’s top 67listed steel mills were still double those generated duringthe previous cyclical peak in Q2 2000 (see Figure 1.2).
This result is even more impressive in the light of thestrong cost increases the steel industry has absorbed inrecent years. From 2003, steel mills have had to acceptdouble or triple digit price rises for most of their key inputfactors: iron ore, coking coal, coke, scrap and energy. As aresult, the cost of steel production has surged. The global operating cost of HR coil, for example, hasincreased from an estimated US$175–250/tonne in2002 to US$300–420/tonne in 2005.
It is not only the average cost of steel production thathas increased, but also the difference between high andlow cost producers in the world. The cost of raw materials,labour and energy has always varied by region,
depending on local availability of resources. Though themarkets for iron ore and coal are global, and prices on thelocal market tend to follow those on the internationalmarket, producers in regions with abundant reservesusually have a strategic cost advantage over producersthat need to source their supplies from overseas. Aconsiderable number of mills in countries with largereserves of raw materials own part or all of their supplyrequirements. Examples include Severstal, NLMK andEvrazholding in Russia, CSN in Brazil, SAIL and Tisco inIndia, US Steel in the USA and several Mittal Steel plantsin various parts of the world. Other mills in thesecountries that do not possess their own mining reserves atleast have the benefit of not having to pay export tariffsand costs of seaborne freight.
The unprecedented increases in the price of steelmakinginput factors have had a major impact on the costcompetitiveness of steel mills in different countries andregions. Figure 2 shows the average operating cost of HRcoil in 2005, broken down into the main components ofraw materials, labour and energy. At the top end of therange, with an estimated production cost ofUS$420/tonne of HR, are steel producers in WesternEurope, Japan and North America, which face costdisadvantages in all three main cost areas. The lowest cost
The steel industry has been confronted with unprecedented increases in prices of raw materials,freight and energy in recent years. As a result, the costs of steelmaking have risen around the world.However, the impact has not been equal for all steel manufacturers. Differences in regional costcompetitiveness have become more pronounced, to the benefit of mills with access to cheap rawmaterials and energy.
New competitive realities in steel
r Figs.1.1/1.2 EBITDA global steel industry/EBITDA global steel industry, index (US$, Q1 2000=100)
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Much of the price increases mentioned above arecaused by a global imbalance between supply anddemand for raw materials and freight, which firstemerged in 2001. This is the result of the unexpectedlystrong economic development of China and severeshortages in raw materials production and transportationcapacity, not only in vessels, but also in railways andhandling and storage facilities.
With growth in Chinese steel production continuing atstrong levels and major capacity expansions for rawmaterials only expected to come on stream in2007/2008, raw materials prices and freight tariffs areprojected to remain high until at least 2007. In the longerterm, however, prices for iron ore and coking coal, are likelyto fall back closer to levels from the past. In principle, thereare sufficient reserves of these materials around the worldto feed future requirements for many more generations,even at strong continuing consumption growth. A certainpart of the price increase, however, is likely to provestructural, as additional production of iron ore and coalwill tend to be mined at higher average cost, from more
steel producers in the world are the Russian millswith an estimated cost price of someUS$300/tonne of HR. Russia is the only countryin the world where steel manufacturers benefitfrom cost advantages on all fronts: iron ore,coal/coke, scrap, labour and energy, though theadvantage of cheap iron ore is somewhat erodedby the generally long distances between minesand mills in Russia.
Brazil, India, South Africa and China are also highlycompetitive steel production locations, though not onall fronts. Brazil has vast reserves of high quality ironore, but needs to import coal and has higher labourcosts than some other emerging markets. India hascheap iron ore and labour, but needs to importconsiderable volumes of low ash coal to blend withits domestically available high ash material. SouthAfrica has iron ore and coal, but, like Brazil, hascomparatively high labour costs. China has cheapcoal and labour, but buys large volumes of highquality iron ore on the international market.
RAW MATERIALSRaw materials are the main cost differentiator inthe steel industry, today more than ever. As can beseen in Figure 3, the cost of raw materials pertonne of HR coil has more than doubled in allparts of the world between 2002 and 2005.Prices for iron ore were raised by 8.5% in 2003,17.4% in 2004 and a staggering 71.5% in 2005.Annual contract prices for coking coal increasedby 119% in 2005, average spot prices for cokerose almost threefold from 2002. However, raw materialscosts have surged not only because of higher market prices,but also because of surging freight costs (see Figure 4). Onaverage, tariffs for Cape size vessels, which are typicallyused to ship iron ore, were three times as high in 2005compared to 2002. Not only have seaborne freight tariffsincreased on average, but they have also become muchmore volatile, raising risk and uncertainty for the steelindustry. At their recent peaks, freight rates added up toUS$60/tonne to the cost of crude steel of mills importingraw materials from overseas. This has particularly affectedthe cost competitiveness of mills in Western Europe, NorthAmerica, Japan and to some extent China.
The rising costs of raw materials and freight have had twoeffects on the cost competitiveness of steel producers: First,they have increased the cost differentials between millswith captive supply of raw materials, mills with domesticaccess to raw materials and mills importing raw materialsfrom overseas. Second, as they have gained even more inweight, they have reduced the relative importance ofdifferentials in other steelmaking cost components.
r Fig.2 Operating cost HR coil by component. (Costs based on average of main integrated HR producers in each country/region)
r Fig.3 Costs of raw materials(Costs based on average of main integrated HR producers in each country/region)
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remote locations, requiring more transportation, and fromlower quality reserves, requiring more beneficiation. Likeraw materials, high tariffs for seaborne freight will attractmore supply, which will bring the market back to balance,though with a time lag of several years.
The differences in cost competitive-ness between millswith captive supply of raw materials, mills buying rawmaterials on the domestic market and mills importing rawmaterials from overseas are likely to regress in the yearsahead.
LABOURThough labour costs account for a much smaller share ofsteelmaking costs than raw materials, the price of labourvaries much more by region than prices for iron ore, coaland scrap. Of all countries with a significant steel industry,India, the Ukraine, China and Russia have the lowestwages. In 2005, hourly labour costs (in manufacturing)amounted to US$1.0 in India and the Ukraine, US$1.1 inChina and US$1.6 in Russia. By comparison, labour costs inthe developed economies of the USA and Japan stoodaround US$22/hr, while they amounted to US$33/hr inthe welfare state of Germany.
As the economies of China, India andRussia are expanding rapidly, the keyquestion is: How soon will wages catchup with those in mature markets?Indeed, forecasts by the EconomistIntelligence Unit (EIU) suggest thatlabour costs in these three countrieswill double in the next five years (seeFigure 5.1). However, as shown inFigure 5.2, the difference with wagesin mature countries is so large thateven a doubling of wages in the nearfuture will leave hourly labour costs inChina, India, and Russia at only afraction of those in mature economies.While wages in Germany, the USA andJapan increase much more slowly inrelative terms, they grow faster in$/hour terms, as they increase from amuch higher base.
In fact, it takes decades for labourcosts in developing economies to catchup with those in developed markets.This is illustrated in Figure 6.1, whichshows the labour costs in Euros/hr inGermany compared to Spain andIreland – two countries that have seenrapid economic development sincetheir accession to the EU. In 2004,
after 18 years of EU membership, hourly labour costs inthe Spanish manufacturing sector were still only 48% ofthose in Germany. Moreover, in $/hour terms, thedifference between the two countries has actuallywidened during the past 10 years. A similar trend can beseen in Asia (see Figure 6.2), where South Korean hourlylabour costs also stand at just 45% of those in Japan,despite years of economic stagnation in Japan and firmlong-term development in South Korea.
Low wages will remain a competitive advantage for steelproducers in developing countries for decades to come.Two of the world’s main steelmaking countries, China andIndia, have the additional advantage of holding hugeuntapped reserves of manpower in their agriculturalsectors. As urbanisation in both countries continues, newjob seekers from the countryside will provide labourmarkets with additional supply for many years, which willhave a dampening impact on wage inflation.
There is a downside, however. Most mills in countries withlow wages also have much lower labour productivity thanmills in high wage countries (see Figure 7.1), as they haveless incentive to increase labour efficiency. This explainswhy the differences in labour costs per tonne of steelbetween high and low wage economies are much lower
r Fig.4 Baltic Capesize & Panamax Indices
r Figs.5.1/5.2 Hourly labour costs manufacturing (US$)
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than the differences in wage levels. Toretain their competitiveness, steel millsin low wage countries need to ensurethat productivity keeps up with risingcosts of employment. Moreover, mills inlow wage countries have an opportunityto enhance their internationalcompetitiveness by improvingproductivity faster than rising US$ costsof employment. Figure 7.2 shows thedevelopment of labour productivity ofthe main steel mills in India and Russiafrom 1998. Although labourproductivity in India is still very low,Indian steel mills have madeconsiderable improvements in recentyears and employee productivity hasalmost doubled since 1998. However,so have hourly labour costs, which haveoffset much of the productivity gains.Russia’s steel industry has managed toraise labour productivity by 39% since1998, but costs of employment in US$terms have more than doubled in thesame period. While Indian labour costcompetitiveness has remained stable,Russian labour cost competitiveness hasactually worsened since 1998, despitethe productivity gains realised.
POSCO is an example of a companythat benefits from both low wages (in comparison tomature economies) and (very) high labour productivity.POSCO’s labour costs per tonne of steel are among thelowest in the world and are without doubt one of thefactors that have made the company the world’s mostprofitable steel mill, with EBITDA of US$7.4bn in 2005.
ENERGYCompared to raw materials and labour, energy has arelatively modest impact on the competitiveness ofintegrated mills. However, the days of cheap energy areover. Except for the energy released by coal and coke, thesteel industry’s energy consumption mainly consists ofnatural gas and electricity. Unlike iron ore and coal,reserves of natural gas are rapidly depleting: since 1980,global reserves have decreased by 26%. Meanwhile,consumption of gas continues to increase at an everaccelerating pace, especially in China and India. Three ofthe four regions that consume the most gas, NorthAmerica, Europe and Asia, have low reserves themselves.Indeed, at current production levels these three regionshave only enough gas reserves left for one or twogenerations (see Figures 8.1 and 8.2).
The situation is most pressing in North America, whichhas just 19 years of production left (at 2004 outputlevels). The increasing shortage has already made itself feltto gas-intensive industries in the USA and Mexico. Notonly are these industries competing for ever scarcer gassupply with one another, but also with electricity producersand commercial and residential consumers. Under pressurefrom high gas prices, several US (gas-based) DRI plantswere idled and recently relocated to areas with moreabundant gas, such as Trinidad & Tobago and the Middle-East. In Mexico, Mittal Steel Lazaro Cardenas and TerniumHylsa are regularly forced to interrupt their production ofDRI when gas prices have risen too high.
Most steel mills outside Russia and the Middle East willincreasingly have to rely on alternative – often moreexpensive – energy sources and on imported gas.International supply of natural gas is dominated by Russiaand Iran, which together hold 50% of the world’s identifiednatural gas reserves (see Figure 8.1). While oil is a globalmarket, gas is a much more regional market. Large scaleinternational transportation is limited to pipelines, whichrequire heavy investments and can be vulnerable tointerruption. The market for LNG is still in its infancy and
r Figs.6.1/6.2 Hourly labour costs manufacturing (Euros)/Hourly labour costsmanufacturing (US$)
r Figs.7.1/7.2 Manhours*/tonne of crude steel, 2004/Labour costs/productivity**,indexed (1998 = 100) (* Manhours based on total company, ** productivity defined as steeloutput per head, *** excludes A3S, **** excludes Aluminium and Distribution and Building Systems)
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even if expanded in the future, would lead to considerableadditional costs. Imported gas will remain considerably moreexpensive than domestic gas. In addition, prices are likely torise over time, as Russia and Iran will undoubtedly maximisetheir political and economic bargaining power as the world’smain suppliers of natural gas. In the longer term, the twocountries might well restrict exports to preserve their gassupplies for domestically based gas intensive industries andso maximise value added within their own borders.
The developments described above will have a numberof consequences for the steel industry:
` Steel producers located in energy rich countries willhave an increasing advantage over their competitorsin other countries. While the advantage may berelatively limited for integrated mills, it will be muchmore significant for DRI and EAF producers;
` Energy that is locked inside coal and is releasedthrough coke oven and BF gas will becomeincreasingly valuable;
` The BF/BOF route will become increasingly attractivevs the (gas based) DRI/EAF route in countrieswithout cheap gas and electricity.
To maintain their competitiveness, steel manufacturersshould seek to further reduce dependency on externalenergy by maximising energy efficiency and recycling.Although mills in Russia and the Middle East are likely toretain advantageous energy prices at least in the shortterm, in the longer term their governments could comeunder mounting political and economic pressure from theinternational community – and in Russia’s case the WTO– to reduce the use of dual pricing systems for domesticand export markets. In anticipation, mills in countries withcheap energy should also seek to improve the energyefficiency of their processes.
In addition to reducing their dependence on externalenergy, mills in countries with expensive energy shouldalso seek to manage their exposure to energy markets. An
innovative way of doing so is toestablish joint purchasing withcompanies in other energy-intensiveindustries, such as aluminium andchemicals, to increase bargainingpower over energy suppliers. In France,for example, large industrial consumersof energy co-operate intensively, whichenables them to secure advantageouscontracts. The French example wasrecently followed by Corus in TheNetherlands, which formed aconsortium with eight other largeDutch energy consumers with the
objective to secure better energy tariffs.
CONCLUSIONSThe differences between high and low cost producers ofsteel have increased since 2002, as strong price rises insteelmaking costs have had a varying impact on steel millsin different parts of the world. The winners are the mills inthe developing markets of Russia, Brazil and India. Theglobal supply/demand balance for raw materials hastightened, and will remain so in the short to medium termfuture. In the longer term, however, prices for raw materialsand freight tariffs will decrease from current exceptionallevels and the competitive advantage of mills with access tolocal raw materials will regress. To retain their current costcompetitiveness, steel producers in developing countrieswill also have to improve labour and energy cost efficiency.Low wages will remain a competitive advantage for mills inlow wage countries for decades, though this advantage isoften under utilised because of low labour productivity.
The large-scale capacity expansions planned in Chinaand India in the next few years present an excellentopportunity for mills in these countries to increaseproductivity while minimising social consequences. Energywill become an increasingly important cost differentiatorfor the steel industry, though, like low wages, itsadvantage is often not fully used by mills with cheapsupply. However, cost is not the only importantcompetitive differentiator. Mills in developing countrieswill also have to further increase investments in R&D,product quality, customer support and deliveryperformance. These criteria are particularly important inview of the continuing consolidation and globalisation ofthe steel industry and the increasing involvement ofleading steel mills in every corner of the world. MS
Gilles Calis is Managing Consultant, SteelConsultInternational, Amsterdam, The Netherlands
