A scrap over Ukraine's steel industry

By bne IntelliNews June 24, 2010

Graham Stack in Kyiv -

Ukraine's remaining independent steelmakers are being pushed to seek partners due to rising raw material costs, obsolete energy-intensive technologies, debts and the government's failure to refund VAT. Two forces are seen benefiting from this consolidation pressure: Ukraine's richest man and best-connected oligarch, Rinat Akhmetov, and the Kremlin. Clashes between these two main backers of Ukraine's new government over the future ownership of steel assets look increasingly likely.

Although steel prices have been soaring on the back of China's seemingly unstoppable boom, Ukraine's steelmakers are still reeling from a combination of factors.

First and foremost, while steel prices have picked up, the costs of raw materials for steel - iron ore and coking coal - have soared by far more, as China earlier this year became a net coal importer for the first time and also signed unprecedented high benchmark deals with the world's largest iron ore producers. Steel prices have dipped 20% since their March high, but not the costs of raw materials. "It could soon be the case that the cost of raw materials for steelmakers exceeds the price of the steel produced. This is what steel producers are most afraid of," says Yury Ryzhkov of Astrum Capital.

According to Ryzhkov, in the first quarter the losses of Ukrainian steel producers totaled $2.7bn, which was up 6% even on the disastrous first quarter of last year, when the global economy had sunk into an abyss.

With global demand for coal and iron ore at high levels, Ukrainian steelmakers who don't have their own source of raw materials aren't just under pricing pressure, but are also experiencing increasing difficulties getting their hands on the supplies they need. In fact, Ukraine's steel sector has experienced a chronic coke and coking coal shortage, which took a further turn for the worst after the tragic disaster at Russia's Raspadskaya mine, an important source. Such steel companies include MMK Ilyich, Alchevsk, Derzhinsk and Zaporizhstal. In contrast, ArcelorMittal Krivoi Rog, Ukraine's largest steel plant, receives guaranteed supplies from its parent, the world's largest steel group, ArcelorMittal. Azovstal and Enakievsk metal plant, the second and seventh largest respectively, likewise get in-house coke and iron ore from their parent, Rinat Akhmetov's Metinvest Holding.

Old fashioned

The huge rise in the price of Russian gas is also punishing Ukrainian steel producers. Ukrainian steel plants are struggling with hopelessly outdated energy-intensive technologies, such as grotesquely obsolete Martin open hearth furnaces, a 19th century technology long phased out internationally, but still producing around 40% of Ukraine's steel output. Steel producer debts to Ukraine's state-owned gas firm Naftogaz have thus been mounting, and Naftogaz has recently announced a reduction in gas supplies to MMK Ilyich, Derzhinsk and Alchevsk due to arrears.

However, Ukrainian steel producers who invested in new energy-saving technologies prior to the crisis are now saddled with massive debts following the devaluation of the local currency and the drying up of refinancing. Industrial Union of Donbass (IUD), formerly owner of the Alchevsk and Derzhinsk plants, is struggling under $3bn of debt after a modernisation programme, with $600m to pay in 2010. Donetskspetstal is currently fishing around for a $150m loan to phase out its remaining Martin furnaces - so far in vain.

Ukrainian steelmakers have also been hurt by the country's disastrous finances, which forced the state to help itself to an illegal 20% emergency tax on exporters by effectively refusing to refund VAT paid on exported goods, thus starving steel companies of working capital. VAT refund arrears are also seen as selective - politically well-connected companies are more likely to have got their VAT refunds, while in the case of foreign-owned AcelorMittal's Krivoi Rog plant, refund arrears have reached a staggering $300m; CEO Jean Jouet has accused the government of favoritism towards client oligarchs when it comes to reimbursement.

Kremlin vs Akhmetov

The combination of these factors means that standalone steel producers are looking increasingly vulnerable. And there are two big players eager to consolidate the sector.

One of those is the Kremlin, in the form of Russian state-owned banks in partnership with Russian oligarchs such as Roman Abramovich. A recently leaked document detailing Russian foreign policy goals across the globe listed the acquisition of controlling stakes in leading Ukrainian companies. Public attention initially focused on potential mergers between Russian and Ukrainian state-owned companies in energy and defence, but speculation about major Russian acquisitions in both metallurgy and finance have been mounting recently.

The Kremlin had been openly calling for Russian companies to expand abroad in the run-up to the economic crisis in 2008. However, the debts to Western banks they ran up doing so nearly proved disastrous when the credit crunch came. Ironically, now with company valuations at rock bottom, especially in Ukraine, this is a perfect time to buy - but crisis-struck Russian companies simply do not have the readies. So the Kremlin, in the person of state-owned banks, is putting up the money itself. Last year saw the near acquisition of global car producer Opel thanks to a monster Sberbank loan; there was also the successful acquisition of Germany's Wadan shipyards thanks to a VTB loan.

Moreover, at least one Russian mining and metallurgy firm - Roman Abramovich's Evraz Holding - already has a foot well in the door in Ukraine. Evraz acquired a number of coke producers in Ukraine in 2007, potentially giving it a base to consolidate standalone Ukrainian steel producers using funds from Russian state banks.

In addition, the Kremlin can count on goodwill within Ukraine's government: state-controlled bank VTB has just provided a $2bn bridge loan to help Ukraine plug its budget gap left by the delay in funding from the International Monetary Fund.

Competing with Russia is Rinat Akhmet, king among Ukrainian oligarchs and owner of metallurgical giant Metinvest, part of his System Capital Management group (SCM). Akhmetov runs a vertically-integrated metals holding, with in-house coal and iron ore producers insulating his steel producers against raw material shortages and price rises. Akhmetov's Metinvest is thus a prime candidate to consolidate the sector, and Akhmetov has accumulated a war-chest to do so, including $500m from a Eurobond issue and $1.5bn in dividends from his cash-rich iron ore plants.

Akhmetov can also easily match the Kremlin for political clout in Ukraine. He is a primary source of financing for the governing Party of Regions, a close associate of President Viktor Yanukovych and other top officials who likewise hail from Donetsk, and a member of the party's representation in the parliament.

Thus the consolidation in the steel sector pits Russia's clout from bankrolling Ukraine's government against Akhmetov's clout from bankrolling Yanukovych and his Party of Regions.

So now a shadowy behind-the-scenes race to consolidate the sector is being waged between Akhmetov and Russian interests around the last four large standalone steel plants: the Alchevsk and Derzhinsk plants owned by IUD, Zaporizhstal, and MMK Ilyich.

The situation with the IUD plants had seemed fairly clear-cut: Russian businessman Alexander Katunin, a co-founder of Evraz, bought a 50%-plus two share stake in the owner of the two plants from IUD, apparently taking a loan from Russia's state-owned development bank VEB to do so. However, in recent weeks it has started to look less straightforward, in particular the coal supply situation for the two plants, Derzhinsk and Alchesk, has seen a sharp deterioration rather than the expected improvement, and both plants have fallen in arrears with gas payments, indicating a behind-the-scene ownership struggle is continuing.

Then at the end of May, corporate conflicts broke out simultaneously around MMK Ilyich and Zaporizhstal. Metinvest looked certain to snap up Zaporizhstal, with reports circulating that the deal was already closed, when out of the blue anonymous Russian investors also with VEB funding swooped to snatch the plant from under Akhmetov's nose by outbidding him. But no less a person than President Yanukovych promptly informed the public on June 6 that the 50% Zaporizhstal stake has been frozen by a London court due to lawsuits brought by Ukrainian parties. To be continued...

Meanwhile, two previously low-profile Ukrainian businessmen announced to the press that they represented the new owners of MMK Ilyich, in their words a large Russian financial-industrial group that had purchased the company a year before. With the company's general director Volodmyr Boiko bitterly denying the sale, developments followed the classic pattern of a corporative raid: The "raiders" tried to exploit the company's anomalous and opaque self-ownership structure to effectively expropriate it from itself. But with government officials backing the company staying Ukrainian, Boiko switched surprisingly quickly from fighting for independence to contemplating a merger with Akhmetov's Metinvest as a purported white knight. On June 18, the company announced a rights issue that will increase its stock 3.7 times, and could facilitate a Metinvest acquisition. Metinvest supplied more than 70% of the company's iron ore and around 25% of its coke in 2009, according to analysts. Moreover, Metinvest's primary steel producer Azovstal is located in the same city of Mariupol as MMK Ilyich, and their merger has always been regarded as a natural development waiting to happen.

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