Inflation & Pricing Strategies – Steel

Interview Transcript

Article | Inflation & Pricing Strategies – Steel
15th June 2021 Atheneum Team

Expert Profile




Tata Steel Europe


NK’s 30-year career in the Steel industry began with Tata Steel, starting as an account officer. As the VP and Group Head of M&A at Tata Steel India he was instrumental in developing the joint vision of Tata Steel – Corus Group. This eventually led to his role as CFO and Executive Director Finance at Tata Steel Europe where he leveraged his knowledge and experience in strategic finance for Tata Steel’s European operations.

Section 1: Input Cost Variability Strategies

1.1. What are the most price sensitive costs in the steel industry?

The steel business, the steel industry or pricing is predominantly dollar driven. If you look at the total steel production in the world, more than half of it is produced by China. So, of 1.6-1.7 billion tones produced 53% of that is produced in China. And, of course, the other countries, Japan, Korea, United States. So, the business is generally dollar denominated. Although, in UK you get UK prices, but it’s on dollar.

There are two key raw materials in steel, that are iron ore and coal which are traded internationally very widely and are also dollar denominated, all the prices are in dollar. So, steel is also an international, global commodity. So, it is something which almost globally comes in dollar denominated prices.

That is important as the local inflation has very little bearing because it has an impact more from a currency fluctuation perspective. In the UK, for example, if a pound weakens, then in terms of pound, the prices are bound to drop, and vice versa. So, the inflation CPI, or wholesale index doesn’t have much bearing. More than half of steel is produced in China. For raw materials, which is iron ore and coal, they are produced predominantly in Australia, Canada, United States, Russia, Ukraine, a little bit in Europe also in Sweden, Norway, and some in Africa. But, again, predominantly it is produced in these countries and it’s dollar denominated.

So, if the inflation goes up, for example in India or in emerging markets or even in Europe, that normally will not have any impact on that because Australia and Canada are the main producers. And Australia is the largest producer of both iron ore and coal. And other additives there are for alloys and metals, like zinc and nickel, etc., which are used, they also are mostly dollar denominated.

The dollar denominated inputs would be something like 50% of the total cost. And local cost will be, in Western world at least, employment costs, which will be more 20%; energy, which is electricity and gas, and then, a whole lot of other local costs, some of which could be in a local currency like maintenance and general administration excises. So clearly the revenue is influenced by dollar and at least 50% of the cost is influenced by dollar. That is why there’s another dimension here, which is the currency movement.

Both iron ore and coal are very volatile. Coal can go from $80 to $400 in a cycle. Similarly, iron ore also, although it has been much more elevated in the last couple of years. Brazil is a major producer of iron ore. So, iron ore is coming from Brazil, also because there was a Brazilian company, Vale, which is one of the largest producers of iron ore. There was an accident in their mine, about two, three years back. Since then, the prices have stayed very elevated. So, coal has been pretty low for the time being, at least for last several months. But iron ore has been elevated and high.

Iron ore seaborne trade is mostly for China. China uses a lot of iron ore, which it imports from Australia. Recently there is a shortage in supply from Australia because of political tensions. So, iron ore they produce maybe half of it within the country and half of it they import. Coal, or metallurgical coal, China produces. But Europe, Japan, Korea, they import all of their iron ore and all of their coal. Almost all of their iron all and almost all of their coal. And that is why the dollar equation, becomes important. So, if the dollar strengthens against Australian dollar, then that benefits Australian miners and vice versa, which may have some impact.

It is not a phenomenon. It is just influenced by inflation in general. So, unless you see a situation, which I anticipate potentially post-COVID, where there is a global surge in the inflation. Because inflation has been very benign in Western world in the last several years. And it has been also not as menacing, even in the emerging markets. It’s been high, but it’s not been as menacing as it used to be. But with this stimulus packages being given by most countries and all the focus on growth, there could be a scenario going forward where there will be maybe worldwide surge in inflations, which is what your note also mentioned that USA has seen some inflation last month and UK has seen some inflation last month.

1.1.1. Have these costs been rising? Why?

Yes, it has. It is a demand-supply kind of a situation. Supply got affected by the Vale mine, which was one of the largest producers. Since then, price has remained at elevated levels. Coal supply has been good. The coal price remains steady. If you map the iron ore prices and the metallurgical coal prices separately, then you will see coal has been relatively steady. But from historical highs, it is very, very low, compared to that. But iron ore, on the other hand, has been almost on an all-time high for last several months. So, it is not down to inflation per se or general inflation or CPI inflation, it’s much more because of the demand-supply situation. The prices also get impacted when demand-supply gets impacted, for example, because of the logistics of this option.

So, if there’s a big storm in Australia, in the Queensland area, then you’ll find that the coal prices will go up temporarily and then they surge because then there’s suddenly a supply shortage. And same as with iron ore, also, which at least it comes from Australia and Brazil and Canada and USA.

1.2. What are some of the current strategies that can be employed to manage this variability?

Multiple things are followed because no single authority can take care of all of it. Steel industry has another feature, its customers are consolidated. Steel industry is very fragmented. The largest steel player, ArcelorMittal, produces 6% of the world’s production. The next player is less than half of that so it’s a fragmented industry. As such, there’s not much bargaining power with customers, especially if the cycle is more than the month is.

Several things are done. One of them is, as currency is one of the features, so currency hedging is something every company does. But you can do only so much currency hedging because if, for example, the companies which will do the currency hedge for six months. So whatever honors they receive for the next six months, they will hedge the currency. The currency movement causes the movement in raw material costs, then to some extent, they will have hedged.

But that will be mostly companies doing it on the underlying the transactions. They don’t do speculative hedging, but they will anticipate what will be their inflow and outflow and, on that basis, they do the hedge.

One measure is to take the currency situation out of the equation. Each company or most companies do currency hedging. So at least if the input price is in dollars, but my revenues are in pounds in UK, then I’ll try to hedge so that I pay the same amount of pounds as I would be paying when I contracted, or when I received the material.

The second strategy which is done, which happens lots in some industries, they have cost escalation clauses. In the automotive industry, with some players, and in packaging steel, tin plate, in these two segments there are instances where the price is linked to the index for iron ore and coal. Or it could be for even CPI inflation. So, if the iron ore price goes up, the steel price is adjusted. If gold price goes up, it is adjusted. And same thing if it comes down. But this kind of a thing would be covering, maybe, 10% of the output. Or maybe not even that. It is much more prevalent in USA. So American customers are more amenable to having escalation clauses, but in Asia they are not so favorably inclined. Because volatility is quite high in raw material prices.

The third strategy which is done is that there are two types of contracting which is done for steel. One is long term contract, which is anything above six months and the price is fixed for six months or one year. But there’s also a fair bit of spot sales. Spot sales reacts to the volatility in the raw material prices. So, if today oil is selling 1,000 and if raw materials suddenly becomes more expensive, it will reflect in the spot prices.

Companies try to do a mix of long term pricing as well as spot pricing so that they get some benefit if the prices go up. Obviously, it works but there’s a downside to it also. So that, I would say, is the third thing.

An important one, which is becoming more important, which will be more relevant is a bit of a financial hedging for the commodities. Unlike zinc and nickel, which are traded in some other commodities, which are traded in LME, iron ore, coal, and steel historically was not traded, and they are now not traded. But in China and in Asia now there’s some liquidity in the iron ore hedging market.

Coal is still almost not available, but in iron ore there’s some availability. Some companies, I know, some companies in Europe, when they receive a contract, they hedge their iron ore prices. So, as I said, unlike zinc or nickel or silver, which are very high liquidity, liquidity is not so high. You can’t go, for example, hedge for 100 millions tons of iron ores or 20 million tons of iron ore. Maybe you’ll do fine with hedging opportunities for one million, two million. And then also the extended period.

1.3. How have these strategies changed in the last few years? How do you expect they will change?

Definitely one change which has happened is, and much more after the 2008 financial crisis, when there was massive volatility & prices crashed, was that there was more emphasis on trying to get the cost escalation clauses into the contracts. So that revenues are kind of linked with raw material price movements.

There’s going to be increasing focus, the buyers are not very keen, other than, as I said, in America and some automotive players and some packaging steel players. There’s an exchange in China, where you can hedge your iron ore. Coal, there are no opportunities so far, or limited opportunities. Iron ore has increased in size. You’ll see that the financial level, your questions are financial solutions. So, there are financial solutions. We’ll find more and more financial solutions coming.

The third thing which should be possible, but has not been possible in last seven years, is that if the steel industry can also contract with the suppliers on a fixed price for supplies. So currently, iron ore and coal both are on quarterly pricing. That means even if I have a contract for five years, this month’s supplies are based on this month’s prices in the market. I cannot fix the prices. The miners don’t take that. But if it is possible that steel companies can fix the prices with their suppliers of raw material, for say, one year, then that takes that volatility out of the equation. But mining companies are not being very favorably inclined towards that. But currently, it’s almost spot pricing for everyone.

Section 2: Inflation Management Strategies

2.1. Do you anticipate inflation impacting your industry? If so, how?

There are two or three things which I’m expecting will happen. First of all, we should understand that steel consumption is very directly linked to GDP growth. So, if the GDP doesn’t grow, if the world economy doesn’t grow, steel industry will not grow. So, it is very important to guess or anticipate what will happen with the global growth.

I’ve seen Western countries, they’re all ready with their stimulus packages, which will mean that UK GDP growth should very, very strong. Boris Johnson has been working strongly for new projects, etc. Which means GDP growth will be significant, or should be significant. If that happens, the steel industry will do well. So, inflation, if it happens, it should be able to take care of that.

Now, there is a catch here. Because of these stimulus packages, it is also possible that the inflation will also go up significantly. Now, if inflation goes up, and it goes up globally, the point that I mentioned at the beginning, instead of being an emerging economies phenomena, if it happens also in Western world, then the money supply will be constrained. And the moment that is done, that will pull down the growth. This is quite a complex situation. The stimulus should push up the GDP, but if that fuels inflation, then governments will tighten their economic policy, which will reduce the money supply and will reduce the growth.

My best guess scenario is if stimulus packages will be there, inflation will not run away. If that happens, then I don’t think steel industry is going to get very severely impacted, local coastal growth, and some more locations, especially in emerging markets. And steel industry will be able to recover all those.

2.1.1. Could inflation impact shareholder value?

Yes, it will impact shareholder value if inflation runs away all over the world, and as a result governments have to pull down their economic policies and make those as tight economic policies, austerity policy. It reduce growth, which will reduce GDP, which will reduce steel consumption. And then that will reduce the prices and profitability of steel industries.

2.2. What will be the pricing strategy in response to cost push inflation?

Currently, there are not many mechanisms. For the input costs, there could be some hedging. For the dollar denominated, currency related impact, there will be hedging. There will be some attempt to get escalation clauses in the contracts. That’s not going to be successful in the short timeframe of 2-5 years. If industry keeps putting on pressure, it may happen. Otherwise I don’t expect any significant increase in contracts which have escalation clauses.

Obviously, the hedging for the raw material, whatever can be done for the iron ore and coal, those are little things. I am not personally seeing any new thing emerging because they said both the customers as well as suppliers of steel industry are much more powerful, and they have much more bargaining power than steel industry itself. Even on the mining side it is very consolidated. Latest customers are consolidated. So, steel industry is caught in the middle within all this, very fragmented.

There’s one other ‘joker in the pack’ in this, and which is all the environment-related costs in Europe. Because that is something which is going to impact European companies much more than anyone else. Europe is not a big player in steel. Europe produces maybe 10% of the world’s steel. It is not a big player, but environmental cost, that will have impact outside of the normal costs. So, if there’s pressure on our alternative technologies, other than steel making or carbon capture and utilization and storage, or simply that emission tradings team EUA as prices go up and that it will shortfall. There’s already less and less availability of free allowances available to steel industry every year.

Currently, we are in ETS phase 4, which has started from 1st January. And freelancers are reducing every year. So, the steel industry will have to make investments in environment-related areas, and it will also have to pay additional costs, which, unfortunately, is not going to be the case with companies in China or India, I would even say, Japan or Korea. So that’s another angle, which will be impacting steel industry in Europe, perhaps more disproportionately than the other steel vendors.

2.3. How will changing prices impact your post Covid-19 recovery?

There are two main scenarios. One is stimulus by various countries. Like the UK is talking about the economic boom, being similar to what happened after World War II. Now, if that happens, there will be significant growth and significant demand for steel infrastructure creation, etc. And that will happen in most of these countries, which should push the demand for steel, prices, profitability. But if that does not happen, or if that causes high inflation, and as a result government has to contain that, then in that case, it will impact steel industry adversely.

So, I would say that one has to watch out for which scenario is going to play out. Is it going to be stimulus-backed, high growth scenario? Or is it going to be stimulus-driven, high growth scenario but leading to tighter economic policies and then reduction in growth?

2.4. What public policies/government support could help steel businesses with rising prices?

Within localized economies, I don’t see any significant intervention from the governments, other than China. In China, all of it is state owned. So, in China, government policy eventually determines how steel companies are running or not running.

The second group will be the countries which are not so obsessed with free economy, which are countries like India, Korea, Japan, etc., which may still want to help steel industry through the difficult phase. But specifically, I would say that one thing to help the steel industry is new infrastructure projects which increase the steel consumption, and which also increase the GDP as a result, demand for steel.

For example, in the UK, the Prime Minister has been talking about this high speed rail link, then cross rail, and then a third runway in Heathrow. So, all these projects, which have been lying dormant, if these infrastructure projects are launched, then steel consumption will go up directly and indirectly because of the growth in GDP. But I think expectation is that governments will do some support to the economy, which will help steel industry not directly, but indirectly. Direct intervention, I will say that other than maybe a little bit of a subsidy for taxes or maybe electricity, duties, etc., I don’t expect any significant support being received from government directly, especially in European context. It has not been there in the past, also. Because also of all the restrictions on state aid.