Oversupply in the Global Steel Sector Challenges and Opportunities DBS Asian Insights SECTOR BRIEFING 27 02

SECTOR BRIEFING number DBS Asian Insights DBS Group27 Research • July 2016 Oversupply in the Global Steel Sector Challenges and Opportunities DBS Asian Insights SECTOR BRIEFING 27 02

Oversupply in the Global Steel Sector Challenges and Opportunities

Eun Young Lee Equity Analyst DBS Group Research [email protected]

Addison Dai Equity Analyst DBS Vickers Securities (Hong Kong) [email protected]

Produced by: Asian Insights Office • DBS Group Research

go.dbs.com/research @dbsinsights [email protected]

Chien Yen Goh Editor-in-Chief Jean Chua Managing Editor Geraldine Tan Editor Martin Tacchi Art Director DBS Asian Insights SECTOR BRIEFING 27 03

05 Executive Summary Macro Outlook Challenges and Opportunities 09 Outlook for Steel Sector Supply and Demand Price Forecasts for Steel and Raw Materials Efficiency and Cost Analysis of Chinese Steel Mills World Steel Trade Flows Trade Conflicts on the Rise 24 Sifting Out Winners in Steel Sector Growing M&A Deals Post-Depression 30 Risks Abound in Current Landscape High Mortality Rate for Major Steel Companies Bumpy Road Ahead for China’s Steel Sector Reforms Pain of Rising Interest Rates 34 Findings From DBS Steel Survey 38 Appendix DBS Asian Insights SECTOR BRIEFING 27 04 DBS Asian Insights SECTOR BRIEFING 27 05

Executive Summary Macro Outlook

Demand outlook: Demand is stagnant. Since 1950, crude steel production has been growing 3.4% annually from 188 million tons to 1.62 billion tons in 2015. The sector experienced strong growth from 1950 to 1975; stagnancy from 1975 to 2000; and astronomical expansion led by strong demand growth in China from 2000 to 2014. We expect the global steel industry to enter a stagnant demand growth stage for the next 10-15 years. The rationale driving this outlook: i) Chinese steel demand and production might have already reached their peaks and are likely to stabilise or decline in the coming years; ii) there won’t be any economies to buffer the slowdown in China; and iii) major steel-consuming industries are also facing overcapacity issues or are expected to see lower growth. In the near term, the World Steel Association (WSA) expects that global finished steel consumption in 2016 is likely to reach 1.49 billion tons, a fall of 0.8% from 2015, on top of last year’s 3% drop from 2014. The key reason for the bearish forecast is the 4% contraction in Chinese consumption.

Supply outlook: Oversupply to persist despite restructuring efforts. Excess capacity in the global steel industry has increased significantly since the financial crisis. Despite slowing demand growth in the global market, there continue to be new investment projects in many parts of the world, especially China. According to the Organisation for Economic Co-operation and Development (OECD), the world’s steel-making capacity reached 2.32 billion tons in 2014, more than double the 1.06 billion ton capacity recorded in 2000. Furthermore, global steel-making capacity is expected to climb another 100 million tons to 2.42 billion tons in 2017, factoring in projects that are already underway. China and India, in particular, have the most aggressive expansion plans of 28 million tons and 31 million tons of new installations, respectively, accounting for 59% of the total increase. Steel mills will try to retain their production in the oversupply phase, as long as selling prices are above the cash cost, as this could reduce the fixed cost by increasing production – especially since the recent steel price hikes have prompted steel mills to restart their facilities. Hence, we project global production volume to be stagnant in 2016 and 2017, with the oversupplied volume to remain at 15 million tons. Following the addition of new capacity, the global utilisation ratio is expected to decline up to 66% in 2017. The exacerbation of global steel imbalances and declining utilisation continue to pose risks to the industry for the foreseeable future, unless more concerted efforts are made by the industry and governments to address the challenges.

We expect the global steel industry to enter a stagnant demand growth stage for the next 10-15 years DBS Asian Insights SECTOR BRIEFING 27 06

Price outlook: Rangebound prices following weak raw material prices and overcapacity. Dampened by oversupply, hot-rolled coil (HRC) benchmark prices for exports and domestic Chinese HRC prices have declined, on average, 32% and 29%, respectively, in 2015 compared to the previous year. The key reason for weak prices are China’s cheap exports, which have increased 2.6-fold in the last five years, with a whopping 50.4% and 19.8% growth in 2014 and 2015, respectively. China’s exports stood at 112.4 million tons in 2015, which was slightly lower than US steel consumption of 121 million tons. Also, weak iron ore and coking coal prices are another key reason for steel price weakness – of note, both sectors suffered from overcapacity on weak demand attributable to Chinese steel production’s decline. Despite the sluggish demand for raw materials, the major mines are reluctant to cut their production volumes as they aim to increase market share, leading to industry restructuring by competitors who are falling behind in the race. In 2016, we expect HRC benchmark prices to drop another 3.3% in view of the continuing global oversupply, which is mainly due to Chinese exports and weak iron ore prices in 2016 (a 12.5% on-year decline is expected). We expect steel prices to edge up following global steel demand growth, with more tangible restructuring measures from China in 2017. However the improvement is likely to be limited, as the excess capacity should hamper any sustainable price hikes. Challenges and Opportunities

Trade conflicts.Steel exports, mainly from China, and steel trade conflict cases have increased significantly the world over. The US has filed 14 anti-dumping and countervailing duties cases – the largest number of lawsuits from a single country. The European Union (EU) has filed 13 lawsuits against imported steel products and Asia has 22 cases of trade conflicts, with ASEAN countries and India filing the most number of such cases. At the same time, emerging countries that have relatively high World Trade Organisation (WTO)- bound rates have raised tariffs for steel imports.

Obstacles to China’s sector restructuring. Facing overcapacity, China’s government plans to cut excess steel capacity by 45 million tons this year and 150 million tons by 2020 – endorsed by the central government’s supply-side reforms. Earlier in 2016, the Ministry of Finance released a special subsidy fund amounting to 47 billion Chinese yuan to spur the capacity curtailment of the steel and coal industries. However, local governments are inclined to keep steel mills in operation, given their strong value-added tax (VAT) contributions (17% charged on revenue). Government subsidies for 24 listed companies surged 80% to 6.3 billion yuan or 24 yuan per ton on average. We deem local governments’ vested interests as the key challenge for steel capacity shutdown.

Interest rate hikes and currency depreciation. The probability of further interest-rate hikes in the US has fuelled concerns over a rising interest-rate environment for the global economy. This would lead to emerging-currency weakness, including the yuan against DBS Asian Insights SECTOR BRIEFING 27 07

the US dollar. A rising interest-rate environment should also increase the financial burden for steel mills in emerging countries by raising interest cost and increasing the repayment amount for US dollar-denominated debt. While exports from China will benefit from weak currencies in terms of price competitiveness, this will be offset by the higher cost of raw material imports and trade protectionism. Of note, 79% of iron ore requirements in China were imported from Australia and Brazil in 2015. Also, the growing protectionism in export markets will dampen the export price advantage arising from the yuan’s depreciation.

Last standing mills. We have ranked major global steel companies based on their financial information, reputation and information available in the steel market. The most respectable steel companies in the world are characterised by high economies of scale, exposure to growing markets and downstream industries, pricing power and less competition in their home markets, value-added products that harness tech innovations, cost competitiveness and profitability. US-based Nucor is the top ranking, followed by South Korea’s POSCO and Japan’s Nippon Steel. Even though it is not a perfectly objective observation, companies with high rankings have been registering more stable earnings than peers. The average shipment of the top 36 companies was 19 million tons and the size of a steel mill was a sufficient, but not a necessary, condition. The analysis suggests that Chinese steel companies need to improve their qualitative competiveness rather than quantitative growth. Chinese companies accounted for 24% of the top 50 makers in terms of size, but made up only 14% of the top 36 world-class steelmakers in 2015.

Mergers and acquisitions (M&As) – from restructuring to growth strategy. Before 1990, M&As among steel companies were engineered to increase scale amidst a growing need to restructure domestic steel industries. In 1990, Europe and the US became the starting point for full-scale M&As, peaking in 2006 to 2007 on the back of Mittal’s merger with Arcelor and Tata’s takeover of Corus. M&A deals tend to increase in business up-cycles with an accompanying uptrend in metal prices. This is obvious given M&A engagements are more affordable to undertake using equity and the valuation for deals would be higher during up-cycles. In 2015, the number and value of deals in the steel sector hit 321 cases and US$11.4 billion, representing declines of 4% and 32%, respectively. Due to the current down-cycle and companies’ cash burn rate, deals in 2016 will remain close to the levels seen in 2015. However, we expect some companies to divest assets that are not contributing to their enterprise value or to raise cash to avoid financial disruption. Also, there is a move away from the vertical integration pursued during good times.

The down-cycle has provided an opportunity for companies to review and redefine their core business. The reorganisation of the business could follow divestments and M&As. We expect the deal market to turn around in 2017, with 2015 and 2016 marking the trough. Steel sector deals contributed 29% and 45% of total metal sector deals, based on the deal values in 2014 and 2015, respectively. Geographically, metal sector transactions DBS Asian Insights SECTOR BRIEFING 27 08

in the Asia Pacific region, including steel, have grown continuously since the 2000s, contributing 68% of total metal deals in 2012 with a deal value of US$68 billion. This declined to US$5 billion in 2015, accounting for 46% of global metal deals.

Potential growth of overseas investment by Chinese mills. China has stepped up overseas investments of late, in a bid to make potential inroads into new markets to cope with rising global trade protectionism and in line with the government’s “One Belt, One Road” initiative. Small-scale plants are already operating in Vietnam, Malaysia, Indonesia, etc., mainly targeting long steel products consumed in the construction sector. These targeted areas have huge potential for demand growth, in light of the low self-sufficient steel production levels in ASEAN countries. The investment preference is skewed toward joint ventures rather than sole ventures. Chinese steel companies have announced a number of plans so far, but due to the current stagnation of the global steel industry and the deterioration in their financial condition, the investment process is expected to face delays.

China has stepped up overseas investments … to cope with rising global trade protectionism and in line with the government’s “One Belt, One Road” initiative DBS Asian Insights SECTOR BRIEFING 27 09

Outlook for Steel Sector

In 2015, global crude steel output slipped 2.8% on-year to 1.62 billion tons, which implies a 68.5% utilisation ratio based on the 2.44 billion tons of global capacity measured by the OECD. The global finished steel apparent consumption was 1.50 billion tons, a decline of 2.6% compared to the previous year. Of the total crude steel production volume, 74% is produced by blast oxygen furnace (BOF) and the other 26% by electric arc furnace (EAF). Flat and long products accounted for 46% and 52% of total steel products in 2014 respectively, with casting and forged products and semi-finished products, such as ingots, slabs and billets, accounting for the remainder.

Construction is the largest steel consuming sector. Long steel products such as railway, sections, rebars, and beams are consumed by the construction sector, which accounts for 50% of global steel consumption. Flat products are used in the transport (16% contribution), machinery (14% contribution) and other manufacturing industries.

Weaker bargaining power of steel sector compared to upstream. For iron ore, the production volume of the top four miners (Vale, Rio Tinto, BHP Billiton, and Fortescue) accounted for 53% of global production volume in 2015. China is the biggest supplier and consumer for metallurgical coal but the BHP Billiton Mitsubishi Alliance had 49% market share for seaborne coal in 2014. The top ten steel players’ share of global steel production was only 27% in 2015, which suggests the steel market is fragmented and close to perfect competition. Although the global overcapacity of iron ore and coal has weakened key players’ bargaining power in pricing, the steel sector has been the weak against the upstream. (Refer to Appendix A for global steel sector value chain.)

In China, crude steel output declined 2.1% on-year to 804 million tons in 2015 following robust output growth in the past decade. Chinese crude steel production registered a 12% compound annual growth rate (CAGR) from 2004-2014, with crude steel capacity utilisation hitting 73% in 2015 versus 77% the year before. Long steel and flat steel products accounted for around 50% of finished steel output in 2015. Around 94% of China’s crude steel output is produced by BOF and 6% by EAF. The country produced 246 million tons of iron concentrates in 2015, implying its crude steel output was 21% fed by domestic ore and 79% fed by imported ore. China’s 2015 coking coal output decreased 14% on-year to 483 million tons, implying the country’s self-sufficiency ratio for coking coal was around 90%. (Refer to Appendix B for China steel sector value chain.)

The steel market is fragmented and close to perfect competition DBS Asian Insights SECTOR BRIEFING 27 10

Supply and Demand Global Steel Sector Growth

Since 1950, crude steel production has been growing 3.4% annually from 188 million tons to 1.62 billion tons in 2015. (There is no data for steel demand for long time horizons; we think that production is the other side of demand). We have divided the last 65 years into three periods:

i) The first strong growth stage from 1950 to 1975, when global production grew 5% annually, driven by Europe, the former USSR and Japan’s economic growth. Japan’s contribution to global steel output, in particular, increased from 2% in 1950 to 11% in 1975.

ii) The stagnant period from 1975 to 2000 when global steel demand inched up 1.1% annually. Despite the strong growth in rising Asian economies such as Korea (11% annual growth rate), Taiwan (10.4%), Malaysia (8.9%) and China (6.5%), stagnant demand growth in Japan (0.6%) and demand decline in the former USSR (down 4.9%) after the end of the Cold War hindered the sector’s growth.

iii) The 2000 to 2015 period, when robust Chinese economic growth led to strong steel demand growth which, in turn, fuelled annual steel output growth of 13% and a super cycle for all commodities.

Diagram 1: Global crude steel production

Source: WSA, OECD, Platts, Bloomberg Finance L.P, DBS Bank DBS Asian Insights SECTOR BRIEFING 27 11

Long-term outlook: Entering low growth stage. We expect the global steel industry to enter the stagnant growth stage for the next 10-15 years. This outlook is driven by the following rationale: i) Chinese steel demand and production might have already reached their peaks and are likely to stabilise or decline in the coming years; ii) there won’t be any economies to buffer the negative growth of China; and iii) the major steel consuming industries are also facing overcapacity issues or are expected to decelerate in terms of growth. Global steel intensity (the amount of steel used to produce one unit of GDP) is likely to decline, as China’s steel intensity decline is expected to continue as its economy undergoes structural change. After three decades of extraordinary economic development, China is now shifting to a lower, but likely more sustainable, growth path.

The first stage of the curve – during an emerging economy’s rapid growth – is the most steel consumption intensive, driven largely by high levels of government investment that boosts construction and infrastructure demand in many rapid growth markets. In general, the steel intensity curve stabilises or starts to decline at around US$15,000-20,000 GDP per capita, as a country becomes more developed and urbanisation rates begin to decelerate. While China’s GDP per capita hasn’t reached the level of US$15,000, China’s steel consumption per capita is located at a much higher level than other economies at the same stage of economic development.

Diagram 2: China’s steel consumption and intensity to GDP

Diagram 1: Global crude steel production

Source: WSA, OECD, Platts, Bloomberg Finance L.P, DBS Bank

We expect the global steel industry to enter the stagnant growth stage for the next 10-15 years DBS Asian Insights SECTOR BRIEFING 27 12

Near-term outlook: Revising down forecasts. The WSA has cut its forecast for 2016 global steel consumption to a 0.8% on-year drop from 0.7%. Finished steel consumption this year is likely to reach 1.49 billion metric tons, a fall of 0.8% from 2015, on top of last year’s 3% drop from 2014. The key reason for the bearish forecast is the 4% contraction in Chinese consumption. Nonetheless, global steel consumption ex-China is expected to register 1.8% growth, backed by 1.7% growth in developed economies, and 1.8% growth in the emerging and developing countries excluding China.

The WSA forecasts that global steel demand will edge up by 0.4% to 1,494 million tons in 2017, as global consumption ex-China will grow 3%, mainly driven by Europe, North American Free Trade Agreement countries and the Middle East and North Africa (MENA). MENA’s demand growth, in particular, is expected to accelerate to 4.8% in 2017 from 3.2% in 2016. However, the WSA expects China’s steel demand to decline further by 3% in 2017.

Among the top ten biggest steel-consuming countries, India has been registering the strongest demand growth since 2015. The country is expected to register 5.4% annual demand growth from 2016 to 2017. We believe that the steel demand outlook for India is promising, as the country is now at the stage of high steel demand elasticity to GDP and is constructing national infrastructure on a massive scale. Diagram 3: Global steel demand forecasts million tons y-o-y growth rates, %

Regions 2014 2015 2016 2017 2014 2015 2016 2017 (f) (f) (f) (f) European Union (28) 149 153 155 158 5.0 2.8 1.4 1.7 Other Europe 37 40 41 43 0.1 8.1 3.0 3.1 CIS 56 50 46 48 -4.6 -10.8 -7.4 4.5 NAFTA 147 135 139 142 11.4 -8.4 3.2 2.5 Central and South America 49 45 43 44 -4.7 -7.3 -6.2 3.3 Africa 37 39 41 43 3.6 4.3 3.8 6.4 Middle East 54 53 54 56 4.5 -1.0 2.5 3.9 Asia and Oceania 1,018 985 969 959 -0.9 -3.3 -1.7 -1.0 World 1,546 1,500 1,488 1,494 0.7 -3.0 -0.8 0.4 Developed Economies 416 399 406 410 6.4 -4.0 1.7 1.1 Emerging and Developing Economies 1,132 1,101 1,082 1,083 -1.2 -2.7 -1.8 0.1 China 711 672 645 626 -3.3 -5.4 -4.0 -3.0 MENA 73 72 74 78 5.7 -0.6 3.2 4.8 Em. and Dev. Economies excl. China 420 429 436 457 2.6 2.0 1.8 4.8 World excl. China 836 828 842 868 4.5 -1.0 1.8 3.0

Source: WSA,DBS Bank DBS Asian Insights SECTOR BRIEFING 27 13

Diagram 4: Top ten steel-consuming countries

million tons y-o-y growth rates, %

2014 2015 2016 2017 2014 2015 2016 2017 (f) (f) (f) (f) China 710.7 672.3 645.4 626.1 -3.3 -5.4 -4.0 -3.0 United States 107.0 95.7 98.8 101.5 11.8 -10.6 3.2 2.7 India 76.1 79.5 83.8 88.3 3.1 4.5 5.4 5.4 Japan 67.6 62.9 64.4 63.6 3.7 -7.0 2.4 -1.2 South Korea 55.5 56.0 56.3 56.4 7.3 0.9 0.5 0.2 Russia 43.0 39.4 35.9 37.4 -0.7 -8.4 -8.9 4.2 Germany 39.6 39.0 40.5 39.9 3.7 -1.5 3.8 -1.5 Turkey 30.8 34.4 35.5 36.7 -1.8 11.7 3.2 3.4 Brazil 22.9 24.2 25.0 26.2 -8.6 5.8 3.3 4.8 Mexico 25.6 21.3 19.4 20.1 11.7 -16.7 -8.9 3.6

Source: WSA,DBS Bank

Global Capacity Development and Supply

Excess capacity in the global steel industry has increased significantly since the global financial crisis. Despite slowing demand growth in the global market, there continue to be new investment projects in many parts of the world, especially China. According to the OECD, the world’s steelmaking capacity reached 2.32 billion tons in 2014, which is more than twice the 1.06 billion ton capacity level in 2000. With continuing investment in projects, global steelmaking capacity is expected to climb a further 100 million tons to 2.42 billion tons in 2017. This projection has only factored in the projects already underway and global capacity will reach up to 2.72 billion tons when planned projects are constructed. The global steel demand slowdown will aggravate the global steel imbalance between demand and capacity in the near future.

China and India to lead capacity growth. Despite the fact that OECD countries are planning to reduce or retain their capacity, non-OECD countries are expected to increase their capacity by 71% in 2017 compared to 2014 – especially as China and India have the most aggressive new installation plans of 28 million tons and 31 million tons, respectively. This accounts for 59% of the total increase, while other Asian and Middle Eastern countries are constructing 13 million ton and 18 million ton capacities by 2017, respectively. DBS Asian Insights SECTOR BRIEFING 27 14

Diagram 5: Global steelmaking capacity forecasts

Source: WSA, OECD, DBS Bank Diagram 6: Global steelmaking capacity expansion plan

2014 2017 2017

(m ton) Underway Planned Low High OECD Europe 281 0 4 281 285 NAFTA 160 1 10 161 172 Asia 217 -1 1 216 217 Japan 131 -1 0 130 130 Korea 86 1 1 87 88 Sub total 670 0 21 669 690 Non-OECD Europe 8 0 0 8 8 CIS 147 4 10 151 160 Latin America 68 5 17 73 90 Africa 34 2 15 36 51 Middle East 58 18 34 76 110 Asia 1,338 72 256 1,409 1,666 China 1,140 28 13 1,168 1,181 India 108 31 207 139 346 Other Asia 90 13 36 103 139 Sub total 1,652 100 331 1,753 2,084 World total 2,322 100 352 2,422 2,774 Source: WSA, OECD, DBS Bank DBS Asian Insights SECTOR BRIEFING 27 15

Oversupply and low utilisation ratio to persist. Steel mills will try to retain their production cost in the oversupply phase, as long as selling prices are above cash prices, as they could reduce fixed costs by increasing production – especially as the steel price hikes in March and April prompted steel mills to restart their facilities. Hence, we project global production volume to be stagnant in 2016 to 2017, with the oversupplied volume to remain at 15 million tons. Following the addition of new capacity, the global utilisation ratio is expected to decline to 66% in 2017. The exacerbation of global steel imbalances and lower utilisation will continue to pose risks to the industry in the foreseeable future, unless more concerted efforts are made by the industry and government to address the challenges.

Diagram 7: Global steel demand and supply outlook

Source: WSA, OECD, Platts, Bloomberg Finance L.P, DBS Bank

Diagram 8: Global steel production and utilisation ratio

Source: WSA, OECD, Platts, Bloomberg Finance L.P, DBS Bank DBS Asian Insights SECTOR BRIEFING 27 16

China supply and demand outlook: China’s 2015 steel product consumption dropped 4.8% on-year to 668 million tons, mainly dragged down by weakened investment in the housing sector. The property and infrastructure segments account for an aggregate 60% of the country’s total steel consumption. The machinery and auto segments contribute 18% and 9% of steel consumption respectively.

In our view, Chinese steel product consumption peaked in 2014 at 702 million tons. We anticipate steel product consumption to be range-bound between 642 and 674 million tons in 2016 to 2020. Correspondingly, we believe China’s crude steel output peaked in 2014 at 813 million tons. We expect crude steel output to be range-bound between 765 and 796 million tons in 2016 to 2020, indicating a capacity utilisation of 74-78%.

Diagram 9: China crude steel capacity and utilisation forecasts till 2020

2008 2009 2010 2011 2012 2013 2014 2015 2016F 2017F 2018F 2019F 2020F

Steel: Capacity (mt) 634 670 740 910 990 1,040 1,055 1,100 1,080 1,064 1,038 1,008 978 Capacity 79% 85% 85% 75% 72% 74% 77% 73% 74% 74% 75% 77% 78% Utilisation rate (%) Crude steel 498 568 627 684 709 775 813 804 796 788 780 773 765 output (mt) Finished steel 579 689 799 878 955 1,067 1,117 1,123 1,115 1,098 1,085 1,072 1,060 (mt) Import (mt) 15 18 16 16 14 14 14 13 13 13 13 13 13 Export (mt) 59 25 43 49 56 62 94 113 95 92 91 90 89 Net export 44 7 26 34 42 48 79 100 82 79 78 77 76 (mt) Apparent 535 682 773 844 913 1,019 1,037 1,023 1,032 1,019 1,007 995 984 consumption (mt)

y-o-y growth: Crude steel 2.1% 14.1% 10.3% 9.2% 3.6% 9.2% 5.0% -2.1% -1.0% -1.0% -1.0% -1.0% -1.0% production Finished steel 3.4% 19.1% 15.9% 9.9% 8.8% 11.7% 4.7% 0.6% -0.8% -1.5% -1.2% -1.2% -1.1% production Net exports -3.9% -84.0% 272.7% 29.2% 24.9% 14.4% 64.6% 26.0% -17.9% -3.5% -1.6% -1.3% -1.3% Apparent 4.0% 27.5% 13.3% 9.2% 8.1% 11.6% 1.8% -1.3% 0.9% -1.3% -1.2% -1.2% -1.1% consumption

Source: China Metallurgical Industry Planning and Research Institute, Custeel, Mysteel, CEIC, DBS Vickers Note: *China’s statistics of steel-product has overlapping calculation of hot rolled coil and cold rolled coil steel output given hot rolled coil is a feed product for cold rolled coil steel DBS Asian Insights SECTOR BRIEFING 27 17

Price Forecasts for Steel and Raw Materials Steel Prices

Benchmark Chinese HRC prices for exports and domestic sales declined 32% and 29%, respectively, in 2015 on average from the previous year. This was attributable to oversupply and negative demand growth in China and a whopping 43% plunge in iron ore prices. China’s overcapacity has triggered the strong growth of exports in the region and dragged down regional steel product prices as well.

In 2016, we expect HRC benchmark prices to drop another 3.7% in view of the continuing global oversupply, which is mainly due to China exports; and weak iron ore prices (a 15.6% on-year decline is expected in 2016). However, we expect Chinese HRC export prices to grow 4.7% on-year in 2016, narrowing the gap with benchmark prices on the back of the recent strong domestic price rally.

Steel prices bottomed in January 2016 and registered strong growth in March. China’s domestic HRC prices increased 20% in March and rose further in April. However, a number of factors have seen steel prices turn downward since the beginning of May – the restocking process for middlemen and clients has ended; supply has increased with the restarting of idled plants in China and Commonwealth of Independent States (CIS) countries; and demand fundamentals are not likely to improve this year. We expect steel prices to remain volatile in the near-term before stabilising in the second half of 2016.

We expect steel We expect steel prices to edge up in 2017 following global steel demand growth on the back of more tangible restructuring measures from China. However, the improvements prices to edge are likely to be limited, as excess capacity should hamper any sustainable price hikes. up in 2017 Raw Material Prices

Iron prices rallied in March and April, backed by improved market psychology – even as more mills restarted their idled capacity, especially in China. However, after reaching a peak of US$70 a ton (China import iron ore fines 62% Fe, CFR Tianjin port), iron ore prices fell below US$50 a ton on June 20. We expect iron ore prices to decline further in 2016 but edge up in 2017.

The sizable new capacities planned at the peak have been started operations recently or will commence operations soon. Major producers added around 80 million tons in production to the market in 2015 and will add more than 90 million metric tons new capacity in 2016. Vale’s mammoth 90 million ton per annum S11D Carajas project will start up in the second half, pushing the company’s capacity to more than 400 million tons in 2016 and 459 million tons in 2019. Rio Tinto’s recent Pilbara expansion pushed DBS Asian Insights SECTOR BRIEFING 27 18

output to record levels in the 2015 third quarter as it moved closer to 350 million tons per annum capacity, with an eventual 360 million tons per annum targeted for 2017. BHP Billiton will increase volumes by 7% this financial year in Western Australia Iron Ore, as it works toward delivering annual production of 290 million tons, up from the current output of 247 million tons. The 55 million ton per year Roy Hill joint venture in the Pilbara has already come on stream.

Game of chicken bolstered by reduction in cash cost in the major mines. Cash cost reductions have been dramatic at the majors, mainly through automation and increased production scale. Rio Tinto reduced its cash cost to US$15.2 per ton in the second half of 2015, down from US$16.20 a ton in the first half of 2015 and US$20.40 a ton in 2014. Brazil’s Vale says significant cost cutting in the 2015 third quarter made it the lowest-cost company in the sector, reaching an unprecedented US$12.7 per ton for iron ore, down from US$15.8 per ton in the 2015 second quarter and US$22.5 per ton in the 2014 third quarter. According to BHP Billiton’s CEO, its unit cost had dropped to around US$15 per ton in the 2015 fourth quarter. Fortescue Metals Group, which has reached its capacity target of 165 million tons per annum, reduced cash costs from US$34.9 per wet metric ton in early-2014 to US$16.9 in the second half of 2015. The cost reduction was also driven by the drop in energy prices and depreciation Diagram 10: Price forecasts

(US$/ton) Iron ore Coking Coal Steel Prices

China import Iron Hard coking coal MB benchmark HRC China Export Ore Fines 62% prices Rebar FOB Main Fe spot China Port

2012 128 209 598 599 2013 135 151 566 524 2014 97 126 544 453 2015 56 103 370 321 2016F 49 95 358 337 2017F 57 100 370 350 % Chg y-o-y 2012 (23.4) (27.6) (15.1) (13.7) 2013 5.3 (27.9) (5.3) (12.5) 2014 (28.4) (16.7) (4.0) (13.4) 2015 (42.5) (18.0) (32.0) (29.1) 2016F (12.5) (7.7) (3.3) 4.7 2017F 15.9 5.3 3.5 4.0

Source: Platts, Bloomberg Finance L.P, DBS Bank DBS Asian Insights SECTOR BRIEFING 27 19

of currencies. The strengthened cost competitiveness in the major mines forces higher cost mines to leave the market. Sizable capacity has already exited the market and more mines are expected to close this year. Half of the closed mines were in China and other half in the rest of the world.

Efficiency and Cost Analysis of Chinese Steel Mills

We think the variation in competitiveness across Chinese steel mills lies in cost efficiency arising from geographic location and finance expenses. Our study of 24 A- and H-share listed companies shows that steel mills in East China and Northern China Hebei provinces outperformed the industry in terms of steel business gross profit margin, overhead cost and finance expenses. The steel mills in Southwest China underperformed on all three metrics.

Relatively speaking, East China possesses the advantages of solid management concepts as well as convenience in shipments of raw materials and finished steel products – as coastal provinces have long-term commitments to learn from foreign manufacturing enterprises and easy access to ports. As China’s top-producing province, North China Hebei has a relatively good marketing network. In contrast, the steel mills in Southwest China are inefficient mainly because of inconvenient logistics – due to the need to transport raw materials from coastal regions to inland Southwest steel mills and transport finished steel products from inland Southwest steel mills to coastal end-users.

Diagram 11: Comparison of gross profit margin, overhead cost, and finance expenses across H- and A-share listed steel companies in 2015

Region/province Company name Business nature GP margin (%) SG&A of sales Finance expenses of revenue (%) sales revenue (%) North China: Inner Mongolia Baotou Steel Local SOE -15.0% 5.8% 3.6% Hebei Hebei Iron & Steel Local SOE 13.1% 6.3% 6.1% Xinxing Ductile Central SOE 4.5% 3.6% 1.9% Iron Pipes Co. Shougang Local SOE 1.0% 7.4% 2.6% Shanxi Taigang Stainless Local SOE 4.5% 5.4% 2.4% Steel Average North 1.6% 5.7% 3.3% Northeast China: Liaoning Lingyuan Iron & Local SOE 3.0% 5.6% 3.2% Steel Bengang Steel Local SOE -2.1% 5.7% 3.6% Angang Steel Central SOE 5.8% 7.8% 2.6% Average 2.2% 6.4% 3.1% Northeast DBS Asian Insights SECTOR BRIEFING 27 20

East China: Jiangsu Shagang Private-owned 4.0% 4.0% -0.1% Nanjing Iron & Private-owned 2.5% 6.8% 3.2% Steel Fujian Sansteel Local SOE -4.7% 1.9% 1.7% MinGuang Shanghai Baosteel Central SOE 8.6% 5.8% 1.5% Shandong Shandong Iron Local SOE 2.1% 4.4% 3.0% & Steel Average East 2.5% 4.6% 1.9% South/Central: Guangdong SGIS Songshan Central SOE -12.6% 3.3% 6.6% Guangxi Liuzhou Local SOE 2.8% 4.3% 2.9% Iron&Steel Hunan Hunan Valin Local SOE 2.5% 5.6% 6.7% Steel Hubei Wuhan Iron & Central SOE -1.9% 6.7% 4.2% Steel Henan AnYang Iron & Local SOE 1.0% 4.8% 4.6% Steel Jiangxi Xinyu Iron & Local SOE 3.1% 3.2% 1.8% Steel Anhui Maanshan Iron Local SOE -1.3% 4.8% 1.8% & Steel Average South -0.9% 4.7% 4.1% and Central Southwest China: Sichuan Pangang Group Central SOE 9.3% 15.3% 9.9% Vanadium Titanium & Resources Co Chongqing Chongqing Iron Local SOE -25.9% 18.1% 15.1% & Steel Average -8.3% 16.7% 12.5% Southwest Northwest China: Gansu Gansu Jiu Steel Local SOE -0.8% 8.9% 3.0% Group Hongxing Iron & Steel Xinjiang XinJiang Ba Yi Iron Local SOE -10.0% 7.8% 4.3% & Steel Average -5.4% 8.4% 3.6% Northwest Average 24 -1.4% 7.7% 4.8% listco

Source: Companies, DBS Vickers DBS Asian Insights SECTOR BRIEFING 27 21

World Steel Trade Flows

The global steel trade volume has been growing 4.8% annually from 115 million tons in 1975 to 452 million tons in 2014, accounting for 29% of global steel production. In 2015, the steel trade volume is estimated to have increased more than 4% despite the 2.8% decline in steel production. The export-to-production ratio has fluctuated between 25% and 39% for the last 30 years and came in at 29.1% in 2014. In terms of product, HRC is the major trading product that contributed 18% of the total trading volume, followed by semi-finished products (12%), steel tube and fittings products (9%), and cold rolled coil (CRC, 8%).

The analysis of the global steel trading flow can be summarised as follows:

• The EU has been promoting intraregional trade for steel products, with intraregional trade accounting for 76% of steel exports.

• CIS countries are strong exporters to other regions, especially to the EU via exports of 53 million tons, or 75% of their total exports, in 2014.

• The biggest export country is China with an export volume 93 million tons, followed by Japan (41 million tons), and Korea (34 million tons). The biggest destination for these three countries’ exports is the rest of Asia, mainly ASEAN.

International specialisation of China and Korea. Interestingly, Korea is the largest export market for China and Japan as a single country despite being an active net exporter of steel. We think this is mainly due to the country’s lower level of protectionism for imported steel compared to other developed countries’, and the fact that Korea imports commercial grade steel products from China while exporting high-grade products to the rest of the world including the US. This could be deemed an international specialisation.

Trade Conflicts on the Rise

Stellar growth of China’s exports to increase trade conflicts.China’s overcapacity has led to strong growth in exports in the region. China’s exports have increased 2.6-fold in the last five years. China’s 2015 steel-product exports surged 20% on-year to 113 million tons in 2015, following a 51% spike in steel product exports in 2014. Exports stood at 113 million tons in 2015 which, was slightly lower than US steel consumption of 121 million tons. Of note, the US is the second-largest steel-consuming country in the world. After taking into account imports by China, its net exports came in at 99.6 million tons in 2015. Going forward, we expect China’s implied net exports (capacity consumption) to decline from the peak of 104 million tons in 2016, following the government’s effort to cut capacity. However, the absolute volume of overflow from China should pose a significant burden on regional steel prices. DBS Asian Insights SECTOR BRIEFING 27 22

Diagram 12: World steel trade flow

Exporting EU Other CIS NAFTA Other Africa China Japan Korea Other Oceania Total of which: Region (28) Europe America and Asia Imports extra- Middle regional Destination East imports* EU(28) 101.3 5.1 13.6 0.4 0.9 1.1 6.2 0.3 1.9 2.8 0.0 133.6 32.3

Other 9.7 0.7 5.8 0.0 0.3 0.1 1.3 0.3 0.7 0.4 0.0 19.3 18.6 Europe CIS 1.7 0.6 11.9 0.0 0.0 0.0 2.2 0.1 0.5 0.0 0.0 17.0 5.1

NAFTA 8.9 2.8 2.5 20.1 5.8 0.5 5.1 4.1 6.4 4.3 0.4 60.9 40.8

Other 1.5 1.4 2.5 1.9 2.6 0.1 8.8 1.2 0.1 2.2 0.0 22.3 19.7 America Africa 8.1 2.8 5.7 0.2 0.1 1.7 6.7 1.1 0.4 1.2 0.0 28.0 26.3

Middle 1.8 5.7 5.5 0.2 0.2 0.1 9.2 1.8 2.0 2.7 0.0 29.2 29.1 East China 1.5 0.0 0.1 0.1 0.1 0.0 6.2 5.0 2.0 0.0 15.0 15.0

Japan 0.1 0.0 0.0 0.0 0.0 0.0 1.6 4.3 0.7 0.0 6.7 6.7

Korea 0.8 0.3 1.9 1.8 0.0 0.4 14.8 11.2 2.2 0.0 33.4 33.4

Other 2.9 0.1 3.5 0.4 1.2 0.7 36.4 14.7 12.5 9.5 0.2 82.1 72.6 Asia Oceania 0.2 0.0 0.0 0.0 0.0 0.1 0.7 0.3 0.0 2.6 0.3 4.2 3.9 Total 138.5 19.5 52.8 23.5 11.3 4.9 92.9 41.3 33.7 30.7 1.0 451.7 287.0 Exports of which 37.1 18.8 40.9 3.4 8.7 3.0 92.9 41.3 33.7 21.2 0.7 301.7 : extra regional exports* Net 4.7 0.1 35.7 -37.5 -11.1 -52.1 78.0 34.7 0.3 -42.0 -3.3 Exports (exports- *Excluding intra regional trade marked imports) Source: WSA, DBS Bank

In 2015, Southeast Asia (mainly Vietnam, the Philippines, Indonesia, and Thailand), Korea, India, Singapore, and Japan accounted for 31%, 12%, 4%, 2.9%, and 1.2% of China’s total exports, respectively. Europe and the US accounted for 8.5% and 2.2% of China’s total exports, respectively. Exports hit a historical record high in 2015 due to cheap export prices. In 2015, we estimate China’s HRC CFR export price of US$355 per ton is US$50-70 per ton cheaper than the Europe ex-work price and US$70 per ton lower than the US import price. About 12% of DBS Asian Insights SECTOR BRIEFING 27 23

Diagram 13: China’s net exports (top) and implied net exports (below)

Source: CEIC, DBS Bank

exports from China went to Korea in 2015, representing around 20% of Korea’s consumption. Among ASEAN nations, Vietnam is the second largest export destination, accounting for 9% of exports. This clearly shows that steel companies’ earnings have been dampened by the poor Following the profitability of cheap Chinese steel imports and the gloomy outlook bodes ill for any earnings increase in steel improvement. exports mainly Following the increase in steel exports mainly from China, steel trade conflict cases have surged from China, steel all over the world. The US has filed 14 cases for anti-dumping and countervailing duties, making trade conflict it the largest single-country complainant. The EU has also filed 13 lawsuits against imported cases have surged steel products and Asia has 22 cases of trade conflict cases, with ASEAN countries and India all over the world filing the most number of such cases. Emerging countries that have relatively high WTO-bound rates have raised tariffs for steel imports. DBS Asian Insights SECTOR BRIEFING 27 24

Sifting Out Winners in Steel Sector

We have ranked the major global steel companies based on their financial information and reputation and information available in the steel market. The purpose of this exercise is to gain a better understanding of the steel companies’ attributes rather than to imply that one company is better than another. However, the factors for evaluation could illustrate the characteristics a respectable global steel company should have. We could summarise the key characteristics as follows:

• Economic scale in terms of size (10%) • Exposure to growing markets and downstream industries (10%) • Pricing power and less competition in the home market (12%) • Value-added products that harness tech innovations (10%) • Cost competitiveness and profitability (20%) • Management’s capability in the areas of growth strategy (10%) • Financial soundness (10%) • Skilled labour and labour cost (10%) • Eco-friendly production process (8%)

Nucor, POSCO and Nippon Steel have high rankings. Nucor in the US has top ranking, while South Korea’s POSCO and Japan’s Nippon Steel also rank highly. Though it is not a perfectly objective observation, the companies with high rankings have been registering more stable earnings than peers. The average shipment of the top 36 companies is 19 million tons, and the size of a steel mill is a sufficient, but not necessary, condition.

Diagram 14: World-class steelmakers’ ranking (2015)

Source: WSA, OECD, Platts, Bloomberg Finance L.P, DBS Bank DBS Asian Insights SECTOR BRIEFING 27 25

China steel companies need to improve The comparison of the score distribution of the companies among the top 50 players in more on their terms of shipment volume and the top 36 world-class steelmakers suggests that Chinese qualitative steel companies need to improve more on their qualitative aspects rather than quantitative aspects rather factors. Chinese steel companies accounted for 24% of the top 50 makers in terms of size, than quantitative while making up only 14% of the top 36 world-class steelmakers in 2015. In the case of India, the country contributed only 3% of the global volume but its steel players made up factors 17% of the top world-class steelmakers in 2015. This is attributable to the strong growth potential of the home market, cost advantages arising from competitive labour cost, and availability of iron ore mines.

Diagram 15: World-class steelmakers’ ranking (2015) Top 50 companies’ shipment volume Top 36 companies for world-class steelmaker

# of companies Share # of companies Share Asia 32 32% Asia 16 44% China 24 24% China 5 14% Japan 2 2% India 6 17% India 3 3% Japan 2 6% Korea 2 2% Korea 2 6% EU 3 3% EU 5 14% Russia 4 4% Russia 4 11% USA 3 3% Brazil 2 6% Brazil 1 1% USA 3 8% Others 8 16% Others 7 19% Total 50 100% Total 36 100%

Source: WSA, OECD, Platts, Bloomberg Finance L.P, DBS Bank

Before 1990, M&As among steel companies were engineered to increase the scale of steel companies amid the growing need to restructure domestic steel industries. In the 1990s, steelmakers in Western Europe carried out M&As to deal with the supply glut after breakup of the Soviet Union. Riva Group was the first to spark full-scale M&As among large-scale European steelmakers in 1995.

M&As a strategic option to reinforce competitiveness. The consolidation of European steel companies from the end of the 1990s through 2000 began to transcend national borders. A good case in point is the birth of Corus and Arcelor. They took into account the synergetic effects from the expanded scale of downstream/upstream or duplicate operations, indicating that M&A activities evolved into a corporate strategy, not a mere restructuring tactic.

Preemptive and voluntarily M&As in Japan. In the past, Japan experienced oversupply pains for an extended period of time. In response, the country’s steel players established a DBS Asian Insights SECTOR BRIEFING 27 26

cooperative custom of production cuts to support the sector’s sustainability. The country has seen voluntary mergers between steel companies to enhance competence levels. In 2001, JFE emerged as an integrated steel company with a 29 million ton capacity via the merger of two companies, Kawasaki steel and NKK. In 2011, Nippon Steel announced plans to merge with Sumitomo Metal Industries. With Nippon Steel producing 26.5 million tons of steel per year and Sumitomo making 11 million tons, the merged entity would produce close to 37 million tons of crude steel per year. In February 2016, it was reported that Japan’s top steelmaker, Nippon Steel & Sumitomo Metal, plans to buy the world’s fourth-biggest player Nisshin Steel. Nisshin Steel is considering closing a blast furnace at its Kure Works in Hiroshima Prefecture as part of its consolidation.

M&As transcend geographical boundaries for integration with upstream operations. Consolidation through M&As is now actively occurring in the global steel industry as a corporate strategy rather than the restructuring tactic of the mid-2000s. In our view, this stems from the free cash flow generated by the intrinsic qualities of the steel industry, the oligopoly of supply/demand industries, and high raw material and steel prices. This M&A trend sparked by Mittal’s acquisition of Arcelor continued with Tata Steel’s M&A attempts vis-à-vis Corus.

Giants suffering from aggressive M&As. In December 2008, ArcelorMittal announced several plant closings, including the Bethlehem Steel plant in Lackawanna, New York, and LTV Steel in Hennepin, Illinois. Its headcount was scaled back from 57,000 to 30,000 employees.

In 2009, Corus (renamed Tata Europe in 2010) cut 1,000 jobs in the Netherlands and 2,500 in the UK due the economic downturn with the mothballing of several plants, including the Teesside plant. By late-2014, Tata Group remained £13 billion in debt, a figure which had increased following the acquisition of Corus in 2007. The sale of Tata Group’s long products division to Greybull Capital for a nominal £1 was agreed on April 11, 2016, with Greybull taking over the assets and liabilities of the division. At the end of March 2016, the Tata board announced it would seek to sell all (or part) of its UK steel business. Its UK steel operations had lost £68 million in the three months to February 2016, from a profit in the previous year. Growing M&A Deals Post-Depression

The outlook for economic growth is very relevant to the metals sector’s M&As, given the cyclical nature of the sector and the way that it can be significantly affected by general economic conditions. M&A deals tend to increase during up-cycles with an accompanying uptrend in metal prices. This is obvious given that M&A engagements are more affordable to undertake using equity and the valuation for deals would be higher during up-cycles. Historically, the number of deals peaked at over 1,000 in 2008 versus around 200 per annum in the early 1990s, according to Thomson Reuters. DBS Asian Insights SECTOR BRIEFING 27 27

In 2015, the number and value of deals came in at 321 cases and US$11.4 billion, representing declines of 4% and 32%, respectively. This was driven by increased downside risks following the downward revision of global growth forecasts. At the current pricing levels, many companies are facing cash burn. This could result in transactions at bargain prices or even capacity simply evaporating from the market as plants shut down without any buyers. Hence, the value of deals in 2016 will remain close to the level seen in 2015.

Demerger moves emerge amid the downturn. We expect some companies to divest assets that are not contributing to their enterprise value or to raise cash to avoid financial disruption. Also, there is a reversal of the vertical integration pursued during good times. In some cases, depressed commodity prices are putting a strain on vertically integrated companies, which have resource supply footprints that far exceed the capacity of their own production. In other cases, as companies move toward greater specialisation, they are seeing value opportunities from disintegration. Tata’s divestment of its European business and POSCO’s sale of POSCO Special Steel to SeAH Besteel are the obvious examples. In the metal sector, Alcoa recently announced its intention to split into an upstream business comprising bauxite, alumina, aluminium casting and energy units as well as a downstream company specialised in metals and products. Completion of the split is expected in the second half of 2016.

Expect a turnaround in M&A deals in 2017. The down-cycle has provided companies with the opportunity to review and redefine their core business. The reorganisation of the business could follow divestments and M&As. We expect the deal market to turn around in 2017, with 2015 and 2016 marking the trough. The deals in the steel sector contributed 29% and 45% of total metal sector deals, based on the deal values in 2014 and 2015, respectively. Geographically, metal sector transactions in the Asia Pacific region, including in steel, have grown continuously in the 2000s, contributing 68% of total metal deals in 2012 via a deal value of US$68 billion. This declined to US$5 billion in 2015, accounting for 46% of global metal deals. Of note, cross-border deals peaked in 2006 to 2007, signified by Mittal’s M&A with Arcelor and Tata’s takeover of Corus.

Diagram 16: Number of M&A deals (left) and value of M&A deals (right)

Source: PWC, Thomson Reuters, DBS Bank DBS Asian Insights SECTOR BRIEFING 27 28

Diagram 17: Metal sector deals in Asia Pacific (left) and cross-border metal sector deals (right)

to global M&A deals to global M&A deals

Source: PWC, Thomson Reuters, DBS Bank

Chinese Mills Venture Into ASEAN

The oversupply of steel in the Chinese market has compelled local steel players to venture into overseas markets. Recently, China has been actively announcing overseas investment plans to make potential inroads into new markets, in order to cope with rising global trade protectionism and as part of the government’s “One Belt, One Road” initiative. Small-scale plants already operating in Vietnam, Malaysia, Indonesia, etc., are mainly targeting long steel products consumed in the construction sector. The targeted areas have huge potential for demand growth, in light of the low self-sufficient steel production levels in ASEAN countries. The investment preference is skewed toward joint ventures rather than sole ventures.

The Chinese steel companies have announced a number of plans so far, but due to the current stagnation of the global steel industry and the deterioration in their financial condition, the investment process is expected to face delays. DBS Asian Insights SECTOR BRIEFING 27 29 Diagram 18: Chinese iron and steel companies’ overseas expansion Operating and under construction Expansion plan

Downstream Baoshan Iron & Steel Co. (宝山钢铁) process Joint establishment of seamless steel pipe mill in Thailand (‘12). *Capacity: 0.2 million tons, operating since 2013 Anshan Iron & Steel Co. (鞍山钢铁) Acquired a French-based company (‘14) *Spent 13 million euros acquiring SAS VAL- DUNES Panhua Group Co. (攀华集团) Color Factory under construction at the Subic Bay, Philippines (‘15) *Capacity: 0.5 million tons, Completion by 2016 first quarter

Steel mills Kunming Iron & Steel Co. (昆明钢铁) Hebei Iron & Steel Co. (河北钢铁) Joint establishment of steel mill in Vietnam Joint establishement of steel mill in South (‘14.9) Africa *Capacity: 0.5 million tons, Produce billet *Capacity: 5 million tons (‘17.3, ‘19.2) *Collaborate with VNC Signed MOU with Zelezara Smedervo (‘15.11) *Capacity: 2.2 million tons Shougang Group Co. (首钢集团) Anshan Iron & Steel Co. (鞍山钢铁) Joint establishment of steel mill in Malaysia Planning of 5 million tons capacity steel mill (‘15.2) in Indonesia passed on (‘15.6) *Capacity: 0.7 million tons (up to 3 million tons), Produce slab Nanjing Group Co. (南京钢铁) Wuhan Iron & Steel Co. (武汉钢铁) Joint establishment of steel mill in Indonesia 5 million tons capacity steel mill in Indonesia under construction (‘14.3) *1st phase 0.5 million tons (‘15), 2nd phase Establish steel mill in Liberia, Bong mines 0.5 million tons (‘17) (‘15.10) *PT Gunung Garuda *Capacity: 0.5 million tons Guangxi Beibu Gulf Iron & Steel Co. (广西钢 Wuhan Iron & Steel Co.,Sinosteel (中钢集团) 铁) etc. Steel mill under construction in Malaysia, PSM Pakistan Steel mills acquisition plan Gebeng *Capacity: 3.5 million tons, Investment of $1 *Capacity: 1.1 million tons billion Ma Steel (马钢集团) Signed MOU with Kazakhstan for establishment of steel mill (‘15.3)

Stainless Tsingshan Holding Group (青山控股集团) Tsingshan Holding Group (青山控股集团) NPI Factory under operation in Indonesia, Establish a Stainless Slab Steel mill in Indone- Morowali sia *1st phase 0.3 million tons (‘15.5), 2nd phase *Capacity: 2 million tons (by 2017) 0.3 million tons (‘15.12) Source: POSRI, Mysteel, Custeel, DBS Bank DBS Asian Insights SECTOR BRIEFING 27 30

Risks Abound in Current Landscape High Mortality Rate for Major Steel Companies

The global steel industry also suffered from oversupply in the 1990s, largely due to exports from Japan and the former Soviet Union. With Japan’s steel demand trending down since the 1970s, it needed to export the excess supply of steel products. And steel demand in the former Soviet Union (CIS countries) had plunged in the post-Cold War era from 165 million tons in 1988 to 30 million tons in 1998, prompting it to dump steel products in overseas market at cheap prices.

In 1998, US steel imports rose 25% due to the sudden crash of the East Asian economies that eroded their demand for steel. This affected some US firms, resulting in the bankruptcies of Bethlehem Steel (second-biggest steel company in the US) and LTV Steel (third-biggest steel player in the US) in 2001, with total steel firms’ losses rising to US$3.8 billion. In 2002, National Steel (founded in 1929) went bankrupt and was acquired by US Steel in 2003.

During the Asian Financial Crisis, many steel companies found it difficult to survive. In Korea, Hanbo Steel, Sami Special Steel, Kia Special Steel, and Kangwon Industries went bankrupt in 1997 and 1998 and were put under court administration for three to five years post-bankruptcy. Hanbo Steel and Kangwon Industries were merged with Hyundai Steel, and Sami Special Steel was acquired by POSCO, while Kia Special Steel became a member of the Seah Group in early 2000s.

More losses in China’s state-owned steel players. According to the China Iron and Steel Association, China’s 101 big steel companies lost a total of around US$10 billion in 2015. State-owned enterprises (SOEs) were the main contributors to the loss, while the most efficient private-sector firms managed to squeeze out marginal profits. The debt default of local SOEs has been rare in China, as local governments have so far sought to avoid such defaults out of fear of a ripple effect. The heavy debt load of state-owned companies may make reform difficult.

ASEAN companies at risk. With rising costs and increasing competition, ASEAN’s steel companies are increasingly defaulting on bond interest payments. According to Focus Malaysia, listed Malaysian steel players have huge debts totalling 12.7 billion Malaysian ringgit (US$3.1 billion). The poor performance of Malaysian steel companies was largely due to less cost competitiveness, with the lack of government intervention and enforcement on dumped Chinese imports. Thailand’s Sahaviriya Steel partly blamed the country’s economic slowdown, which had a direct impact on consumer confidence, for its default. Indian steel companies, which are built with huge borrowings from banks, have been hit hard by falling steel prices globally. DBS Asian Insights SECTOR BRIEFING 27 31

Diagram 19: Chinese bankruptcy cases and firms at risk

Company Name Year Capacity Amount of Comments (m tons) debt (US$m) Bankruptcy Haixin Iron & Steel Mar-14 5.2 1,600 • Second largest private steel company Group • Cause of bankruptcy: Industry overcapacity, stagnant market, capital shortage, tightened credit and management issues Dongbei Special Steel Mar-16 6.2 131 • Consolidation of the state-owned special Group steel enterprises in China including Dalian Iron & Steel Group, Fushun Special Steel Group and Beiman Special Steel Group Fufeng Steel Jan-15 - - • Factory closed (Steel plant on the outskirts of Tangshan) Qingquan Steel Dec-13 - - • Factory closed Firms at risk Sinosteel 2015 0.7 315 • A major Chinese state-owned miner and steel trader • Lacked the funds to repay principal and interest on US$315 million in bonds sold in 2010 • China’s state-owned Assets Supervision and Administration Commission and the National Development and Reform Commission have intervened in China’s bond market to pre- vent a default by state-owned Sinosteel. Bohai Steel 2015 20 29,000 • Struggling to meet debt obligations following years of aggressive expansion • Missed a payment on a 350 million yuan trust plan that promised investors yields of more than 9 percent. Sansteel Minguang Co. 2016 8.2 30,000 Xining Special Steel Co. 2016 1.3 - • Under default risk due to low cash flows. Liuhou Iron & Steel Co. 2016 11.3 -

Source: POSRI, Mysteel, Custeel, DBS Bank

The heavy debt load of (Chinese) state-owned companies may make reform difficult DBS Asian Insights SECTOR BRIEFING 27 32

Diagram 20: ASEAN and India bankruptcy cases and firms at risk

Company Name Year Capacity Amount of Comments (m tons) default (US$m) Sahaviriya Steel Sep-15 4 1,400 • Failed with defaults on 50 billion Thai baht (Thailand) of loans from Thai banks, biggest default for Thai banks since 1997 Asian crisis Megasteel (Owned by Nov-15 1.5 8.8 • Due to the challenging steel operating Lion Group Malaysia) environment resulting from rampant import of steel products into the country at dumping prices • The weakening of the ringgit also resulted in the default of the partial redemption of the bonds, which are denominated in US dollars Perwaja Steel Sdn Bhd Mar-14 0.8 - • Cause: rising costs and increasing (Malaysia) competition, unable to fulfil the coupon payment of 9.8 million ringgit for its 280 million ringgit nominal value of 7% redeemable convertible unsecured loan stock Uttam Galva Steels Apr-14 1 - • Challenging operating environment (India) • Inability to refinance its long-term borrowings Jindal Steel & Power Feb-16 1 - • Delayed payment of interest on term loans (India) due to weakened liquidity

Source: POSRI, Mysteel, Custeel, DBS Bank

Bumpy Road Ahead for China’s Steel Sector Reforms

China plans to cut excess steel capacity by 150 million tons by 2020, as endorsed by the central government’s supply-side reforms. Earlier in 2016, the Ministry of Finance released a special subsidy fund amounting to 47 billion yuan to spur capacity curtailment of the steel and coal industries. However, local governments are inclined to keep steel mills in operation, given their strong value-added tax (VAT) contributions (17% charged on revenue). Besides, private capital players are also keen to make equity investments in steel mills, in view of the fact that the National Development and Reform Commission will no longer approve new production licences for blast furnace capacity construction.

Our review of the 2015 financial reports of 24 A- and H-share steel listed companies found that the government subsidies included in the non-recurring profit or loss for the DBS Asian Insights SECTOR BRIEFING 27 33

aggregate 24 companies surged 80% to 6.296 billion yuan, indicating a government subsidy of 24 yuan per ton, on average. Four out of the 24 steel companies received subsidies of up to 140-350 yuan per ton. These hefty subsidies were given to three local SOEs and one central SOE. In the medium- and long-term, we deem the local governments’ vested interests as the key challenge for steel capacity shutdown. Pain of Rising Interest Rates

Interest rate hikes and yuan depreciation to increase the financial burden of Chinese steel mills. The probability of further interest rate hikes in the US has fuelled concerns over a rising interest rate environment for the global economy. This would lead to emerging- currency weakness, including in the yuan against the US dollar. A rising interest-rate environment would also increase the financial burden of steel mills in emerging countries by raising interest costs and increasing the repayment amount for US dollar-denominated debt.

Better export price competitiveness from weak yuan will be offset by higher raw material import cost and trade protectionism. While exports from China will benefit from weak currencies in terms of price competitiveness, this could be offset by lower steel export prices in oversupplied export markets and rising raw material costs as the bulk of raw materials are imported. Of note, 79% of iron ore requirements in China were imported from Australia and Brazil in 2015. Also, growing trade protectionism in export markets will dampen the export price advantage arising from the yuan’s depreciation.

DBS Asian Insights SECTOR BRIEFING 27 34

Findings From DBS Steel Survey

DBS surveyed its Institutional Banking Group customers operating in the metal ferrous vertical in April, with respondents distributed evenly between steel mills and traders. The steel mills were primarily located in the northern province of China (Hebei, Tianjin, Shanxi and Liaoning) and a third of traders were located outside China.

Diagram 21: Steel survey respondents by location and type

Classification Central East North South Outside Grand % to China Total Total Steel Mill respondents mix by location 14% 9% 59% 5% 14% 100% 46% Ferrous Trader respondents mix by location 0% 46% 19% 4% 31% 100% 54%

China POE Total 8% 8% 69% 8% 8% 100% 59% Production volume <=5mt 8% 0% 46% 8% 8% 69% China SOE Total 29% 14% 57% 0% 0% 100% 41% Production volume>10mT,<=25mt 29% 14% 14% 0% 0% 57% Production volume >25mT,<=50mt 0% 0% 43% 0% 0% 43%

Source: DBS Bank Diagram 22: Outlook on steel market: Cautious

Steel sector bottomed out? Central East North South Outside Grand China Total % Yes - Steel Mills 33% 0% 46% 0% 100% 45%

% Yes - Traders 0% 50% 40% 100% 75% 58%

% Yes - All 33% 43% 44% 50% 82% 52%

Classification Price hike sustainable? (1 - optimistic; 5 - pessimistic)

1 2 3 4 5 Steel Mill Response Mix 5% 9% 9% 50% 9%

Trader Response Mix 8% 8% 27% 38% 8%

Steel Mill Response Mix 6% 8% 19% 44% 8%

Source: DBS Bank DBS Asian Insights SECTOR BRIEFING 27 35

No expectation on sustainable steel price growth. Most of the respondents agreed that steel prices bottomed out in the beginning of this year. However, they do not expect the price rebound seen in March to April to last as they see a HRC price of US$360 per ton for the rest of 2016. Of the companies surveyed, 59% expected their margins to improve due to the recent price hikes, while around half of the steel companies located in South China did not expect profit improvements. More privately owned mills expected improved margins than did SOE mills. Anecdotally, this matches the intelligence from the market that privately owned enterprises (POE) tend to have older and fully amortised machinery, whilst SOEs have high staff costs and more recent capital expenditure investment, often financed by bank lending.

No threat from trade conflict. SOE mills with large-scale steel capacity export their products all over the world, while small-scale POE mills, with around 5 million tons of capacity, export mainly to Asia only. The most interesting finding was that most respondents have not flagged anti-dumping measures as a real issue. We interpret this several ways: i) A biased sample was surveyed; ii) Korea and ASEAN, which are the major Asian markets for Chinese steel products, have no significant measures to block Chinese imports; and iii) the cost competitiveness of Chinese companies is superior to regional peers, enabling them to export at a competitive price even after considering anti-dumping margins.

Diagram 23: Export market and trade conflicts

SOE/POE Main Export Regions Mix

China - POE Asia only 39% EMEA only 6% Nil response 6% China - SOE Asia only 6% EMEA only 6% EMEA And Asia 17% Nil response 11% RoW Asia 6% Nil response 6%

Is anti- Central East North Outside South Grand dumping China Total an Issue? % No 100% 100% 54% 100% 100% 73%

Source: DBS Bank DBS Asian Insights SECTOR BRIEFING 27 36

No permanent measures for restructuring; and challenges for sector reforms. To address the weak steel market, 68% of the respondents had gone through maintenance of the plant and production lines, 27% laid off employees, and 9% closed their production line temporarily. Only 14% of the respondents have closed lines permanently.

The survey also asked the respondents for their view on the likely impact of the latest sector reforms. Interestingly, the majority of the respondents were quite optimistic that the reforms would successfully reduce overcapacity. This reflects their trust in the recent reform plans of China’s central government. However, the biggest challenge for the reform is local governments’ unwillingness to shut down steel mills that would create large-scale unemployment in the region.

Diagram 24: No concrete restructuring measures yet

Measures taken to counter weak steel market % of Total Steel Mill Respondents Temporary closure of plant and production lines 9% Permanent closure of plant and production lines 14% Maintenance of plant and production lines 68% Laying off employees 27% Sales of assets/affiliates 5% Relocation of HQ/Plant to save cost 9% Source: DBS Bank

Diagram 25: Optimism on Chinese reforms

Classification Will China reforms succeed in reducing overcapacity? (1 - optimistic; 5 - pessimistic) 1 2 3 4 5 Nil Response Steel mill response mix 5% 41% 36% 9% 9% 0%

Trader response mix 4% 46% 19% 19% 8% 4%

Biggest obstacles to successful reform of Chinese steel market % of Respondents Local government willingness to shut down steel mills 73% Large scale unemployment 73% Lack of capital to support restructuring 44% Rebound in steel price 35% Yuan depreciation 15% Increase in exports 10% New capacity/new plants 6%

Source: DBS Bank DBS Asian Insights SECTOR BRIEFING 27 37 DBS Asian Insights SECTOR BRIEFING 27 38

Appendix A: Global Steel Sector Value Chain Raw material Global Steel Sector Iron Ore (2015) Global (2015) Global production: 3,320m ton (raw ore), 1,950m Crude steel capacity: 1,704m ton ton (Fe content 63.5%) Crude steel production: 1,623m ton China: 1,380m ton (raw ore), 325m ton (17%, Fe content 63.5%) Finished Steel apparent consumption: 1,500m ton Australia: 824m ton (42%) Brazil: 428 ton (22%) Geographical share of crude steel output (2015) China 49.5% Coking coal (2015) EU 10.2% Global coking demand: 993m ton Japan 6.5% China: 593m ton (60%) India 5.5% Asia ex. China: 170m ton (17%) US 4.9%

Steel scrap Crude steel production by process (2014)

Global use: 585m ton Blast oxgen furnace 73.9% Purchase: 378m ton Electric arc furnace 25.6% EU28 91.3m ton 16%

China 88.3m ton 15% Major Players (2014) USA 62m ton 11% m ton share of total output ArcelorMittal 98.1 5.9% Major Players Nippon Steel and 49.3 3.0% Iron ore (production volume, 2015) Sumitomo Metal Corporation Vale 372m ton 19% Hebei Steel Group 47.1 2.8% Rio Tinto 263m ton 13% BHP Billiton 237m ton 12% Baosteel Group 43.3 2.6% Fortescue 167m ton 9% POSCO 41.4 2.5%

Shagang Group 35.3 2.1%

Coking coal: Seaborne volume (2014) Ansteel Group 34.3 2.1%

BMA 49% Wuhan Steel 33.1 2.0% Group Yancoal 10% JFE Steel 31.4 1.9% Anglo American 8% Corporation Shougang Group 30.8 1.8% Peabody 8% Tata Steel Group 26.2 1.6% Jellinbah 8% DBS Asian Insights SECTOR BRIEFING 27 39

Finished steel products Steel consumption by sector Production 1,608m ton (2014) m ton share Construction 50% Long Products 837 52% Transport 16% Railway 12 1% Machinery 14% Heavy section 51 3% Metal products 14% Light section 64 4% Domestic appliance 3% Rebars 280 17% Electrical equipment 3% Bars 144 9% Wire rod 205 13%

Flat Products 741 46% Heavy plate 255 16% HRC 380 24% Tin plates 9 1% Coated sheets 121 8% Tublar products 137 9% DBS Asian Insights SECTOR BRIEFING 27 40

Appendix B: China Steel Sector Value Chain Raw material Steel: Iron concentrates: (mt) (mt) production 246 Crude steel capacity 1,100 Import 953 Crude steel production 804 Demand 1,206 Crude steel apparent consumption 804 Finshed steel production 1,123 Coking coal: Finished Steel apparent consumption 1,023 production 483 Export 113 Import 48 Export 0.97 Crude steel production by process Demand 530 Blast Furnace 756 Electric arc furnace 48 Steel Scrap: production nil Import 15.5 Export 0.004

Nickel: production 0.58 Import 0.30 Source: WSA, OECD, Platts, Bloomberg Finance L.P, DBS Bank Export 0.04 Demand 0.85 DBS Asian Insights SECTOR BRIEFING 27 41

Finished steel products Production (mt) Long Products: 503 Railway 9 Heavy section 14 Light section 57 Rebars 71 Bars 204 Wire rod 148

Flat Products: 577 Heavy plate 72 HRC 246 CRC 97 Coated sheets 61 Tubes and pipes 100

Special steel products(mt) 112 Stainless steel products(mt) 22

Source: WSA, OECD, Platts, Bloomberg Finance L.P, DBS Bank DBS Asian Insights SECTOR BRIEFING 27 42 DBS Asian Insights SECTOR BRIEFING 27 43

Disclaimers and Important Notices

The information herein is published by DBS Bank Ltd (the “Company”). It is based on information obtained from sources believed to be reliable, but the Company does not make any representation or warranty, express or implied, as to its accuracy, completeness, timeliness or correctness for any particular purpose. Opinions expressed are subject to change without notice. Any recommendation contained herein does not have regard to the specific investment objectives, financial situation and the particular needs of any specific addressee.

The information herein is published for the information of addressees only and is not to be taken in substitution for the exercise of judgement by addressees, who should obtain separate legal or financial advice. The Company, or any of its related companies or any individuals connected with the group accepts no liability for any direct, special, indirect, consequential, incidental damages or any other loss or damages of any kind arising from any use of the information herein (including any error, omission or misstatement herein, negligent or otherwise) or further communication thereof, even if the Company or any other person has been advised of the possibility thereof.

The information herein is not to be construed as an offer or a solicitation of an offer to buy or sell any securities, futures, options or other financial instruments or to provide any investment advice or services. The Company and its associates, their directors, officers and/or employees may have positions or other interests in, and may effect transactions in securities mentioned herein and may also perform or seek to perform broking, investment banking and other banking or financial services for these companies.

The information herein is not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation. Living, Breathing Asia