China Commodities Watch: Steel Mills Move House July 15, 2019 PRIMARY CREDIT ANALYSTS Key Takeaways Christine Li Hong Kong - China's steel-mill relocations should enhance industry clustering and logistics. (852) 2532-8005 Christine.Li - Large capex requirements will force some mills to sell out or merge, increasing market @spglobal.com concentration. Danny Huang - Relocations will focus more on upgrading output than reducing capacity. Hong Kong (852) 2532-8078 danny.huang @spglobal.com Ronald Cheng Chinese steel mills are relocating to reduce urban pollution and improve industrial clustering. S&P Hong Kong Global Ratings anticipates the process will help streamline the industry and boost efficiency. The (852) 2532-8015 ronald.cheng cost of moving house could put strain on some steel companies' financials, however this should @spglobal.com further the consolidation trend in the country's steel sector. SECONDARY CONTACT Led by China's top steel-producing provinces--Hebei, Shandong and Jiangsu--many regions have Lawrence Lu, CFA announced relocation plans for steel mills within their reign. Since late 2017, announced plans Hong Kong amount to at least 100 million tons per annum (mtpa) covering various cities in different provinces, (852) 2533-3517 or about 10% of national total capacity. lawrence.lu @spglobal.com Relocating steel mills will help but not complete reform guidelines set by state planners. Under a plan devised by the Ministry of Industry and Information Technology (MIIT), the overriding targets to be reached by 2025 are: (1) structural adjustments with reduced capacity; (2) increased market concentration led by several large groups; (3) improved efficiency and profitability. Clustering Takes Precedence Over Reducing Capacity In our view, the key objective of relocation is to improve logistics and geographic layout by moving facilities out of populated cities and clustering them in coastal areas near ports. These objectives take precedence at this juncture because other goals, such as de-capacity, are already ahead of schedule. China has reduced crude steel capacity by 150 mtpa since 2016, according to China Iron and Steel Association. This exceeds timeline targets set by the MIIT's planning targets of reducing 100-150 mtpa by 2020 (see chart 1). www.spglobal.com/ratingsdirect July 15, 2019 1 China Commodities Watch: Steel Mills Move House Chart 1 We also believe that urban pollution is no longer the headline issue for relocation. Steel production is less polluting than in the past, due to large investments into monitoring and controlling pollution. Whether located in urban areas or elsewhere, the mills still need to meet new, tighter emissions standards. Mills will focus on improving logistics and location by moving from inland to coastal areas. In our Logistics should view, coastal areas have geographic advantages due to the China steel sector's heavy reliance on improve as mills imported iron ore. We note that many steel mills have started to expand their presence near deep-water ports that can berth large ore carriers from Australia and Brazil. These include relocate to coastal Qingdao Port and Rizhao Port in Shandong province; Caofeidian Port and Jingtang Port in Hebei; areas near ports… and Zhanjiang Port in Guangdong. We also see moves to industrial parks, which facilitates consolidation and industry clustery. ..or to industrial Shandong province recently announced a plan to consolidate steel capacity spread over 12 cities parks. to the coastal regions of Rizhao-Linyi and to inland industrial parks around Laiwu-Taizhou by 2023. Jiangsu province has designated a range of coastal industrial parks to harbor steel capacity relocated from other cities. These moves are influential because Jiangsu and Shandong produced 106 and 74 million tons of crude steel in 2018, ranking the second and third after Hebei, accounting for 11% and 8% of the national total, respectively. We believe the Chinese government will try to prevent steel mills from increasing capacity in the name of relocation. Still mills are supposed to adhere to the principle of "replacement at reduced capacity," usually 80% of original capacity. We note however that overall steel capacity began www.spglobal.com/ratingsdirect July 15, 2019 2 China Commodities Watch: Steel Mills Move House creeping up again in 2018, and that China's crude steel output set a record in 2018 and again in the first half of 2019. There seems to be no clear penalty for building more capacity, and good profitability could boost tax income for local governments, encouraging them to loosen their grips. Crude steel capacity is estimated to reach 1,150-1,200 mtpa by end of 2019, according to S&P Global Platts. Relocation Will Also Give Rise To Fewer And Larger Players Moving steel mills to coastal areas or industrial parks will accelerate industry consolidation and market concentration, thereby addressing one of the three major pillars of industry restructuring. The government's target is for the top-10 steel mills to account for 60% of China's total capacity by 2025, compared with 34% in 2015. It also expects to see three to four large steel manufacturing groups with capacity of over 80 mtpa each. We believe large steel mills, especially state-owned enterprises (SOEs), will more likely drive Baowu is the world's market concentration through more mergers and acquisitions in the next five to 10 years. China second-largest Baowu Steel Group Corp. Ltd., formed by the merger of Baosteel and Wuhan Iron and Steel (WISCO), recently acquired Magang (Group) Holding Co. Ltd. by taking a 51% stake from the Anhui steelmaker by province State-owned Asset Supervision and Administration Commission (SASAC) at no capacity, following its consideration. Baowu's post-deal capacity has reached about 90 mtpa, making it the absorption of second-largest steel mill globally after ArcelorMittal. Two out of Baowu's four major production bases are close to Magang, which is located at the mouth of the Yangtze River, so this provides Magang. some synergies in transportation and raw materials procurement. Private steel mills will also look for alliances when replacing their smaller and older facilities. Combining capacity will help them achieve economies of scale and synergies, in our view. In Tangshan city, Hebei province, two privately owned steel mills--Hebei Tianzhu Iron & Steel Group Co. Ltd. and Tangshan Rongcheng Steel Co. Ltd.--will merge and move out of the city. The new entity has commenced the construction of a plant with capacity of 3.6 mtpa to replace their combined 4.5 mtpa old capacity. Tangshan Jianlong Iron and Steel Co. Ltd., and Tangshan Xinbaotai Iron & Steel Co. Ltd., both privately owned, will also merge and build new capacity of 3.2 mtpa, scheduled to be on stream around the end of 2020. Nonetheless, mergers among private mills could be a complicated and lengthy process, as owners negotiate over shareholding structure, control, and the new development plan. Upgrades Will Add Capex Burdens During the relocation and construction of new sites, steel mills will upgrade technology and also, As they relocate, in some cases, product offerings, with a slant to higher-value-added products. Many steel mills will upgrade facilities are designed to make long-steel products serving construction-related demand, a segment that fit well with the construction and property-led investment of recent decades. This technology and output is low-value-added compared with flat steel products used in sophisticated product offerings. manufacturing. As China's manufacturing sector also moves up the value chain, demand for premium steel products will rise over time. Relocation provides an opportunity for steel mills to build advanced facilities when constructing new plants. However, capital expenditure (capex) needs could constrain certain steel mills from upgrading. Relocation will make some mills vulnerable financially, in our view. Most steel mills barely survived the overcapacity that long plagued the industry, eking by on chronic thin margins or suffering periodic losses. Steel prices recovered during the past couple years only when capacity was removed, but the sector's financial buffers remain fragile. Relocating or rebuilding steel mills www.spglobal.com/ratingsdirect July 15, 2019 3 China Commodities Watch: Steel Mills Move House will require substantial capex. Past projects had typical price tags of Chinese renminbi (RMB) 50 billion for an 8-10 mtpa-capacity project, excluding pollution control facilities, which adds another 10%-20% to investment costs. Table 1 Capital Expenditure For Past Steel Projects Date Expected Total investment Total capacity Unit investment Major projects announced completeion (bil. RMB ) (mtpa) (RMB/ton) Shougang Jingtang 2005 2010 67.7 10.0 6,770 Phase I Baosteel Zhanjiang 2012 2016 58.0 10.0 5,800 Fengnan Iron and Steel November, 2019 32.0 7.7 4,156 2017 Guangxi Liuzhou December, End-2019 64.0 10.0 6,400 Fangcheng Port Iron and 2017 Steel Meishan Steel December, 2022 50.0 10.0 5,000 2018 Tangshan Tiancheng March, 2019 End-2020 12.0 3.6 3,333 mtpa--Million tons per annum. RMB--Chinese renminbi. bil.--billion. Relocation could cause releveraging The heavy cost burden of relocations will likely reverse recent sector-wide deleveraging efforts. Even with subsidies to help cover costs, we expect an increase in leverage in the short term, since many subsidies are paid after the fact. This will be particularly so for weaker companies. Baoshan Iron & Steel Co. Ltd. (Baoshan) is one of the few major companies that has sufficient operating cash flows to be able to finance its relocation. Baoshan plans to relocate its facilities in Meishan, Nanjing, to a coastal city in Jiangsu province, as announced in December 2018. Total investment for the 8-10 mtpa project will be RMB50 billion over the next three years. After moving out of its original base in Nanjing city, the company will likely receive compensation from the local government, based in part on the value of the land being vacated.