Shoring up the supply chain for steel producers

07 March 2011

Iron ore prices continue to rise, forcing steel producers to consider investing in mines to ensure a supply of raw materials

Key fact

Iron ore prices have risen 80-90 per cent during the past year, from around $100 to $180-$190 a tonne

Source: MEED

The global steel industry bounced back in some style in 2010, after the global economic crisis decimated demand in 2009, which some analysts have called the worst year in the sector’s history.

Steel production rose by 15 per cent to more than 1.4 billion tonnes last year, with all the main steel-making hubs recording double digit growth.

Although the Middle East does not rank among the world’s leading steel producers, the region has a sizeable and expanding steel industry, producing around 20 million tonnes a year (t/y).

Middle East steel demand, 2010
Saudi Arabia22
Other GCC8
Source: Metal Bulletin

Several large-scale mills are currently under construction in Saudi Arabia and Bahrain and many existing plants across the region are undergoing expansion or refurbishment.

Despite the recovery in demand, soaring iron ore prices are squeezing the margins of steel producers worldwide. As a result, some producers in the Middle East are now looking to secure their own supply chain by investing in iron ore mining projects in countries such as Brazil and Australia.

Soaring iron ore prices

Iron ore prices have risen 80-90 per cent during the past year, from around $100 a tonne in March 2010 to $180-$190 in February 2011, for ore with an iron content of more than 63.5 per cent. There are no signs of respite on the horizon. Analysts are predicting prices to continue climbing throughout the rest of the year.

Despite the recovery in demand, soaring iron ore prices are squeezing the margins of steel producers worldwide

Several reasons have caused iron ore prices to increase so dramatically, but the one cited by most steel producers is the change in the pricing mechanism introduced by the major iron ore producers in 2010.

Under the previous system, iron ore was sold under year-long contracts, but the world’s three biggest suppliers, Brazil’s Vale, and the Anglo-Australian duo of Rio Tinto and BHP Billiton changed to quarterly pricing last year.

The big three mining companies account for two thirds of the seaborne iron ore market and also own the majority of the world’s low-cost iron ore reserves.

Iron ore prices
($ a tonne)
Source: Index Mundi

“Being at the low end of the cost curve has put the big three in an extremely strong position when it comes to supplying the market and adjusting their own production to the prevailing market conditions,” says Patrick Cleary, iron ore analyst at London-based consultancy CRU. “Especially since the pricing mechanism changed and allowed them to take advantage of rising costs.”

With just three companies controlling the bulk of the world’s reserves, there is far more pricing power on the iron ore side of the business than on the steel side.

However, while steel producers were all quick to blame the change in the pricing mechanism for the sharp increase in ore prices, it was a tightening of supply in India that was the root cause of the problem.

India is the world’s fifth largest steel producer and for years there has been conflict between mining companies wanting to export iron ore and steel producers wanting it to stay in the country.

Last year, Karnataka State in India decided to protect its domestic steel industry and announced a ban on iron ore exports from the region.

Despite not boasting the low-cost reserves of Australia or Brazil, India’s iron ore deposits play a vital role in the global steel industry, as the country contributes large volumes to the spot market. Consequently, any tightening of supply pushes up prices.

If demand is high, then economies of scale dictate that a 500,000 t/y rebar plant makes economic sense

“Politicians generally want to see the value added on the home market, so they are always keen on the iron ore staying at home, which is why some areas in India have issued an export ban and that has hit supply,” Cleary says. “There are other constraints in terms of infrastructure, but it is primarily a conflict between the need for ore to stay home against exports.”

Iron ore export ban

While India protects its own market, other regions with little or no iron ore deposits have to ride out the spike and wait for prices to return to manageable levels.

In the Middle East, many smaller steel producers in areas where demand has dropped since the economic crisis hit, are seriously suffering, even though they themselves do not actually buy iron ore.

As the price for iron ore rises, so does the cost of other raw materials used in steel production, such as coking coal and scrap metal. The increase in prices in turn drives up the price of steel products, such as steel billets.

“The UAE in general and Dubai in particular is probably the best example of a drop in demand in the region,” a steel industry source based in the UAE says. “Many of the steel plants that were planned during the boom years have now stopped production or are looking for a buyer.”

The UAE’s RAK Steel stopped production at its plant in Ras al-Khaimah in July 2010, just two years after inauguration. The reason given by the chief executive officer, Ajay Aggarwal, at the time was the combination of rising cost and low demand for its 500,000 t/y of steel reinforcing bars (rebar), which are used in the construction industry.

The simple economics of the decision make sense. At 2011 prices for scrap steel and steel billets, margins have been squeezed to such an extent that only small profit of $15-$20 can be expected on a tonne of rebar.

If demand is high, then economies of scale dictate that a 500,000-t/y rebar plant makes economic sense. When demand slumps, and firms are competing against large steel producers that make their own billets and are at least part-owned by a government entity, then the smaller companies will struggle.

“Competing against a major operation like Emirates Steel is making it tough for the smaller operators,” the steel industry source says.

Outside the UAE, there is still relatively strong demand for steel in the wider GCC region, with the promise of greater demand to come from economies flush with petrodollars such as Saudi Arabia and Iraq.

Supply chain control for Middle East producers

The large Middle East producers that are mostly state-owned have obvious advantages over smaller producers in that they make their own direct reduced iron and their own billets. “What the iron ore price increases have proved is that controlling as much of the supply chain as possible is vital for the large Middle Eastern producers now,” the steel industry source says.

It seems that the region’s large steel players agree, with many now looking at ways to achieve this.

In the past, producers would be content to move into more downstream activities to increase the value of their output, but now they are also looking further upstream.

“No steel producer is happy with the pricing mechanism established by the major mining companies because they are controlling the market,” says Khalid al-Qadeeri managing director of Bahrain’s Gulf United Steel Holding Company (Foulath). “I don’t want to use words such as cartel or monopoly, but the situation is causing a mismatch between what we are paying for raw materials and the price we get for our steel.”

Al-Qadeeri believes that the major producers in the region should be working together and cooperating in the same way that the mining companies are cooperating in regards to pricing iron ore. The steel executive says his company is now looking to invest in its own iron ore mine and is in discussions with a number of interested parties in Brazil.

Supply chain integration has already become a feature of the region’s aluminium sector. In 2009, Dubai Aluminium took a 19 per cent stake in an alumina venture with Brazil’s Vale. This followed an earlier deal to develop a bauxite mine and refinery in Cameroon. As a steel company, Foulath would benefit more from its own iron ore supply due to the fact that it has a 6 million t/y pelletising plant in Bahrain. The plant processes iron ore and produces pellets that are then used in steel production.

If it is successful in its plans then Foulath will be one of the few steel companies in the world that controls the full value chain of steel production from iron ore to finished products.

Investing in iron ore assets that are positioned away from the big three mining companies’ control might well be the way forward for Foulath. However, it is not without its risks, and, with iron ore commanding such high prices, it will not come cheaply.

If prices for iron ore do continue to increase in the months and years ahead then the case for the region’s steel producers to secure their own iron ore supply will become increasingly compelling. But what needs to be remembered is that, unlike oil, iron ore reserves are plentiful and therefore it may be that prices will come down again in the future. So, in some cases, buying into iron ore mines at the top of the market could well prove calamitous.

High demand for iron ore

As with all commodities, demand will ultimately determine whether iron ore prices remain high.

“While it is possible that steel could become so expensive that it adversely effects demand in some areas, but I don’t think the Middle East would be one of those areas,” Cleary says. “The big three iron ore producers will be looking at the Middle East as well as other regions undergoing rapid development and know that steel is vital for growth.”

Soaring iron ore prices are not going to have the same effect on global trade and industry as a similar spike in oil prices would. However, if the price hikes continue, some projects could be stalled by the sharp rise in raw materials prices.

Despite these fears, Vale, Rio Tinto and BHP Billiton have no intention of reverting back to their previous annual pricing mechanisms.

“Iron ore is costing these companies about $20-$25 a tonne to produce, but is being sold for more than $180,” Al-Qadeeri says. “In today’s market you have to start thinking the iron ore business is better than the oil business.” With such a compelling investment case, Foulath is unlikely to be the only firm looking to secure its supply chain.


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