Metals - In search for inflation hedge - upgrading steel - ICICI Securities

With strong undercurrents of inflation, we expect supply side imbalances to continue in various commodities (steel, aluminium, zinc, nickel, etc.). The (double) impact of cost curve increase and export restrictions out of Russia is being felt in i) aluminium, ii) zinc and iii) steel. Impact of possible sanctions is expected in coal and nickel, and possible impact of export volumes out of Ukraine is felt in ferro alloys (FeMn, Fe SiMn), iron ore and steel. With coking coal at ~US$600/te, the primary (integrated) spreads fail to expand. International thermal coal prices are > US$400/te; sooner than later, Indian secondary players may be faced with crunched up domestic supply of thermal coal. Lead lag of steel prices vs RM prices may allow interim expansion of EBITDA/te (as has been seen in past cycles). We have already seen such MTM expansion in aluminium. Hindalco, Jindal Stainless and APL Apollo remain our top BUYs in the sector. We also upgrade Tata, JSPL to BUY - hopefully part RM integration can support spreads.

• Increase in gas and electricity prices in Europe (Atlantic) will push up the cost curve for steel. It is clear that there are no viable alternatives to replace Russian gas for EU in the medium term. H2CY21 witnessed ~EUR100/te of price increases for long products (EAF based), given EUR100-150/te of cost increase (power cost driven). The impact was relatively less for flat products given generation of BF and coke oven gas. Long product prices in Europe can increase more than EUR100-150/te if the current trends persist. Further, restricted supply of steel (~15mtpa of Russian steel exports; including ~ 5mtpa via Turkey) to Atlantic will also support prices. Arcelor has increased steel prices by EUR150/te recently.
• Case study - the oil shock of 1979 (Chart 1-3) and the rerating of the minimills. While charts 1-3 show resilience of US steel prices even as demand faltered globally (as in US) in the wake of the oil price shock, the story had many layers. While the minimills Florida Steel and Nucor's common stock price increased by 164% and 647% respectively between CY76-85, the average integrated producer's common stock price fell by 50% while NYSE rose by 80%. The reason being, cost competitiveness allowed minimills to increase absolute volumes while demand declined in the US, leading to a serious drop in production and capacity of integrated steel players in the US; imports also moved up. Even with such a significant period of rerating for Nucor, what our study shows that Nucor's earnings kept declining from CY80 to CY82, after the peak oil crisis had passed. Probably similar things will happen this time as well. As its clear from Chart 3, investors who would have waited for the inflation cycle to pass wouldn't have missed much.
• Scenarios (trade flows) that we expect to play out in steel. We expect China to import Russian steel to alleviate the impact of sanctions. This serves dual purpose i) reduce Chinese domestic production - allow ESG goals and control inflation of RM (Chinese iron ore and coal) and ii) Russian steel will be available at a discounted price (we see Urals currently drawing >US$20/bbl discount to Brent) and this will also help control inflation in China and in the region. The export market that Russia leaves out - mainly Europe and APAC - can be potentially taken up by India. European exports will be extremely lucrative till the time inflations starts pulling down industrial demand in Europe. These events should play out over next 3-4 quarters, in our view. Thus, the initial excitement on higher export realisations can't last beyond 2-3 quarters. These are MLE (most likely estimates); risks to view as we see now i) some of the largest Chinese banks are refusing to finance purchase of Russian commodities and ii) Chinese purchase of coking coal, which was dependent on Russia partly, shifting to Mongolia, with a significant increase in road purchased expected over the next few weeks.
• Possible sanctions and disturbed supply. Any sanctions or disturbed trade flows are not going to normalise in a hurry. This will continue to impact i) ~25- 30mtpa of net steel exports from Russia, ii) ~ 2mtpa of aluminium exports from Russia and iii) nickel exports from Russia etc. Russia is responsible for 6% of global aluminum supply and 7% of mined nickel. Nickel had just turned into surplus in Dec'21 after successive months of deficit, while ally continues to be in deficit. We foresee continued inventory gains for stainless steel players till demand deteriorates, impacting spreads. Also, higher European power prices are expected to increase cost structure for SS players by EUR50-100/te.
• Europe's curtailment and losses due to high energy prices. Aluminium Dunkerque, Europe's largest producer of the metal, has cut production by 15% while Nyrstar, the zinc producer owned by commodity trader Trafigura, has mothballed a 150,000tpa smelter in Auby, northern France, and halved output at three other sites. There are estimates that 820,000te (700kte as per Norsk Hydro) of primary aluminium capacity and 750,000te of primary refined zinc smelting capacity had been suspended across Europe in recent months. Aluminium smelter in Europe fully exposed to market-power pricing in the fourth quarter of last year would have lost US$1,000/te. For zinc smelters, the equivalent loss would have been US$540/te (despite such elevated pricing).
• Maintain BUY on Hindalco. The impact and the duration of the shock may create some more cost curve bump. Aluminium prices will correct now under the scenarios of i) softening power prices and ii) softening demand on account of higher aluminium prices (historically high compared to steel or copper) [Clearly demand for new age vehicles is not going to be material driver over the next two years] and both the events appear some time away. Hopefully, Hindalco can hold off aspirations of smelter capex, inorganic acquisitions [Novelis and its downstream will have little scope to increase its capacity inorganically hereon] and keep increasing downstream capacities [India and abroad]. Alcoa CEO reiterated the company's stance that it is not going to invest in any conventional smelter.

Source : Equity Bulls

Keywords

ICICISecurities Metals Steel Aluminium Upgrade Zinc Nickel