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Ernst & Young questions vertical integration in the steel industry

World Coal,

Ernst & Young has released analysis that questions the value of steelmakers buying metallurgical coal and iron ore assets to ensure security of supply. In its annual survey of the global steel market, the financial services company notes that, although in recent years vertical integration has become a trend in the steel industry, “it may not always have a positive benefit on enterprise value”.

Ernst & Young’s analysis of the top 30 steelmakers by market capitalisation over the last three years found that vertical integration has either had no effect or a slightly negative effect on the valuation of those companies, although there is a positive correlation between integration and profitability. “Raw material costs and price volatility continue to pose major challenges for the steel sector. In response to these challenges, many steelmakers have vertically integrated raw material mines into their supply chains; however, there needs to be a balance between cost reduction activity and conserving/demonstrating enterprise value,” said Carlos Assis, Ernst & Young’s South America and Brazil mining and metals leader.

Entering the mining industry also poses a number of substantial risks for steelmakers, including the CAPEX required to start up a new mine, the increasingly remote location of many minesites and the need to compete with pure mining companies for skilled labour. There is also the risk that a mining asset tailored to a steelmaker’s needs may not be able to fully realise potential market opportunities.

Talking to World Coal about these findings, Mike Elliott, Ernst & Young’s global mining and metals leader, noted that: “Ernst & Young analysis suggests that, for some of the vertically integrated players, it may be more valuable if they were to separate their downstream and upstream businesses – so we may see some steelmakers make divestments or spin-outs of mining assets in 2013.” However, given the low prices, there are also opportunities: “we think 2013 may [also] see opportunistic buyers take advantage of depressed valuations, not only in coal but across most commodities,” Elliott continued.

Elliott also noted that Ernst & Young expects the rate of steel demand growth to increase in 2013 (albeit not spectacularly), providing consistent growth in metallurgical coal demand. Given this, the company expects “metallurgical coal prices to be [more likely] impacted by supply rather than demand” with coal prices for long-term contracts lower in 2013 that in 2012. The industry should also expect “some further rationalisation of higher cost metallurgical coal producers”.

Written by Jonathan Rowland.

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