Upstream integration and the end of long-term raw material contracts

Shorter contracts and their implications for the steel industry

In order to capitalize on improving economic conditions, and subsequent price increases, the main raw material producers for the steel industry are rethinking the yearly contracts. They evidenced that even during such a dire crisis as the last one (2008-2009), the raw material prices do not fall too much. And the rebound is much quicker if the price isn't adjusted through long-term contracts (≥ 1 year). In fact, the aim is to mimick the spot prices. Therefore, BHP is moving towards quarterly contracts for coking coal and Vale for iron ore. Given a stable economic outlook, the trend is set to continue and include other suppliers.

What does this trend imply for the steel industry? Coking coal and iron ore are the biggest cost items in producing steel. A bigger variation in these prices could have profound implications for the way that the steel industry operates.

Given that the integrated steel plant is capital intensive, a constant high-level production level is important for two reasons, where the first reason converges towards the second. Firstly, productivity depends on constant production level. Varying the production volumes normally tend to decrease productivity and equipment life-time. Secondly, not using the highest possible production level, the fixed assets will quickly erase any EBITDA.  This analysis also holds true for mini-mills, though the impact is slightly lower given that the reduction area is really where constant production is essential.

With these considerations, it becomes obvious that the steel industry needs to try neutralizing price variations in raw materials. Formerly, this has been achieved through long-term contracts.  With a clear industry-wide tendency to approach spot prices even for contracts, the steel industry is forced more than ever towards upstream integration.

The upstream integration could take two forms: joint-venture/shareholder participation or full ownership.  In the first case, the bargaining power for more constant prices is strengthened through a formal, long-term relationship.  In the second case, the price is an internal decision, where the price could be anything in the range between the production cost to the market price (being a strategic decision where the company wants to generate the profits.).

In South America, Vale is quickly increasing their steel production business.  Thus, the other market participants in the area should be forced towards similar upstream integration, or they would become underperformers, and eventually, take-over targets. Given the logistics costs of iron ore, one could deduce that the price premium for well-located (read: close to existing steel plants) mines should be considerably higher than the general market valuation.