There is lot of stigma about selling assets in India, so it is going to be a lot trickier in here than it will be abroad, feels Neelkanth Mishra, India Equity Strategist at Credit Suisse.
India's banking system's fortunes are closely tied to steel and the domestic steel industry's fortunes are tied to the global growth cycle. Since December, there has been a huge upsurge in the prices of both steel and its raw materials.
Chinese steel prices have shot up by 48 percent since December lows, and European prices by 23 percent; raw material iron ore has shot up by 45 percent since December. At home, steel prices have surged by a more modest 15 percent in the last couple of months while the Indian government has sought to protect domestic steel by imposing a minimum import price of USD 440 per tonne since February, landed prices are ruling higher currently. Simultaneously, pressured by the Reserve Bank of India (RBI), banks have been arm-twisting steel companies to shape up or ship out, which itself is driving cost efficiencies.
"...The cost curve is viscously moving up and the supply chain in steel cannot respond fast enough. Hence, in 1500 million tonne demand, 1.5 billion tonne demand, if demand goes up by 2 percent, you are talking about 30 million tonne additional demand, which means 50 million tonne of additional iron ore. That is a lot of material," says Neelkanth Mishra of Credit Suisse.
"...The steep rise in prices which has happened over USD 200 per tonne, in the last few weeks, is quite steeper but the demand-supply dynamics will not justify the kind of pricing which we have seen... There will be lower steel demand that is the projection for FY2016 by 12 million tonne over 2015," says Seshagiri Rao, Group CFO of JSW Steel.
To discuss the fate of steel prices going forward, Latha Venkatesh of CNBC-TV18 had an exclusive chat with Seshagiri Rao, Group CFO of JSW Steel, Neelkanth Mishra, India Equity Strategist at Credit Suisse, Krishnan Sitaraman, Senior Director Ratings at CRISIL, and Kevin Bai, Analyst at the commodities think tank CRU Group.
Below is the verbatim transcript of Seshagiri Rao, Neelkanth Mishra, Krishnan Sitaraman and Kevin Bai's interview with Latha Venkatesh on CNBC-TV18.
Q: We have seen this 45 percent upsurge in landed steel prices especially from China from USD 250 in December to about USD 450 today. Can prices stabilise at current levels for the rest of 2016 or will we see a correction?
Rao: As far as the steel sector is concerned, the outlook which has been given for the year 2016 by World Steel Association is a lower demand by 0.8 percent. The total steel demand for this year is estimated to be 1488 million as against 1500 million tonne for the year 2015. There will be lower steel demand that is the projection for FY2016 by 12 million tonne over 2015. So, that is the outlook as far as the steel demand is concerned.
What has happened in the last few weeks, either sudden increase in steel prices and at the same time increase in production by the Chinese steel companies. But, the price at which the steel was sold in the calendar year, January and February, they were unfair prices, they were not sustainable prices. So steel prices had to go up. However, the steep rise in prices which has happened over USD 200 per tonne, in the last few weeks, is quite steeper but the demand-supply dynamics will not justify the kind of pricing which we have seen.
However, some stability in the prices would have to come in. So some correction to the downside may happen from the current levels.
Q: What is your sense of the downside? Take an average flat steel products, what are they selling at now USD 450 how much do you think they may dip to? Can they dip even below USD 400?
Rao: In my view, it should be above USD 400 but the pricing which has happened close to USD 500 which is there in international markets has happened at a faster pace. This is driven measurely by Chinese production and also the increase in the market prices in the China. That has driven the prices. For the actual demand side, I don’t think there is a perceptible change in the overall demand outlook across the world. So taking that into account, I think the prices at the current level is not sustainable particularly the demand outlook which has been driven by the World Steel Association.
Q: Your company has gone from underweight on materials to buying or recommending buys in some of the materials companies, what is your outlook on steel prices?
Mishra: For once in many years I think I am more bullish than Seshagiri Rao on the prospect for the steel industry. When you see very steady decline in prices, so for the last two years steel prices have been falling. If you are anywhere in the steel value chain, whether you are a steel producer, steel distributer, a truck company, which is a steel, there is no incentive for you to hold inventory. So, you pare down the inventory to the minimum possible. Inventories have gone down to very low levels after a 2-year down stock.
So what has happened is that the DXY, the trade weighted dollar because the Fed's remarks that the rates won't go up as much as expected, so because of that there has been a spike in the currencies of countries that produce raw materials for steel. So, the Brazilian Real, the Aussie Dollar, the Canadian Dollar, South African Rand they have all bounced back. Now there is a floor drawn on steel prices. What that starts to do is that immediately -- if you are a steel buyer and you realise that steel prices could start going up, you start demanding more steel and throughout the value chain -- this is a supply chain and in supply chain theory this is called a bullwhip effect -- even for a small volatility in end demand, so your car demand volumes may not go up very much but the steel producer will see massive a move up in steel demand.
So, the decline that we had seen was a de-stock effect. The upturn that we are seeing is also a re-stock effect and the viciousness of the re-stock, so Mittal has now raised prices by almost 40 euro in Europe, iron ore prices have gone up USD 70. I think the base case for everyone is USD 45. Iron ore is in such shortage that is has gone to USD 70.
Now the cost curve is viscously moving up and we think that the supply chain in steel cannot respond fast enough. So in 1500 million tonne demand, 1.5 billion tonne demand, if demand goes up by 2 percent, you are talking about 30 million tonne additional demand, which means 50 million tonne of additional iron ore. That is a lot of material.
You need to charter ships, you need to start the railway lines and so on and so forth. If you saw the output numbers, the guidance for this year's output has been brought down. So it is very likely that the re-stock can last for several quarters.
Q: But is it not likely that precisely this up move in prices will bring mothball capacities into the market?
Mishra: So two things here, the first is that this restock is actually a global event, so if you see the apparent demand growth in Brazil, in Russia, the apparent demand growth is minus 25 percent year-on-year (Y-o-Y) for many months in these markets, so clearly this demand surge will be actually global is not just about China. The supply response is actually going to be muted, so there are two reasons for that, one is that the steel companies themselves are actually quite suspicious given the kind of stress and pain they have gone through in the last two years of the sustainability of this rebound. Therefore, they will be reluctant to start furnaces if this is going to get over in two months.
Secondly, banks are very reluctant to give working capital to some of these companies because they realise this is throwing good money after bad. Particularly in China, the restart of some of the furnaces could actually take longer and which is why this restocking can last for long enough for investors to take advantage of it and I must clarify that this is a restock rally. The structural concerns on steel that China cannot keep consuming that much per capita those still exist. What has also happened and this is an important point as well that China on a strategic level seems to be moving away from the supply controls and back to demand stimulation and while so far it has only been visible in the credit growth numbers. Our China analyst believe that there have been a surge in project approvals and that will drive a surge in metals demand in the second half of this calendar year possibly into 2017 as well, as those projects hit the ground, which is why the steel traders in China, so as the credit availability has improved slightly. They have started stocking up on steel in anticipation of the demand surge and suddenly everyone wants iron ore and no one is getting it and that is why iron ore is at USD 70 and this can actually last for several quarters, so it won't get over in a few months.
Q: Do you think that movement like this in terms of positivity of margins can lead to better merger and acquisition (M&A) activity so that weak companies move on into strong hands?
Mishra: I certainly hope so. That is where it is important that I keep highlighting that this is a tactical move. This is a restocking move. This is not demand structurally coming back and that we are suddenly very positive on steel on a five year basis, we are not, so this is a restocking move and it is very important that companies with weak balance sheet use this opportunity to repair themselves means someone goes and does the rights issue, someone does go and raise an equity, someone does M&A, sells of the assets so it is very important that these activities happens so when the restock ends and steel prices start coming down again that the balance sheets are in much healthier position than they are right now.
Q: You expect M&A activity in India. Are you confident from what you are picking up as straws in the wind?
Mishra: It is going to be much difficult in India. It is quite more likely outside where there is a lot of history of mergers and acquisitions. There is a lot of stigma about selling assets in India. A lot of promoter group think it will bring shame on their families, on their groups. There is reluctance to completely give away stake. There is an instinct, there is an urge to sort of control or say keep 20-30 percent of the stake while you are selling of the rest and no one really wants to buy if the old promoter is still around. It is going to be a lot trickier in India then it will be abroad.
Q: Do you think that stress from commodity companies would lessen enough for you to improve your outlook on the financial sector on banks?
Sitaraman: See immediately, I don't see the scope for that happening, but as I said there are these positive developments of recent times which we are looking into. If I look at the banking sector asset side, we are still seeing a very high proportion of weak assets and our projection still is looking at that increasing to till March 2017, so we are looking at what we called as the weak assets in the banking system going to around 8.9-9 percent of the total asset book. We have not seen a reduction in that percentage so far because of the way we are looking at things is if I look at the entire commodity space or the investment linked space, we are still seeing stress there, debt levels are high and we are not seeing cohesive or constructive means or sustainable means to reduce that threat of debt.
Q: Do you think that before this year is out some weak steel companies will pass on into slightly stronger hands in India?
Rao: There is a big gap in the actual valuation which one perceives and the perception the existing managements and also the bankers have there is a big gap. Unless, that gap is bridged taking into account the future outlook of steel industry in general and India in particular then only any activity can happen otherwise I don’t think it possible to have any M&A activity.
Q: If you look at the composite picture, the Reserve Bank has been forcing banks to recognise bad loans. There is public pressure from Courts, from government, from the media that defaulters have to be punished. So there is a pressure and arm-twisting that’s coming from the eco-system that coupled with the fact that prospects look a little better can they ensure that something will happen in FY17 in terms of M&A activity?
Rao: We have to wait and watch. It is very difficult to say that will happen or not, but today whatever interactions we are seeing in the market place there is a gap in the expectation or the valuations, so therefore I don’t think still it is ripe to have any big M&A activity in steel sector in India.
Q: You all have become overweight on the material space on the metal space. When might this pass on to financials. You have upgraded one bank, ICICI when might you extend it to more finance companies?
Mishra: See for financials in general so you have to appreciate that model portfolio weights are relative weights, so there are sectors which are faster growing, so if your credit growth is going to be 12-14 percent at most, there are segments and sectors where we think the growth can be faster. We are expecting that capital goods demand or private sector capital expenditure (Capex) may not pick up that fast. We also don’t think that the up cycle will last long enough for people to sustainably pare their debt and therefore we are sticking to the relatively high quality names even when we are playing the up cycles, so what is going to happen is that if there is let’s say a broken steel company, I mean it may not be broken right now but in market views it is unviable, debt per tonne is USD 2,000 is clearly unsustainable. The amount of that debt that needed to be written down was going out of the banks’ profits, so the banks’ book. So equity value is near zero in anyway. The debt value had to be pared down, so the quantum by which the debt had to be pare down now falls at least in the market perception for the next several quarters and that adds to the banks’ valuations and that is the call we have made given that it is not the repeat. It is not a 3-5 year bull run yet, one quarter at time, so we are going to stay cautious on the quality names, going down the quality curve at this stage will be too risky for us.
Q: Hasn't the rise in prices since December led to more capacity utilisation? Do expect more supplies and hence steel prices to fall?
Bai: To be honest the profitability at steel mills in China has improved significantly and these and some of traders are making significant margins by selling low priced stock and this has encouraged mills especially in Kobe province and Shanxi province to come back to the market. So, the answer is yes, there are some production resumptions since the price rise and these can be proved by year-on-year (Y-o-Y) increase of Chinese crude steel production in March about 2.9 percent and we also hope that April production will be higher as well.
Also I just mentioned that the output resumption is below expectation. There are several reason behind this. The first one is it will need a lot of money to restart furnace. But currently speaking, the financial condition at steel mills and the credit availability for the steel industry is still tight and the second one is given the hike in prices it is easy to become cautious, rational and people in steel mills are worrying because they fear that the price hike is just relatively short lived. The third reason is that, there are steel stresses and pressures from the government level to control output. So, that's why.
Q: How do you see prices of Chinese steel exports for the rest of 2016?
Bai: Firstly I must apologise first because we don't forecast on Chinese Export prices at the moment. But we do have a net image of Chinese domestic prices in terms of hot-rolled coil. It is still likely to face some downward pressure especially in late Q2 that is, say May to June and give it output resumption as I just mentioned before capacity control and credit tightness. So, these are all the downward pressure for further price increases and it is also very likely that prices will see correction very soon given the unbelievably high prices at the moment. Actually today a little bit of downward correction has already seen in the Chinese domestic market.
Q: So what do you think will be the average domestic steel price in China in 2016?
Bai: According to our research the annual average is around 2500 RMB/ tonne for hot-rolled coil. It is from our focus made in early April but I must admit that it should be higher as this forecasted didn't feed in the latest prices and the latest prices definitely are much higher than we expected. So the average will be higher if we see it right now.
Q: And how much is that in dollar terms?
Bai: It will be less than USD 380 I suppose.
Q: In general will steel prices in 2017 be higher or lower than prices in 2016?
Bai: From the current price cost condition we don't expect the price will fall to level that we have seen late last year because the level we see last year is based on very low iron ore and coal prices in terms of production cost and at the same time mills were selling them below marginal cost to minimise losses. But they cannot keep doing that because they are losing money and we have seen a lot of mills actively shut down their mills for good. So, we don't think that for now given the current price cost additions that price will happen.
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