A manager at Severstal's Rouge steelmaking plant near Detroit, Michigan

Russian billionaires bet big on U.S. steel market
Mon Apr 7, 2008 7:28am EDT
By Robin Paxton - Analysis

MOSCOW (Reuters) - Russia's steel elite, with cash to burn from record profits, has accumulated almost 10 percent of U.S. steelmaking capacity as it bets big that demand in the world's largest economy will ride out a global credit crunch.

Billionaires who built their fortune on Soviet-era steel giants have spent nearly $9 billion in the last few years acquiring U.S. mills to expand their global presence. At today's knockdown prices, investors believe it's a gamble worth taking.

"They're buying them because they're cheap. The underlying motive behind buying these mills is making money, not enhancing the political glory of Russia," said Tim McCutcheon, a partner and fund manager at DBM Capital Partners in Moscow.

Betting on U.S. steel is risky, say analysts, as the once-mighty automotive and construction sectors are in decline and demand growth has been eclipsed by emerging economies such as China and India.

But this has not deterred Alexei Mordashov, owner of Severstal (CHMF.MM), whose acquisitions have pushed his company into the top five steel makers in the United States -- a scenario unthinkable when the countries were Cold War enemies.

"We remain committed to growth in North America and believe in the long-term promise of the U.S. market," Mordashov, ranked the world's 18th-richest man by Forbes magazine, said after announcing Severstal's latest acquisition last month.

Mordashov says the weak dollar is making Russian companies, which derive most of their revenues supplying a domestic market expanding at more than 7 percent annually, more competitive in the United States. The dollar has lost nearly 15 percent of its value against the Russian ruble in the last two years.

CHANGING WORLD

Russia's foray into North American steel marks the growing power of its leading steel firms, which are unburdened by high raw material costs after absorbing their own mines during a carve-up of the country's mineral assets in the late 1990s.

Severstal was the first Russian company to buy a U.S. steel asset when it bought Dearborn, Michigan-based Rouge Steel, once the in-house steel unit for Ford Motor Co (F.N: Quote, Profile, Research, Stock Buzz), in late 2003.

Evraz Group (HK1q.L), part-owned by billionaire Roman Abramovich, followed with the acquisition of Oregon Steel Mills and Claymont Steel Holdings. Last month it also agreed to buy IPSCO's North American assets from Sweden's SSAB (SSABa.ST: Quote, Profile, Research, Stock Buzz).

"How the world has changed!" said Jack Dzierwa, global strategist at Texas-based U.S. Global Investors Inc.

"In the 1990s, Russia was a laughing stock, but its muscles have grown and the country has gone on an acquisition spree," said Dzierwa, who co-manages the $19.2 million Global MegaTrends fund and holds stock in Evraz and Mechel (MTL.N).

Cash-rich Russian oil and gas firms were the first to announce large trans-Atlantic acquisition plans, including projects by Gazprom (GAZP.MM) to build regasification terminals and refinery acquisition plans by oil major LUKOIL (LKOH.MM).

Their penetration, however, has so far been limited to LUKOIL's network of 2,000 filling stations.

Steel barons have avoided the political scrutiny that has hampered other Russian attempts to invest overseas by spending at a time when parts of the U.S. steel industry are on their knees and limiting their ambitions to small or mid-sized mills.

This has, however, raised questions over asset quality.

Charles Bradford, New York-based metals analyst for Soleil Securities Group Inc, said Russians had bought assets nobody else wanted and face a huge challenge in turning them round.

"Some of these plants were so bad. I don't know if they could have been sold as scrap," he said.

FUTURE BUYS

Severstal's record $1.9 billion in net profits, for example, mask a sharp decline in earnings at its North American unit due to weaker market conditions and a blast furnace reline.

Its latest acquisition suggests more of the same. The Sparrows Point mill in Baltimore, Maryland is a former unit of Bethlehem Steel and was the world's largest steel plant in 1950. At least $350 million will be needed to turn it around.

But outdated mills shunned by U.S. firms present less fear to those well acquainted with the overmanned behemoths that once served the Soviet military-industrial complex.

"Someone who comes from Cherepovets or Lipetsk is not going to have a problem with an integrated mill," McCutcheon said, referring to the home cities of Severstal and NLMK (NLMKq.L).

Evraz Chairman and Chief Executive Alexander Frolov said his company's acquisitions would expand its presence in rails -- its Oregon buy made it the world's biggest rail maker -- and pipes.

"This is an important sector for U.S. industry as it's linked to energy and infrastructure, and we believe there's long-term stable demand," Frolov said.

Click here to read the rest of the article from Reuters.

A report issued in May 2008 by the Canadian International Bank of Commerce World Markets, "Will Soaring Transport Costs Reverse Globalization?" further explains why the Russians shrewdly invested at a time when steel production is making a comeback in North America:

"We are already starting to see some change in capital-intensive manufacturing whose products carry a high ratio of freight costs to final selling prices. Take the steel sector for example. With little over an hour and a half of labor time embodied in the production of a ton of steel, and relatively high freight costs, the global cost curve of the steel sector is changing rapidly. Given that most parts of China (and Asia in general) are short on iron ore, getting the raw materials to the steel mill (mainly from Australia and Brazil) adds an additional and growing cost not typically incurred by US steel producers. Add to it the $90 freight cost of shipping a ton of hot-rolled steel sheet from China to the US, and the transport component is large enough to turn the global steel cost curve on its head.

"Even at today’s oil prices, rising transport costs have already more than offset China’s otherwise slim cost advantage, giving US steel a competitive advantage in its own market for the first time in over a decade. The rapidly changing economics of steel is already reflected in the trade statistics. China’s steel exports to the US are now falling by more than 20% on a year-over- year basis—the worst performance in almost a decade. While many might attribute this decline to the slowdown in the US economy, it is noteworthy that US domestic steel production has risen by almost 10% during the same period (Chart 6)."

In addition to preserving some manufacturing jobs in the U.S. and Canada, the authors of the study also envision higher fuel prices creating a new opening for renewed foreign investment in Mexico. Most of this investment will come from Mexico's NAFTA main partners, the U.S. and Canada, but look for European and perhaps even Russian firms to get in on the action:

"While there remains a strong imperative in the world economy to arbitrage wage costs, the arbitrage willincreasingly take place within the constraints imposed by soaring transport costs. Instead of finding cheap labor half-way around the world, the key will be to find the cheapest labor force within reasonable shipping distance to your market."

"In that type of world, look for Mexico’s maquiladora plants to get another chance at bat when it comes to supplying the North American market. In a world where oil will soon cost over $200 per barrel, Mexico’s proximity to the rest of North America gives its costs a huge advantage. It seems that American importers are starting to do the math. Compare, for example, how relative transport costs have recently changed between the Pacific Rim and Mexico. In 2000 American importers paid 90% more to ship goods from East Asia to the US East Coast, today they pay 150% more, and when oil prices reach $200 per barrel,they will pay three times the amount it costs to ship the same container from Mexico (Chart 8)."

"To put things in perspective, today’s extra shipping cost from East Asia is the equivalent of imposing a 9% tariff on East Asian goods entering the US. And at oil prices of $200, the tariff-equivalent rate will rise to 15%. While the pace of shipments from China to the US is slowing—mainly among freight-intensive goods, even non-energy Mexican exports to the US are still rising at a healthy annual rate of more than 7%. And interestingly, the goods that have seen the fastest growth are the ones that, on average, are more freight-intensive and directly compete with China, such as furniture, iron and steel,rubber and paper products (Chart 9)."

"In a world of triple-digit oil prices, distance costs money. And while trade liberalization and technology may have flattened the world, rising transport prices will once again make it rounder."