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Worsening risk-reward in steel equities

Lead indicators of Chinese demand for steel continue to worsen. Weak realestate data (chart 23) as well as contagion fears on account of debt defaults in the high-yield developer market, sets a context for the current steel production cuts. Risk-reward in steel equities is further worsened by the precipitous fall in iron ore prices.

The last cost support for steel is in elevated coking coal prices and it appears that it is only a matter of time, given the current pace of Chinese steel production decline, that coking coal starts to correct. Higher coking coal prices are currently compressing Chinese steel margins and supporting steel prices.

Global steel equities continue to derate in expectations of a price decline (table 6). Low iron ore prices should lead to lower scrap and eventually lower long product prices in our view. Thus, we see sharp decline in MTM earnings for SAIL and JSPL. We are more constructive on aluminium; maintain BUY on Hindalco. JSPL, given its potential to be debt-free by FY23E post Jindal Power divestment, is our top pick in the ferrous space.

* Steel MTM earnings continue to decline; low iron ore prices don’t augur well for long product prices in India. Higher coking coal prices (Australian HCC coal crossed US$335/te) continue to bear down upon MTM earnings and spreads for Indian steel players (table 2). While lower iron ore prices (expectantly) are positive for unintegrated producers like JSW Steel and JSPL, such prices bring along not so exciting news for (predominant) long product producers like JSPL and SAIL. Lower iron ore prices imply lower scrap prices (scrap and iron ore generally move in tandem) and lower scrap prices imply lower sponge iron prices (scrap being the substitute for sponge iron in DRI). Sponge iron prices are the trendsetter for long product prices in India. Demand recovery can help inter-product spreads; however, iron ore at doesn’t augur well for long product prices. We see largest MTM earnings drop for SAIL and JSPL (14-17%). We don’t see meaningful impact of higher GST incidence (5-18%) on iron ore for steel players or merchant miners.

* Hindalco remains our top pick; aluminium players continue to see uptick in MTM earnings despite coal cost inflation. China’s aluminium output in Aug’21 fell for the fourth straight month due to tight restrictions on metal production and power usage (down 3.2% MoM) (NBS). Yunnan, in Southwest China, has asked the local smelters to reduce aluminium production by 30% for the rest of the year to help them meet their goals of reducing greenhouse emissions and energy use. Yunnan Aluminium has reduced its CY21 production target by more than 500,000te, or almost 18%, after the local government enforced production curbs for the rest of the year. Yunan uses local hydropower sources for the energy-intensive smelting process. It said in a filing on Thursday, 16th Sep’21, that its primary aluminium output was expected to fall to 2.36mnte this year (Link). While there are risks to current LME, ESG-driven production cuts as well as higher cost incidence and higher adoption in EVs helping demand are structural levers for aluminium prices in the medium to longer run. Hindalco’s pivot as a downstream player adds potential RoE expansion possibility.

* Coal to clean energy pivot: some framework for Indian metal + miners to think about. Glencore has acquired a stake in battery startup Britishvolt, as part of its ambitious plans for a gigafactory (GBP2.6bn project) to equip the UK’s car industry for an electric future. Glencore will also supply the gigafactory, Cobalt, for electric batteries. The UK has banned petrol and diesel cars from 2030.

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