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Learnings from upstream
integration of steelmakers
OECD workshop
December 11, 2014
CONFIDENTIAL AND PROPRIETARY
Any use of this material without specific permission of McKinsey & Company is strictly prohibited
Cape Town
McKinsey & Company | 1
Contents
▪ Steel industry characterized by low degree of
vertical integration
▪ Upstream integration by steelmakers driven by
desire to secure supply and increase margins
▪ Steel industry increased investment in
upstream assets during commodity boom years
▪ Integrated players outperformed their non-
integrated peers during the commodity boom
years, but that trend has now reversed
McKinsey & Company | 2
Only about 20% of HRC production is based on captive iron ore… Percent of global HRC production, EBIT margin, 2013
ESTIMATES
1 Integrated steel production (BF, BOF, HRC) with captive iron ore supply (pellets, sinter, lump)
2 TK Bochum
SOURCE: McKinsey Flat Steel Cost Curve, Company reports; S&P capital IQ
NOT EXHAUSTIVE
x % of global volume (X) % EBIT margin
Downstream Upstream (iron ore) Midstream
Slab production Captive/semi captive in iron
ore mining HRC
Iron ore integrated flat steel mills1
Non integrated flat players with
BOF/EAF production
Iron ore mining only
(47.9)
(58.1)
(39.2)
(31.6)
(60.8)
(56.0)
(-0.4)
(-3.6)
(1.4)
(1.6)
(-1.9)
18 22 23
82
70
78
Re-roller
7
2
(9.3)
(7.2)
(12.6)
(30.6)
Anshan (1.8)
(3.1)
(5.9)
McKinsey & Company | 3
ESTIMATES
1 Integrated steel production (BF, BOF, HRC) with captive coking coal supply
2 EBITDA margin
3 TK Bochum
SOURCE: McKinsey Flat Steel Cost Curve, Company reports; S&P capital IQ
Downstream Upstream (met coal) Midstream
Slab production Captive/semi captive in coal mining HRC
Iron ore integrated flat steel mills1 (3.1)
Non integrated flat players with BOF/EAF production (Met) coal mining only2
(-9.7)
(-3.6)
(2.8)
(3.4)
(-1.9)
12
9 8
88
85
91
Re-roller
7
3
(9.3)
(7.2) (12.6)
(16.3)
NA
(42.0)
(18.0)
(21.0)
NA
NA
… and a mere 8% is based on captive coal NOT EXHAUSTIVE Percent of global HRC production, EBIT margin, 2013
x % of global volume
(X) % EBIT margin
McKinsey & Company | 4
1 Income before income tax; 2 For total Rio Tinto Group; 3 Underlying EBIT; 4 Adjusted EBIT; 5 Calculated as Results from ordinary income + Financial result; 6 Profit before derivatives;
7 consolidated figure
One third of the aluminum upstream/midstream value chain is
integrated whereas downstream segment is more fragmented
SOURCE: Annual Report, RMG, Alken, Aluminium suppy model v4.32, Woodmac, McKinsey analysis
Downstream Upstream Midstream
Aluminum
smelting Bauxite mining Alumina refining Semis production Fabrication
Mining/refining/smelting/manufacturing
57
18 (-8)
(15) (3)
Smelting only
(-3
(3)
8
n/a 49
19
Mining/refining
(32) 3%
14
(4)
Manufacturing only
82
13%
9%
2%
n/a
Format
casting
32
Mining/refining/smelting
(29)
(-18)
(9)
29
3
4 6
5
2
1
ESTIMATES
(9.5) 7
(6.3)
NOT EXHAUSTIVE
Percent of global aluminium volume, operating profit margin, 2013 x
% of global volume
(X) % operating profit margin
x
McKinsey & Company | 5
NOT EXHAUSTIVE
1 Supply local market
2 average of selection of listed players only operating in one part of the value chain
The oil industry has a high level of vertical integration
SOURCE: McKinsey Global refinery model
Upstream
Refining capacity Production of crude oil and NGLs
Full value chain (listed)
Upstream
86
14
75
Mid- and downstream
25
Percent of global oil volume
Refining - Midstream-Downstream
4
24
3
48
Retail Midstream Refining Upstream
Typical EBITDA
margin 20132
ESTIMATES
x % of global volume
Full value chain (NOCs)
McKinsey & Company | 6
Contents
▪ Steel industry characterized by low degree of
vertical integration
▪ Upstream integration by steelmakers driven by
desire to secure supply and increase margins
▪ Steel industry increased investment in
upstream assets during commodity boom years
▪ Integrated players outperformed their non-
integrated peers during the commodity boom
years, but that trend has now reversed
McKinsey & Company | 7
Over the last years, steel players have been "squeezed" between volatile
raw material cost and the increased pressure coming from downstream
Drivers
Mining End-user industries
Upstream Midstream Downstream
▪ Demand outpacing supply growth
▪ Cost inflation
▪ High volatility due to short term (spot market) price indexing and steepening cost curves
Steelmaking
▪ Significant overcapacity
▪ Higher transparency of total cost position
▪ Increased transparency on steel raw material cost
▪ Centralization of steel purchasing at OEM level and integration in "continuous cost reduction programs"
Pressure Pressure
Risk of moving
to pure trans-
former role
McKinsey & Company | 8 SOURCE: Company websites; press clippings
▪ “We will continue to invest in mining to secure our access to raw materials. “
▪ Stated intention of reaching 50% self‐sufficiency in iron ore and coking coal by
2015. Its captive supply will be boosted by
– exports from Hancock Prospecting’s Roy Hill – in which it owns a 12.5% stake –
starting from Western Australia next year
– 25% ownership of West Pilbara iron ore project. Ability to work together with
Chinese rival Baosteel on off-take arrangements will be important
▪ Continues its commitment to the West Pilbara iron ore project (7 USD bn): recent
85% ownership of Aquila Resources (owning 50% of West Pilbara)
▪ Vertical integration to secure supplies of raw materials
– In 2013 (assuming full production of iron ore at ArcelorMittal Mines Canada, Serra
Azul and full share of production at Peña Colorada for its own use), approximately
62% of ArcelorMittal’s iron-ore requirements and approximately 19% of its PCI
and coal requirements were supplied from its own mines or from strategic
contracts at many of its operating units
▪ Tata Steel’s long-term strategy is to have as much control as possible over its raw
material resources and to ensure security of supply for its operations globally
▪ Goal to become 100% self-sufficient in iron ore and 50% self-sufficient in coking coal
– India :100% self-sufficient in iron ore
– Europe: currently investing in New Millennium Iron and other projects in Canada
NOT EXHAUSTIVE Examples
In response, steelmakers increased vertical integration into mining
McKinsey & Company | 9
Why did steel players pursue upstream vertical integration?
Benefits of
upstream-
midstream
integration
Stated by
steel players?
Possible benefits
-
-
-
-
▪ Security of raw material supply
▪ Larger share of the value chain EBITDA pools
captured
▪ Integrated mining operation benefitting midstream
purchasing strategy and bargaining power for
externally sourced raw materials
▪ Optimized operating parameters (value-in-use trade-
offs) between upstream and midstream
▪ Integrated, optimized logistics system between
upstream and midstream assets
▪ Ensuring market access for product
▪ Achievement of stakeholder goodwill for upstream
assets by leveraging higher employment ratio for
midstream vs. the upstream assets
McKinsey & Company | 10
Contents
▪ Steel industry characterized by low degree of
vertical integration
▪ Upstream integration by steelmakers driven by
desire to secure supply and increase margins
▪ Steel industry increased investment in
upstream assets during commodity boom years
▪ Integrated players outperformed their non-
integrated peers during the commodity boom
years, but that trend has now reversed
McKinsey & Company | SOURCE: Dealogic
0
50
100
150
200
250
300
14
2
0
16
12
10
8
6
4
10 09 08 07 06 05 04 03 2002
Iron ore, coking coal USD/t
Transaction value USD billions
14YTD 13 12 11
0 0
3
10
4
8
15
9
3
5
7
5
1
Transaction value
HCC FOB Australial USD/t
Iron ore fines FOB Brazil USD/t
Steel players have stepped up investments in acquisition
of mining assets, especially during the boom years Acquisitions of mining companies by steel players based on
date of completion
McKinsey & Company | 12
100
300
250
200
150
100
50
0 0
1,000
900
800
700
600
500
400
300
200
350
Industry’s absolute fire firepower1
Current cash + leveraging up to 2.5 net debt/EBITDA + increasing capital by 30%, USD Bn
13
175
12
317
11
285
10
224
09
136
08
218
07
235
06
190
05
100
04
56
03
43
02
44
01
65
2000
40
Investment USD billion
20143
138
Mining investment activity has been driven by the industry absolute
financial firepower, i.e. not taking into account asset ‘prices’
SOURCE: Bloomberg; Dealogic; Value Pools 3.0
1 Sample of 144 mining companies
2 Considering deals equal or higher than USD 100 million
3 Annualized
Corporate M&A2
Capex1
Asset M&A2
Industry’s absolute financial firepower1
Wrong
approach
“In cyclical industries, assets are often
undervalued at the bottom of the cycle,
which could create relatively cheap
acquisition opportunities.”
Koller, Valuation
Right
approach
McKinsey & Company | 13
Most iron ore mining assets owned by steelmakers are located in third
quartile, and not cash contributive at current pricing
Mt Dry 62% Fe, USD/ton real 2012 standardized to fines cost
Iron ore cost curve 2013 CIF China
SOURCE: McKinsey Iron Ore Supply Outlook, indexmundi.com
170
30
20
10
0
2,000 1,500 1,000 500 0
130
120
200
190
180
110
160
150
140
100
90
80
70
60
50
40
Not owned by steelmakers
Owned by steelmakers
IODEX 62% Fe CIF
China December 2014
McKinsey & Company | 14
2013 seaborne metallurgical coal cost comparison
20
0
280
260 240 220 200 180 160 140 120 100 80 60 40 20 0
40
60
80
100
120
140
160
180
200
220
240
260
320 300 280
~159 USD/mt 2013
avg contract price2
~147 USD/mt 2013
avg spot price2
~111 USD/mt 2014
Dec spot price2
FOB cash cost, adjusted to HCC quality1 USD/metric tonnes
Seaborne supply Million metric tonnes
1 Quality adjustment relative to premium HCC, based on value differential
2 FOB Australia terms
3 Or partially owned by steelmaker
Also several 3rd/4th quartile coal assets owned by steelmakers
Not owned by steelmakers
Owned by steelmakers3
SOURCE: AME; Platts; McKinsey analysis
McKinsey & Company | 15
Contents
▪ Steel industry characterized by low degree of
vertical integration
▪ Upstream integration by steelmakers driven by
desire to secure supply and increase margins
▪ Steel industry increased investment in
upstream assets during commodity boom years
▪ Integrated players outperformed their non-
integrated peers during the commodity boom
years, but that trend has now reversed
McKinsey & Company | 16
Integrated players outperformed their non-integrated peers during the
commodity boom years, but that trend has now reversed
SOURCE: Datastream
Total Return to Shareholders; indexed (January 2000 = 100)
Note: Latest quote on Dec 02, 2014
0
300
600
900
1,200
1,500
1,800
2,100
2,400
2,700
3,000
12 05 04 03 02 01 00 11 10 09 08 07 06 15 14 13
Significant
mining
Steel
only
Some
mining
CAGR, percent
43
29
28
Some mining
Significant mining -79
-73
-73
162
93
79
-21
-15
-4 During last 5 years
non integrated steel
companies’s TRS
decreased less than
(partially) integrated
steel companies that
Steel only
McKinsey & Company | 17
Vertically integrated players do not show a higher valuation multiple
SOURCE: S&P capital IQ; McKinsey analysis
Historical evolution of valuation multiple; average EV/EBITDA
0
2
4
6
8
10
12
14
16
18
20
22
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Some mining
Steel only
Significant mining
McKinsey & Company | 18
In sum
▪ The steel industry is characterized by a low degree of vertical
integration compared with many other commodity industries
▪ Over the last decade, the steel industry has over 60 Bn USD
invested in the acquisition of mining assets, driven by a
desire to
– Secure supply of raw materials
– Capture higher margins in the value chain
▪ investments in mining assets took place at high asset prices,
and often in 3rd and 4th quartile of the cost curve
▪ Vertically integrated players outperformed their non-integrated
peers during the commodity boom years, but that trend has now
reversed
McKinsey & Company, Inc.
www.mckinsey.com
+32 477 480 165
McKinsey & Company | 20
Vertical integration segmentation
25 Maanshan Iron & Steel
26 Magnitogorsk Iron & Steel Works
27 Nippon Steel & Sumitomo Metal
28 Novolipetsk Steel OJSC
29 POSCO
30 Shandong Iron and Steel Co Ltd
31 Shanxi Taigang Stainless Steel
32 Steel Authority of India Ltd
33 Usiminas
34 Voestalpine AG
35 Wuhan Iron & Steel Co Ltd
36 Xinjiang Ba Yi Iron & Steel Co Ltd
37 Xinyu Iron & Steel Co Ltd
38 Anyang Iron & Steel Inc
39 APERAM
40 BlueScope Steel Ltd
41 Carpenter Technology Corp
42 China Oriental Group Co Ltd
43 Cia Electro Metalurgica SA
44 Commercial Metals Co
45 Corp Aceros Arequipa SA
46 Daido Steel Co Ltd
47 EL Ezz Aldekhela Steel Alexandria
48 Feng Hsin Iron & Steel Co
Company
49 Grupo Simec SAB de CV
50 Guangzhou Guangri Stock
51 Hangzhou Iron & Steel Co
52 Hyundai Steel Co
53 Industrias CH SAB de CV
54 Laiwu Steel Corp
55 Maruichi Steel Tube Ltd
56 Nanjing Iron & Steel Co Ltd
57 Nucor Corp
58 Osaka Steel Co Ltd
59 Outokumpu OYJ
60 Rautaruukki OYJ
61 Sahaviriya Steel Industries
62 Salzgitter AG
63 Seah Besteel Corp
64 Sims Metal Management Ltd
65 SSAB AB
66 Steel Dynamics Inc
67 Tenaris SA
68 ThyssenKrupp AG
69 Tung Ho Steel Enterprise Corp
70 Worthington Industries Inc
71 Xinxing Ductile Iron Pipes
72 Yamato Kogyo Co Ltd
Company
1 Aichi Steel Corp
2 Cia Siderurgica Nacional SA
3 Severstal OAO
4 Tata Steel Ltd
5 United States Steel Corp
6 Vallourec SA
7 Acerinox SA
8 AK Steel Holding Corp
9 Allegheny Technologies Inc
10 Angang Steel Co Ltd
11 ArcelorMittal
12 Baoshan Iron & Steel Co Ltd
13 Beijing Shougang Co Ltd
14 Bengang Steel Plates Co
15 China Steel Corp
16 Dongkuk Steel Mill Co Ltd
17 Eregli Demir ve Celik Fabrikalari TAS
18 Gerdau SA
19 Hebei Iron & Steel Co Ltd
20 Hunan Valin Steel Co Ltd
21 Inner Mongolian Baotou Steel Union
22 JFE Holdings Inc
23 Kobe Steel Ltd
24 Lingyuan Iron & Steel Co Ltd
Company
Significant mining
Significant mining
Significant mining
Significant mining
Significant mining
Significant mining
Some mining
Some mining
Some mining
Some mining
Some mining
Some mining
Some mining
Some mining
Some mining
Some mining
Some mining
Some mining
Some mining
Some mining
Some mining
Some mining
Some mining
Some mining
Vertical
integration
Some mining
Some mining
Some mining
Some mining
Some mining
Some mining
Some mining
Some mining
Some mining
Some mining
Some mining
Some mining
Some mining
Steel only
Steel only
Steel only
Steel only
Steel only
Steel only
Steel only
Steel only
Steel only
Steel only
Steel only
Vertical
integration
Steel only
Steel only
Steel only
Steel only
Steel only
Steel only
Steel only
Steel only
Steel only
Steel only
Steel only
Steel only
Steel only
Steel only
Steel only
Steel only
Steel only
Steel only
Steel only
Steel only
Steel only
Steel only
Steel only
Steel only
Vertical
integration
McKinsey & Company | 21
Upstream shift of value in the steel industry over the last 2 decades
1 Profit pool calculated based on EBITDA × demand/production, calculated for 12 major regions, with EBITDA based on historical highs and lows by
region and product
2 Flat steel assumed to represent 70% of the overall iron ore/met coal demand (the other 30% being long steel); HRC assumed to be 85% of flat steel
81 78
61 57
72
35 36 3426
4348
117
2222
10
3927
2430
24 14
815 17 21 18
2637 41 44
33 38
Iron ore
2013
207
12
229
11
302
10
200
09
80
08
241 100% = 136
06
101
Steel
making
(HRC)
Coking
coal
07 2005
125
00
23
1995
54
HRC value chain1 profit pool split evolution since 1995, USD billions
Profit pool1 split, HRC
McKinsey & Company | 22
SGX Cleared Iron Ore volumes
Iron Ore
Million tons ▪ First cleared Iron ore swap
contract in 2009 by SGX
▪ Exponential growth leading to
expected 2014 iron ore
derivatives volume of 500 Mn
tons or 40% of physical
volume (0.4 velocity)
▪ Coking coal derivatives
launched on CME in 2011
▪ Coking coal swaps on CME
traded growing 5-fold this year
(from 168k tons in 2013 to
>1Mn tons this year)
▪ SGX launching a TSI Coking
Coal Swap in July 2014 as well
Increased transparency on steelmaking raw material prices over the last
years
Source: SGX
25
20
15
10
5
0
60
55
50
45
40
35
30
+249% p.a.
2014 2013 2012 2011 2010
Futures Options Swaps
Coking Coal
04-
2009
McKinsey & Company |
Steel players have stepped up investments in acquisition
of mining assets, especially during the boom years
46 6
11
21
12 129 10
111
0
5
10
15
20
25
8
16
14
12
10
6
4
2
0
12 11 10 09 08 07 06 05
10
03 2002
Number of M&A #
Transaction value USD billion
04 14YTD 13
1
5
9
7
5
3
15
8
4
10
3
0 0
1 Completed transactions
Total value of transactions¹
USD billion
Number of transactions
SOURCE: Dealogic; McKinsey analysis
Acquisitions of mining companies by steel players based on date of completion
19 20 23 36 46 52 79 69 112 175 123 122 89
47 47 55 108 118 103 250 172 191 289 210 159 126
IO fines FOB Brazil USD/t
HCC FOB Australial USD/t
23
McKinsey & Company |
In response, steelmakers increased vertical integration into
mining, especially between 2005 to 2008
0
10
20
30
40
50
60
70
80
90
100
110
120
130
140
150
160
ArcelorMittal
US Steel
SAIL
CSN
Severstal
Tata Steel
CAP
Jindal
2013 12 11 10 09 08 07 06 2005
Iron ore production of steelmakers, million tonnes
SOURCE: RMG; US Steel
IRON ORE EXAMPLE
NOT EXHAUSTIVE
24
McKinsey & Company | 25
Many oil companies which are active in upstream and
downstream have limited physical integration
SOURCE: Total Factbook, 2011
Total crude/products balance, 2011
kbd
Production
939
Crude purchases
1,798 Crude sales
1,264
Total trades more crude
than it produces or
refines Total trades more
products than it
produces from refining
Core activity
Trading
Upstream Refining Marketing
Other feedstock
114
Refining
1,587 Product output
1,636
Refinery fuel
50
Product purchase
1,738
Product sales
3,374
Marketing sales
2,159
Trading sales
1,215
McKinsey & Company | 26
However, there are also some arguments against taking a position along
the value chain – it is important to consider how to deal with these issues
SOURCE: Team analysis
How should
steel players
manage
these
issues?
Different skill sets
▪ Upstream, midstream, and downstream require different skill
sets in terms of engineering, operating, and
commercialization
Organizational bias
▪ A position across the value chain may get in the way of
optimizing each part of the business in its own right –
organizations tend to be biased and optimize one part at the
expense of the other (e.g., suboptimal mine plan to cater to
the needs of the smelters)
Different capital structure requirements
▪ Upstream needs to manage capital structure carefully and
requires low leverage because of capital-intensive mega
projects and price volatility – midstream/downstream has less
volatile results and can use higher leverage to improve low
margins
