Changes in demand

Due to the slowdown of economic growth and restricted availability of financial resources, the market situation has significantly deteriorated in 2009. Unlike previous years, demand for steel in the world market was approximately 8% below the level of the previous year. A permanent decline in the global steel market may damage our operational results. Though prices for steel improved in the second half of 2009 due to the scarcity of available steel for sale, as a large number of global steelmaking companies reduced output to prevent overproduction, further slowdown is possible.

Mitigation

Despite the decline in steel output at our business units, we benefited from entering international markets as our comparatively low production costs for most products allowed us to offer competitive pricing internationally. CherMK (Cherepovets Steel Mill) revenue breakdown changed from 74.6% domestic sales to 58.5% in 2009 as exports significantly improved. To keep our low cost advantage, we have demolished the outdated open-hearth furnace production and concentrated on low-cost basic oxygen furnace production. Management has also initiated an Early Warning System project to increase our reaction speed for possible market changes.

Fluctuations in the prices of raw materials, energy and services

Severstal consumes significant volumes of raw materials such as coking coal, iron ore, ferroalloys and base metals, as well as electricity, natural gas and industrial gases.

Since the fourth quarter of 2008, prices of raw materials for steel production decreased because of the world financial crisis, deteriorating demand and market pressure from the steel industry. The prices for ferroalloys, scrap and freight decreased by more than 50% on average from the level of the third quarter of 2008. Nevertheless, there is a high risk that coking coal prices for 2010 will be 50–60% above 2009 contract levels, while iron ore prices may increase by 40–50%. Combined with a sharp increase in scrap prices in the fourth quarter of 2009, this may cause steelmakers’ margins to squeeze.

Timing and volumes of raw material deliveries can be significant factors which can easily run out of control, in particular the rapid suspension of production due to lack of steel demand, along with slow changes of the prices and tariffs for raw materials and energy resources, and tariffs for land transport remaining high. Some of our major suppliers in Russia are natural monopolies (suppliers of electric power and natural gas, and also JSC Russian railways) whose tariff policy is regulated by the state authorities. This can lead to an increase in natural gas tariffs and energy resources tariffs due to the low price base, and growth in transportation costs due to long-term rolling stock limitations.

The infrastructure level of development is an important factor influencing both costs and supply risks of doing business in Russia. Electrical power delivery and railway transportation interruptions, other infrastructural crises and accidents can affect our activities, interrupt production and worsen financial results.

Mitigation

We manage the sector risks regarding the provision of raw materials and services by establishing long-term mutually advantageous contracts with key suppliers, optimising purchasing processes and continuous inventory management. Most of our purchasing contracts for primary raw materials (pellets, iron ore, coking coal, and coke) are concluded for a period of at least a year. In these contracts we are not subject to the influence of short-term changes in price, except for ferroalloys (quarterly) and scrap (monthly). High reliance on our own iron ore, coking coal and scrap supplies helps mitigate price rises for raw materials.

Changes in selling prices

One of the specific features of steel and mining industries is their liability to cyclical changes in steel prices. Positive price conditions which existed before the fourth quarter of 2008 were followed by a sharp fall in prices. Results of our activity are particularly dependent on changes in the price for rolled steel and steel products, both in the domestic and foreign markets. In crisis conditions and sharply decreased demand, orders in the domestic market have substantially decreased. Export sales in 2009 accounted for a substantial part of the sales volume of CherMK. Particularly low prices, close to the global average production cost, and the low production cost of CherMK compared to global production costs, were the drivers of export sales in 2009. The overall average price for HRC in 2009 for Russian exports has reduced by approximately 47% year-on-year compared to the 41% year-on-year global average HRC price decline. High spot prices for iron ore and coking coals, along with increasing scrap prices, in the fourth quarter of 2009 and first quarter of 2010 resulted in an increase in steel prices for the same period. It is likely that in the second quarter of 2010, steel prices will continue rising, backed by new iron ore and coking coal contracts.

Mitigation

We have been able to moderate the negative impact of the adverse economic situation and to overcome the consequences of the crisis faster. We made major efforts to manage working capital effectively, to increase operational effectiveness, to use raw materials and energy effectively, increase labour productivity, control costs closely, focus on customers (with quality of production and service), increase production of high-value-added goods whose prices are less sensitive to economic fluctuations, and strengthened our position in most prospective product niches, which have preferable competition conditions and an attractive balance of supply and demand. Our comparatively low production costs are a mitigating factor for the risk of steel price fluctuations. To reduce the influence of sharp market fluctuations on our revenue, the management has initiated the Foresight project, to improve our understanding of our markets, and the Early Warning System to predict short-term price fluctuations three months in advance.

Competition

The current economic situation may cause a serious change in competition conditions in the industry. As domestic markets for a large number of steelmakers have shrunk, there is a threat of a greater presence of imported steel in our traditional markets. Low-cost steelmakers may offer lower prices for their products to increase their market share. Possible mergers or alliances of competitors may cause our competition strategy to change. Consolidation of the producers of niche products may lead to an increase in entrance barriers to these markets, and as a result we may miss certain opportunities to develop our business. Artificial barriers created by local governments may reduce our ability to enter new markets or increase our share in existing markets. The appearance and development of new steel technologies or areas of use create prospective new profitable markets for steel companies to generate revenue. However, competition for entering new markets and winning in them is rising. Moreover, there is a threat of competition from substitute materials (aluminium, concrete, plastic), which may replace steel in auto-making, construction, pipe production, and the production of packing materials.

Mitigation

We have started a ‘Clients Development & Retention’ project to improve our understanding of customers’ needs, to increase our brand recognition and to fight effectively for domestic and international market share. The project is to improve our competition capabilities, assuming continuous efforts to decrease costs and increase effectiveness, search for prospective new niche markets daily and enter them early, and research the needs of customers, including service and technical support.