10_12_16_ICUSectorPrimer-IronOre

Sector Primer

Iron ore 2010

Focus Scope Sector

Ukraine Equity markets Metals & Mining

December

2010

Alexander Martynenko Kiev, +38 044 2200120

[email protected]

READ FIRST THE DISCLOSURES SECTION FOR IMPORTANT DISCLOSURES AND ANALYST CERTIFICATION

3

December 2010 Sector Primer Iron ore 2010

Contents Executive summary 4

Key drivers of profitability 5

Key risks 7

Supply chain and technology 9

Technology basics ......................................................................................................... 9

Key stages of iron ore processing ................................................................................ 10

Mining .................................................................................................................. 10

Beneficiation ........................................................................................................ 10

Agglomeration ...................................................................................................... 10

Supply chain ................................................................................................................ 10

Domestic iron ore market should further shrink.................................................... 10

Sales structure and key commercial products ..................................................... 12

Strong growth potential 15

Reserves: Underexploited and undistributed ............................................................... 15

The state controls ore reserves allocation ................................................................... 16

Industry players’ uneven control of reserves ................................................................ 16

Privatisation process nearly finalised ........................................................................... 17

Favourable geographical location and logistics ........................................................... 18

Favourable market environment 19

Iron ore and steel demand ........................................................................................... 19

China drives the global demand for iron ore ................................................................ 21

Pricing: oligopoly benefits ............................................................................................ 22

The Big Three ...................................................................................................... 22

Benchmark system .............................................................................................. 23

Pricing mechanism ............................................................................................... 23

Transition of the benchmark system .................................................................... 24

Competitive environment ............................................................................................. 24

Production costs pose key concerns 26

Inferior quality of iron ore deposits implies costlier mining ................................... 27

Energy inefficiency creates the main risks for costs ............................................. 27

Labour structure needs further optimisation ......................................................... 30

Modernisation is time-consuming and capital-intensive ....................................... 31

Appendixes 32

Appendix 1. SWOT analysis ........................................................................................ 32

Appendix 2. Financial market exposure ....................................................................... 33

Appendix 3. Financial performance highlights ............................................................. 33

Glossary 34

4

Sector Primer Iron ore 2010 December 2010

Executive summary Our formal coverage of the Ukrainian metals and mining industry begins with the publishing of this Iron Ore

Sector Primer, which we plan to follow up by a similar primer on Ukrainian steel sector. We focus on the key

factors driving profitability of Ukrainian iron ore producers, both short- and long-term. We also examine the

iron-ore supply chain, key commercial products, and production technology prevailing in Ukraine. Finally, we

provide a SWOT analysis of the sector and the sector’s significant risks.

Sector importance: The iron ore sector captures one of the main competitive advantages

of Ukrainian steel mills on international steel markets by supplying the relatively cheap key

steelmaking input, iron ore. At the same time, the sector itself plays an increasingly active

role in the Ukrainian steel industry exports, having amounted to US$1.6bn in 9M10, or 13%

of the total Ukrainian exports of ferrous metals & mining products and 2% of the

corresponding Ukrainian GDP figure. One of the sector leaders, Ferrexpo, has its shares

listed on the LSE, which are the most liquid among all the traded Ukrainian stocks. Also, the

iron ore business segment accounted for 22% of US$6bn revenue and for 56% of

US$1.4bn EBITDA of the leader of Ukraine’s metal-and-mining industry, Metinvest, in 2009.

Strong growth potential: Having the third largest reserves of iron ore in the world based

on iron ore content, Ukraine ranks just sixth in terms of the annual iron ore production.

Privatization of the last state-owned iron ore company, KGOKOR, further development of

reserves and introduction of additional processing capacities by private businesses have

the potential to boost Ukrainian iron ore exports by at least 65% during 2011-15. Ukrainian

iron ore companies are able to expand their market share in Europe and the Middle East,

the regions where they have an edge over competitors in transportation costs and where

they can supply the products with competitive quality. Ukrainian miners can also capitalize

on the growing demand for iron ore in Southeast Asia, particularly China.

Low production efficiency: On the back of volatile energy prices, energy-intensive

production process is the main weakness of Ukrainian iron ore sector. High energy

consumption is caused by significant mining depth and the low iron grade of local deposits,

obsolete equipment, and cold winters. Producers also inherited an inefficient organisational

structure and excessive headcount from the previous state ownership, which has led to low

labour productivity. At the same time, modernisation and capacity increase are complex,

time-consuming, and require substantial capex.

Key drivers: In our view, the most significant factors affecting the profitability of Ukrainian

iron ore producers are the world demand for steel, international benchmark iron ore prices,

sales volumes, competitiveness in international markets, energy prices, transportation

costs, the hryvnia’s exchange rate, and domestic inflation. Capex and the availability of

financing are drivers affecting the sector in the longer term; however, they substantially

influence Ukranian companies’ exposure to the other drivers mentioned above.

Key risks: Highly volatile energy prices are the main threat to Ukrainian iron-ore

companies’ profitability, as they face increasing competition on their way to foreign markets.

At the same time, equipment upgrade aimed to improve energy efficiency and product

quality, as well as production capacity increase may take longer than planned by

companies due to possible scarcity of finance and technological complexity.

5


Key drivers of profitability We believe that the following factors significantly influence the profitability of Ukrainian iron-ore producers:

World demand for steel and iron ore. World prices for iron ore are influenced to a

considerable degree by global economic growth, which determines the world demand

for steel and its inputs. At the same time, the oligopolistic international market for iron

ore has an additional significant effect on iron ore prices, supporting them during

economic downturns, and boosting them during growth phases. International iron ore

benchmark prices are currently the key indicator of both steel and iron ore demand in

the world. Ukrainian iron ore prices closely trace international benchmark prices on

both the domestic and international market.

Sales volumes. While driven by demand as a result of world economy growth, sales

volumes also depend on Ukrainian companies’ ability to withstand competition on the

international market. The key factors affecting competitiveness are production costs,

transportation costs, and product quality. With their current exposure to these factors,

Ukrainian companies are at least able to retain their current market share. Traditionally,

Ukrainian producers have been highly competitive in Eastern and Central Europe and

Turkey, due to the proximity of these markets to Ukraine and good transportation

infrastructure, which minimise transportation costs, as well as due to their products’

technical compatibility with steel mills of their long-standing customer base. However,

as Ukrainian companies are striving to expand their sales to Western Europe, the

Middle East, and Southeast Asia, competition is increasing considerably. In order to

further penetrate the markets of Western Europe and the Middle East, Ukrainian

companies will have to produce more products with higher iron content. To become

more cost-competitive in all targeted markets, Ukrainian mining companies have to

improve their energy efficiency, labour productivity, and control over transportation

costs.

Energy prices. Due to the low iron content of deposits, significant depth of

open/underground mining pits, obsolete equipment, and severe winters, Ukrainian

production of iron ore is energy-intensive compared to non-CIS competitors. In pellets,

which have the highest added value, energy costs of Ukrainian producers account for

nearly 45-55% of their total production costs, according to our estimates. In particular,

Ukrainian iron-ore-making costs are driven substantially by prices for natural gas,

diesel fuel, and electricity.

Transportation costs. Transportation costs add another 40-70% on top of the

production costs of Ukrainian iron ore producers, according to our estimates. At the

same time, transportation costs are largely out of Ukrainian iron producers’ control, as

the railway services in Ukraine are provided by the state monopolist, Ukrzaliznytsia,

and are tightly regulated by the state, while seaborne transportation services are

provided by international carriers. As a result, Ukrainian iron ore producers’ railway

transportation costs are driven mostly by domestic inflation and the government’s

policy, while seaborne transportation costs are driven by global demand, which in turn

is significantly affected by China. We believe the share of seaborne transportation

costs is likely to grow, as Ukrainian companies plan to build up their iron ore exports to

Southeast Asia.

6


Hryvnia exchange rate and domestic inflation. Most of the Ukrainian iron ore

producers’ revenues are either denominated in US dollars (related to exports) or

pegged to the UAH/USD exchange rate (in relation to domestic sales). At the same

time, we estimate that 60-70% of the production costs of Ukrainian producers are

denominated in and pegged to hryvnias, as they relate to the majority of labour costs,

electricity, and consumable materials. As a result, hryvnia appreciation is directly

related to growth in Ukrainian miners’ costs, translated into US dollars, and thus lowers

their profit margins.

Capex. For Ukrainian iron ore producers, the key capex projects at the moment are the

development of new mines, upgrading existing ore-processing facilities, and

introducing new ones. The main purpose of these projects is to increase production

capacity, improve efficiency and productivity, improve product quality, and raise the

share of products with higher added value. Domestic iron ore investment projects are

capital-intensive, technologically complex, and time-consuming.

Availability of financing. Given the scope of capex required, Ukrainian iron ore

producers are quite often unable to finance their investment projects exclusively from

operating cash flows, and therefore need to raise additional funding through debt

and/or equity. This makes domestic miners dependent on the stability and cycles of the

financial markets. Furthermore, the low credit ratings of Ukraine compared to

developed markets and a significant portion of emerging markets result in attracting

debt that is more expensive for Ukrainian companies compared to their foreign peers.

7


Key risks Rising energy costs. Although energy prices for Ukrainian industry have been lower

than energy prices in Europe and South and North America during the last four years,

they have nevertheless seen a converging trend, which is likely to continue in the next

four-to-five years. Russia’s monopolist natural gas company, Gazprom, has pursued in

recent years the policy of bringing its gas prices for Ukraine close to prices charged to

European countries. Ukraine’s political concessions to Russia, such as the

prolongation of stationing the Russian Black Sea Fleet on Ukraine’s territory have so

far allowed Ukraine to receive additional discounts on the natural gas price. Electricity

tariffs, which are charged to Ukrainian iron ore producers, are currently regulated by

the state. The Ukrainian government plans to liberalise electricity tariffs, making them

likely to rise in the next three-to-five years. We expect that the liberalisation mechanism

will provide for a gradual increase in electricity tariffs. Probability: Medium to high

Increasing competition. As Ukrainian producers are striving to expand their sales to

the markets of Western Europe, the Middle East, and Southeast Asia, they face

stronger competition from international competitors, particularly from Brazilian and

Australian companies. In the cost competition area, such threats as rising energy

prices, inflation in Ukraine, and competitors’ optimisation of their transportation costs,

should prompt Ukrainian mining companies to improve their energy efficiency and

labour productivity. In the product quality and product range area, Ukrainian iron ore

producers should introduce technologies to allow both raising the share of products

with higher iron content and improving energy efficiency. Probability: Medium to high

Undermined ability to finance investment projects. Ukrainian iron ore producers

may fail to raise sufficient funding for their capex, if international financial markets start

tightening again. However, the shortage of liquidity on the financial markets is likely to

be mitigated by quantitative easing measures taken by developed countries.

Probability: Medium

Increasing reliance of Ukrainian steel mills on iron ore imports from Russia. As

Russia’s Vneshekonombank has acquired control stakes in the Industrial Union of

Donbass (IUD) and Zaporizhstal for their further transferring to Russian businesses,

these key Ukrainian consumers of domestic iron ore may reorient at least a part of their

consumption towards imports of Russian iron ore. As a result, Ukraine’s iron ore

market may shrink considerably. This risk is pertinent mostly to Metinvest, which is the

key supplier of iron ore to the IUD and Zaporizhstal and controls about 70% of the

domestic iron ore market. The risk is mitigated by the uncertainty in transferring the

control stakes to well-integrated steelmaking groups of Russia, the existence of

framework agreements between Metinvest and the IUD on ore supplies until 2015, and

possible reorientation of Metinvest’s sales to the voracious Chinese market.

Probability: Medium

Decline in international benchmark prices for iron ore. World iron ore prices may

decline due to the prospect of a double-dip recession and a resulting decline in steel

demand. However, the industrialisation of developing countries mitigates the risk of the

global demand for steel and steelmaking inputs falling again. The growing demand for

seaborne iron ore from China will be the key factor supporting the international

benchmark prices. Probability: Low

8


Appreciation in the hryvnia may hurt competitiveness. An appreciation in the

hryvnia versus the US dollar would raise Ukrainian ore miners’ costs denominated in

dollars, and, as Ukrainian iron ore is priced in USD, would lower their cost

competitiveness. Although we believe that the hryvnia will appreciate against the dollar

in the next two years, the negative impact from this appreciation will be mitigated by

the dollar’s depreciation against other currencies, including key competitor currencies

the Australian dollar and Brazilian real. Probability: Low

Possible shift of the global demand towards higher-grade iron ore products. To

increase the iron content of their products, Ukrainian producers will have to raise

energy consumption and thus inflate their production costs, with a likely decline of profit

margins. This shift in demand, however, is most likely to be slow for another five years,

given the current scarce financing of the modernisation of both steelmaking and iron

ore processing caused by the financial crisis. Also, the sector leaders, Metinvest and

Ferrexpo, are already planning to upgrade their equipment in order to increase the

share of products with higher iron content. Probability: Low

9


Supply chain and technology The relatively low grade of Ukrainian iron ore necessitates its further processing through the consequent

stages of beneficiation and agglomeration before being consumed by steel mills. Iron ore concentrate and

pellets are the key commercial products sold by Ukrainian companies, with pellets playing an increasingly

important role in exports. Ukrainian pellets are quality-competitive for the markets of Europe, Turkey, and

Southeast Asia. Low integration of the domestic iron ore sector with Ukrainian steel mills has created the

domestic market of iron ore, which is 60-70% controlled by one supplier, Metinvest, while a number of other

producers, including Ferrexpo, are focused on exports. However, as Russian steelmakers are gaining control

over the main Ukrainian ore-deficient steelmakers, Russian iron ore imports to Ukraine are likely to increase

in the long term, which will cause the Ukrainian iron ore sector to reorient more towards exports.

Technology basics

Ukrainian iron ore mining companies represent a constituent part of the domestic blast

furnace/base oxygen furnace (BF/BOF) process chain used to produce steel. The

behaviour of iron ore is determined by its chemical composition (content of iron, sulphur,

phosphorus, etc) and by its structure of form (ore lump, fines, or pellets), each of which

affects blast furnace (BF) productivity. Typically having a low iron content of 30-35% Fe,

Ukrainian iron ore cannot be used in BFs directly, and needs preliminary upgrading. The

process of iron ore upgrading used to obtain higher iron content and minimise chemical

impurities is called beneficiation.

Chart 1. Supply chain of Ukrainian iron ore companies

Sources: Ferrexpo, Metinvest, ICU estimates

The main product of beneficiation, iron ore concentrate, cannot be charged in the BF

directly, since it blocks the passage for ascending gas inside the BF, and thus blocks the

smelting process. Hence, concentrate is agglomerated in high temperatures into larger,

lumpy pieces with/without the mixing in of additives like limestone, dolomite, etc. Two types

of products commonly made in the agglomeration process are sinter and pellets, made in

the sintering and pelletising processes, respectively.

Iron ore extracted in

Ukraine typically needs

beneficiation and

agglomeration before

being fed to a steel mill’s

blast furnaces

Lump ore, sinter ore (60-61% Fe)

Agglomeration

Sinter (47-58% Fe) Pellets (58-67% Fe)

RELATED

STEEL

MILLS Concentrate (65-67% Fe)

Concentrate (65-67% Fe)



Sintering

Combining sinter material

Dewatering

Pelletizing

Combining pellet material

Dewatering

Sinter (47-58% Fe)

O R E M I N I N G A N D P R O C E S S I N G P L A N T S

Iron ore (Fe<50%)

Beneficiation

Crushing and grinding

Dry magnetic separation

Flotation

Lump ore, sinter ore (60-61% Fe)

Pellets (58-67% Fe)

E X T E R N A L S T E E L M I L L S

Lump ore, sinter ore (60-61% Fe) Mining

Drilling

Blasting

Excavating

10


Key stages of iron ore processing

Mining

Iron ore in Ukraine is extracted either from open-pit or underground mines. Open-pit mining

is more common, and is performed by the sector leaders Metinvest, Ferrexpo, and

Southern GOK. The open-pit mining process includes drilling blast holes, blasting, and

shoveling massive amounts of dislodged ore. After extraction, iron ore is transported to the

beneficiation stage. However, a number of Ukrainian miners, such as Kryviy Rih Iron Ore

Combine, Sukha Balka, and Zaporizzhia Iron Ore Combine are engaged in the

underground mining of relatively rich iron ore with Fe content of over 50%, which does not

require beneficiation. Additionally processed through crushing and heating, such ore is

ready for the sintering stage, and is most commonly termed sintering ore.

Beneficiation

Upgrading iron ore to a higher iron content may involve several different techniques, such

as washing, jigging, dry magnetic separation, advanced gravity separation, and flotation.

The resulting product, concentrate, with a Fe content of 65-67%, apart from being directed

to further processing stages, is marketed by Ukrainian miners to external customers.

Agglomeration

Agglomeration of concentrate in Ukraine is made through either sintering or pelletising. In

the sintering process, iron ore, iron ore concentrate, and other iron-bearing materials, flux

(limestone), and coke breeze, form the sinter burden, which is then granulated and heated.

After crushing, screening, and cooling, the sinter is ready for use in BF. In pelletising, which

is a more recent alternative to sintering, concentrate is mixed with water and other

additives, and the resulting slurry is dried, mixed with binding agents, and baked. The

output material is ball-like granules with an 8-10mm diameter called pellets. After the pellets

have been screened and undersized material removed, they are prepared for use in BF.

Supply chain

Domestic iron ore market should further shrink

The existence of the iron ore market in Ukraine is possible due to the low integration of the

Ukrainian iron ore sector with the domestic steel mills. However, acquisitions in the Ukrainian

steel sector made by Russian companies are likely to reorient at least part of its iron ore

consumption towards imports from Russia; otherwise, non-integrated Ukrainian steel mills will

either develop their own mines, or merge with domestic iron ore suppliers. In both cases, the

domestic iron ore market should considerably shrink, although we believe that this will mostly

likely happen gradually, in a three-to-five-year term. Correspondingly, the role of exports in

Ukrainian iron ore producers’ sales structures should substantially increase.

All the Ukrainian iron ore companies evolved from formerly state-owned ore-mining and

processing plants (OMEP, an abbreviation that is the equivalent of GOK in Russian), which

were privatised by the Ukrainian government in 1999-2004. As this privatisation was carried

out in a non-transparent and corrupt fashion, the previous economic relations between

domestic OMEPs and steel mills were mostly destroyed. In the process of ownership

concentration, which followed privatisation, the key event occurred in 2007, when Metinvest

Holding merged with the main iron ore-making and steel-making assets of Smart Holding.

As a result, the addition of Ingulets GOK to Metinvest’s existing assets, Central GOK and

Northern GOK, increased the holding’s share in Ukraine’s production of merchant

concentrate from 21% to 80%.

Open-pit mining of iron

ore prevails in Ukraine

Iron ore beneficiation is

used to increase Fe

content

Sintering and pelletising

are two common types of

iron-ore agglomeration

As Ukrainian steel mills

will be becoming more

upstream-integrated, the

domestic iron ore market

will shrink, making iron

ore producers increase

their exports

The Ukrainian iron ore

sector remains poorly

integrated with domestic

steel mills

11


At the moment, only ArcelorMittal Kryviy Rih’s OMEPs and Metinvest’s Northern GOK,

Central GOK, and Ingulets GOK are downstream-integrated to Ukrainian steel mills in one

steelmaking holding. Of the rest of Ukrainian OMEPs, some have to sell their products on

the open market either in Ukraine or abroad (Poltava GOK-Ferrexpo, Southern GOK, Kryvyi

Rih Iron Ore Combine), while others export to their parents’ countries (Zaporizhzhia Iron

Ore Combine, Sukha Balka).

At the same time, only two steelmaking groups in Ukraine, Metinvest and ArcelorMittal

Kryviy Rih, have upstream-integrated their steel mills to domestic OMEPs. Furthermore,

having concentrated substantial ore-mining capacities with rich reserves, Metinvest is 130%

sufficient in iron ore (based on its current steelmaking capacity, which includes Mariupol

Illich Steel, acquired in 2010), and controls over 60-70% of the Ukrainian iron ore market.

Chart 2. Domestic external buyers of Ukrainian iron ore in 2009

(%)

Chart 3. Suppliers to the Ukrainian iron ore market in 2009 (%)

Note: The volume of sales by Ukrainian companies to external domestic steel

mills in 2009 – 11.99mln tonnes (excluding Mariupol Illich Steel, which merged

with Metinvest in 2010)

Note: The volume of the Ukrainian iron ore market in 2009 – 15.69mln tonnes

(excluding Mariupol Illich Steel, which merged with Metinvest in 2010)

Source: Metal-Courier Source: Metal-Courier

The domestic iron ore market, in fact, is currently formed by three Ukrainian steelmaking

groups, which are not self-sufficient in iron ore: IUD, Zaporizhstal, and Donetskstal. Mainly

due to this dependence on external iron ore, control stakes in the IUD and Zaporizhstal

were acquired by Russian companies through Russia’s state-owned Vneshekonombank in

2010. With the acquirers most likely acting as mediators, these control stakes may finally go

to Russian steelmaking groups, of which Metalloinvest looks to be the main candidate, due

to its significant excessive iron ore-making capacity. The possible reorientation of

Zaporizhstal and the IUD towards the iron ore imports from Russia will further squeeze the

domestic iron ore market, with Metinvest and other Ukrainian producers having to focus

more on exports of iron ore. The whole process, however, may take several years, as

Russian steelmakers currently have deleveraging issues as their first priority, while

Metinvest has a framework agreement on supplying iron ore to the IUD until 2015.

IUD60.6

Donetskstal17.0

Zaporizhstal19.2

Petrovsky Steel3.1

Imports23.6

Metinvest71.4

Other domestic producers

5.0

A high concentration of

ownership in the iron ore

sector has created an

oligopoly in the Ukrainian

iron ore market

The biggest domestic

buyers of iron ore, the

IUD and Zaporizhstal,

may substantially

reorient towards imports

from Russia

12


Sales structure and key commercial products

Formed by steelmaking companies which are not self-sufficient in iron ore (the IUD,

Zaporizhstal, Donetskstal), the domestic iron ore market accounts for only about 20% of

Ukrainian iron ore producers’ total sales in 2010, after Mariupol Illich Steel, the second-

largest consumer without its own iron ore base, merged with Metinvest.

Exports play an increasingly significant role in the iron ore sector operations: the share of

iron ore exports in the sector’s total sales volumes grew from 34% in 2008 to 45% in 2009,

mainly at the expense of sales to poorly integrated steelmakers, which were hit the hardest

by the global economic recession. Metinvest and Ferrexpo have emerged as the leading

iron ore exporters in Ukraine, with Ferrexpo exporting 100% of its products in 2010. At the

same time, the share of OMEPs’ internal sales to related steel mills within one steelmaking

group grew from 24% in 2009 to 34% in 8M10.

Chart 4. Ukrainian iron ore sales structure in 2009 (%) Chart 5. Ukrainian iron ore sales structure in 8M10 (%)

Note: total amount of Ukraine’s iron ore sales in 2009: 73.2mln tonnes Note: total amount of Ukraine’s iron ore sales in 8M10: 56.4mln tonnes


Different mining conditions, ore quality, and technological specifics have caused Ukrainian

iron ore producers to market all the products created along the iron ore production chain.

Sintering ore is traded mostly by the Kryviy Rih Iron Ore Combine, Sukha Balka, the

Zaporizhzhia Iron Ore Combine, and other companies with deposits of iron ore with

relatively high iron content (55-62% Fe). Sinter is mostly traded by Southern GOK, which is

the only Ukrainian OMEP with a sinter plant on its premises, while other sinter plants

belong to domestic steel mills. Nevertheless, concentrate and pellets are the key

commercial products of Ukrainian iron ore companies, jointly accounting for 72% in the total

sales volumes in 2009. These products are even more significant in terms of exports,

accounting for 79% in total export volumes in 2009. Concentrate is traded by Metinvest

only, both for domestic sales and exports, and pellets are traded by Metinvest and

Ferrexpo, which specialises in the pellet segment only.

Exports39.7

Internal domestic sales

33.7

External domestic sales

26.7

Exports39.9

Internal domestic sales

42.3

External domestic sales

17.9

During the recession, the

share of exports in iron

ore sales of Ukrainian

companies substantially

increased

Concentrate and pellets

are the key commercial

products of Ukrainian

iron ore producers

13


Chart 6. Sales structure of key domestic iron-ore producers in

2009

Chart 7. By-product sales structure of key domestic iron-ore

producers in 2009

Notes: (1) - Zaporizhzhia Iron Ore Combine (ZIOC) is 75%-controlled by

Minerfin; (2) - Kryviy Rih Iron Ore Combine (KrIOC) is jointly controlled by SCM

and Smart; while SCM owns a 75%-stake in Metinvest, KrIOC is not included in

Metinvest’s assets and is deemed a separate business unit; (3)- Southern GOK

is jointly controlled by Evraz (50%) and Smart (50%)

Notes: (1) - Zaporizhzhia Iron Ore Combine (ZIOC) is 75%-controlled by

Minerfin; (2) - Kryviy Rih Iron Ore Combine (KrIOC) is jointly controlled by SCM

and Smart; while SCM owns a 75%-stake in Metinvest, KrIOC is not included in

Metinvest’s assets and is deemed a separate business unit; (3)- Southern GOK

is jointly controlled by Evraz (50%) and Smart (50%)


Pellets are the iron ore product with the highest added value, and as such, their prices

incorporate premiums related to other marketable products of iron ore. The main

disadvantage of pellets is that during steel demand downturns, steel mills tend to switch to

lower-quality iron ore products, as they focus instead on cost-cutting rather than productivity

targets. Nevertheless, pellets should gain an increasing share in demand for iron ore

products in Ukraine and the rest of the world, due to the following advantages:

As opposed to sinter, pellets are considerably stronger, which makes them more

transportable.

Pellets’ physical and chemical characteristics enable steel mills to achieve the highest

BF productivity.

Due to their hardness, pellets are also more transportable than concentrate, which is

more subject to spillage and tends to accumulate moisture and freeze during winters,

thus causing serious transportation bottlenecks.

Sintering plants are likely to face increasing sanctions and limitations due to substantial

pollution produced by the sintering process, while on the European market, strict

penalties already allow deliveries of Ukrainian pellets only.

Further depletion of deposits of high-quality lump ore, which does not require

agglomeration, will increase demand for pellets.

The pulverised coal injection process, which is being actively introduced in steel mills’

BFs in Ukraine and other countries, puts additional quality requirements on iron ore

feed, thus increasing demand for pellets.

All over the world, steel mills are raising their shares of direct reduced iron production,

which is largely pellet-based.

Ferrexpo plans to keep pellets as its key merchandise product, while Metinvest plans to

increase the pellet share in its total sales and decrease the share of concentrate.

0.0

5.0

10.0

15.0

20.0

25.0

30.0

Other Evraz ZIOC (1) KrIOC (2) Southern GOK (3)

Ferrexpo Arcelor-Mittal KR

Metinvest

(mln tonnes)

exports internal domestic external domestic

0.0

5.0

10.0

15.0

20.0

25.0

30.0

Other Evraz ZIOC (1) KrIOC (2) Southern GOK (3)

Ferrexpo Arcelor-Mittal KR

Metinvest

(mln tonnes)

concentrate sinter sintering ore pellets lump ore

The Ukrainian iron ore

sector will further

increase the share of

pellets in its sales

14


Chart 8. Product structure of Ukrainian iron ore sales

in 2009 (%)

Chart 9. Product structure of Ukrainian iron ore exports

in 2009 (%)

Total amount of Ukraine’s iron ore sales in 2009: 73.2mln tonnes Total amount of Ukraine’s iron ore sales in 2009: 29.0mln tonnes


Ukrainian pellets have the competitive quality necessary for the markets of Europe, Turkey,

and Southeast Asia. Being long-standing customers of Ukrainian iron ore miners, the steel

mills of Central and Eastern Europe have good technical compatibility with Ukrainian

pellets. Furthermore, the low phosphorus content in Ferrexpo’s pellets make them

particularly valuable for European and Asian flat steel producers delivering their products to

automakers (such as BMW, Audi, and Toyota) and electronics manufacturers (such as

Panasonic Corporation). Iron content of pellets produced by Metinvest is in the range of

60.5-63.5% Fe for Northern GOK and an average of 63.9% Fe for Central GOK, while

Ferrexpo produces pellets of 62% Fe and 65% Fe. To further penetrate the market of

Western Europe, the companies should increase the share of 65% Fe pellets produced,

while for the Middle East other than Turkey, they should introduce 68% Fe pellets, which

would require additional capex.

Concentrate43.4

Pellets28.3

Sintering ore15.8

Sinter12.3

Lump ore0.2

Concentrate46.0

Pellets33.4

Sintering ore18.9

Sinter1.3

Lump ore0.5

Ukrainian pellets have

the competitive quality

necessary for the

markets of Europe,

Turkey and Southeast

Asia

15


Strong growth potential Having the third-largest reserves of iron ore in the world based on iron ore content, Ukraine ranks just sixth

in terms of the annual iron ore production. Privatisation of the last state-owned iron ore company, KGOKOR,

further development of reserves, and introduction of additional processing capacities by private businesses

have the potential to boost Ukrainian iron ore exports by at least 65% during 2010-15. Being traditionally

dominant in Central and Eastern Europe, Ukrainian iron ore companies are able to further penetrate the

markets of Western Europe and the Middle East, the regions where they also have an edge over competitors

in transportation costs due to Ukraine’s favourable geographical location and well-developed transportation

routes, and where they can supply the products with competitive quality. As the sole owner of Ukraine’s

mineral resources, the state still plays a key role in distributing and regulating private businesses’ access to

iron ore reserves.

Reserves: Underexploited and undistributed

Substantial commercial underdevelopment of domestic iron ore reserves in Ukraine creates

solid growth opportunities for Ukrainian mining businesses. Ukraine ranks No.1 in the world

in terms of crude iron ore reserves, accounting for 19% of the world total. In the case of

recalculating the country’s reserves based on iron ore content, this implies a No.3 position

in the global ranking and a 12% share of the global reserves.

At the same time, Ukraine’s share in global iron ore output in 2009 was just 2%. This places

Ukraine among the countries that underproduce the most in terms of their reserves.

Chart 10. Top 10 countries in the world in terms of iron ore

reserves based on iron content

Chart 11. Top eight countries–producers of iron ore in 2009

Source: U.S. Geological Survey Source: U.S. Geological Survey

Among proven Ukrainian iron ore deposit sites, the Kryviy Rih Iron Ore basin is the largest

(56% of the total national reserves) and the most actively exploited, with the largest number

of business groups involved in iron ore extraction, including national steelmaking leaders

Metinvest and ArcelorMittal Kryviy Rih. The adjacent Kremenchuk Iron Ore region ranks

second in terms of reserves accessed by just one business group, Ferrexpo, which plans to

actively develop currently idle deposits in an attempt to more than double its output in the

next five years.

10.2

2.1

2.2

2.4

3.3

4.5

7.2

8.9

9.0

13.0

14.0

0.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0 16.0

Other

United States

Sweden

Venezuela

Kazakhstan

India

China

Brazil

Ukraine

Australia

Russia

(bln tonnes) 0.21

0.05

0.06

0.09

0.26

0.37

0.38

0.90

0.0 0.2 0.4 0.6 0.8 1.0

Other countries

South Africa

Ukraine

Russia

India

Australia

Brazil

China

(bln tonnes)

Ukrainian iron ore

reserves are substantially

underdeveloped

Ukrainian companies

most actively exploit the

Kryviy Rih Iron Ore

basin, which accounts

for nearly 56% of the

total national reserves of

iron ore in the region

16


Other iron ore regions have a low presence of extraction activities, among which the

Pryazovya region is the most prospective one, since its deposits have been prepared for

further development since the 1970s, and can provide ore that is relatively easily

beneficiated to concentrates, with 69-72% iron content. Currently, the likeliest candidate for

obtaining the license to exploit Pryazovya region’s reserves is Donetskstal, which plans to

construct an OMEP with a 20mtpa iron ore capacity in the region.

Table 1. Business groups’ presence in the top five iron-ore basins and regions of Ukraine

Iron ore

basins/regions

Number of ore deposits (bln tonnes) Reserves Fe content

(%)

Business group presence

Total Exploited bln tonnes % of total

Kryviy Rih Basin 29 21 16.9 56% 30-67 Metinvest, Privat, ArcelorMittal, Smart, Evraz

Kremenchuk Region 5 2 4.3 14% 27.4-58.5 Ferrexpo

Bilozirka Region 6 1 2.5 8% 55.7-62.8 Zaporizhstal, Minerfin

Pryazovya Region 3 - 3.0 10% 27-70 Donetskstal1

Kerch Basin 8 - 1.4 5% 28.4 --

Other 29 6 1.8 6% --

Total 80 30 30.0 100%

Notes:1- Donetskstal is in the process of obtaining a mining license.

Sources: Company data, ICU estimates.

The state controls ore reserves allocation

In order to obtain and sustain access to iron ore reserves in Ukraine, businesses are

critically dependent on the Ukrainian state’s licensing system. According to the current

Ukrainian legislation and regulations, the country’s mineral resources cannot be privately

owned, and may only be granted for the use of legal entities or individuals.

Correspondingly, companies in Ukraine may be authorised for mining activities by obtaining

licenses and permits from relevant state authorities. For the development of an unexplored

deposit, miners should obtain an exploration license for an initial period of five years, which

may be further extended for another five years. A separate license is required for the

extraction of minerals for an initial period of up to 20 years, and may contain special

conditions relating to scope of work, technology, environment, and other issues. These

licenses may be suspended or revoked if a company does not comply with existing

regulations, or does not satisfy its license conditions, including adherence to mining

schedules.

Industry players’ uneven control of reserves

Uneven access to iron ore reserves by the domestic industry players allows the ore-rich

business groups (Metinvest, Ferrexpo, and ArcelorMittal) to expand their mining and

production, while ore-insufficient steelmakers have either to depend on outsourcing, or seek

mining licenses from the state to engage in costly greenfield projects.

Metinvest, Ferrexpo, and ArcelorMittal together account for 82% of the iron ore reserves to

be exploited under the current licenses. At the same time, the IUD and Donetskstal are so

far totally deprived of their own iron ore mines, and Zaporizhstal has just a minority control

(25%) stake in one of its iron ore suppliers, Zaporizhzhia Iron Ore Combine.

All mineral resources,

including iron ore, are

owned by the Ukrainian

state, which gives out the

rights for their

exploitation to private

businesses

Three companies

currently control about

82% of the total iron ore

reserves licensed by the

Ukrainian state for

exploitation

17


Table 2. Business groups’ control of iron ore reserves and production assets in Ukraine

Group Control (%) Ore-mining and enriching

plant/deposit

JORC4 reserves

(mln tonnes)

JORC4 mineral resources

(mln tonnes)

GKZ5 reserves (mln

tonnes)

Iron content (%)

Metinvest 75.9 Central GOK 709 2,689 -- 32

Metinvest 63.3 Northern GOK 713 3,807 -- 32

Metinvest 82.5 Ingulets GOK 444 937 -- 34

Metinvest total 1,866 7,433 --

Ferrexpo 97.3 Poltava GOK 899 3,648 -- 29-31

Ferrexpo 100.0 Yeristovo GOK 632 1,192 -- 30

Ferrexpo 100.0 Belanovskoe deposit -- 1,702 -- 30

Ferrexpo 100.0 Galeshinskoe deposit -- 326 -- 55

Ferrexpo 100.0 Brovarkovskoe deposit -- -- n/a3 --

Ferrexpo 100.0 Manuylivske deposit -- -- n/a3 --

Ferrexpo 100.0 Kharchenkivske deposit -- -- n/a3 --

Ferrexpo 101.0 Vasylyivske deposit -- -- n/a3 --

Ferrexpo 102.0 Zarudnenske deposit -- -- n/a3 --

Ferrexpo total 1,531 6,868 15,169

ArcelorMittal 97.0 ArcelorMittal Kryviy Rih -- -- 900 33

Minnerfin (Slovakia) 75.0 ZaZhRK -- -- 300 58-66

Zaporizhstal 25.0 ZaZhRK -- -- 300 58-67

SCM1 49.9 Krivorizhsky Iron Ore Combine -- -- 266 59

Privat1 49.9 Krivorizhsky Iron Ore Combine -- -- 266 59

Smart2 50.0 Southern GOK -- -- 300 35

Evraz2 50.0 Southern GOK -- -- 300 35

Evraz 99.3 Sukhaya Balka 82 -- n/d 56-59

Industrial Union of Donbass -- -- -- -- -- --

Donetskstal -- -- -- -- -- --

Notes: 1- Privat and System Capital Management (SCM) jointly control Kryviy Rih Iron Ore Combine. SCM also controls 75% in Metinvest, which does not include Kryviy Rih Iron Ore

Combine in its Iron Ore Division; 2- Evraz and Smart jointly control Southern GOK; 3- there are no data available on GKZ reserves for separate deposits; 4- according to standards set by

Australasian Joint Ore Reserves Committee (JORC); 5 – GKZ standards - classification system and estimation methods for reserves and resources established by the Former Soviet Union

.

Sources: Company data, ICU estimates

Privatisation process nearly finalised

Kryviy Rih Mining and Processing Plant of Oxidized Ore (KGOKOR) has so far remained

the only non-privatised iron-ore-making company in Ukraine. However, in October 2010, the

Ukrainian government announced its intentions to sell KGOKOR and initiated preparations

for the plant’s privatisation. The privatisation and the consequent completion of the

construction of KGOKOR could potentially result in more than a 100% increase in Ukrainian

pellet export volumes, based on their 2009 level of 9.7mt, or a 34% increase in Ukrainian

total export volumes of iron ore products, based on their 2009 level of 29mt.

KGOKOR has so far been the sole Ukrainian plant designed to process oxidized iron ore.

Potential resources to be used by KGOKOR are the oxidized iron ore of Eastern Valiavkino

deposit, with an estimated 1bn tonne reserves, as well as 724m tonnes of oxidized ore

accumulated by neighbouring Southern GOK (jointly controlled by Smart and Evraz) and

ArcelorMittal Kryviy Rih. The Soviet Union, the German Democratic Republic,

Czechoslovakia, Hungary, and Romania began construction of KGOKOR in 1985, but froze

the project in the early 1990s, so it is now 70% complete. About US$1.65bn of the projected

US$2.4bn has been invested in the construction so far. In order to privatise KGOKOR,

KGOKOR is the last non-

privatised large iron ore

mining and processing

plant in Ukraine

Once completed,

KGOKOR alone will be

able to add 34% to

Ukraine’s total export

volumes of iron ore

based on the 2009 level

18


Ukraine has to pay off debt to other countries-participants of the project. Of US$517m debt,

Romania accounts for 68%, Slovakia for 22%, Germany for 9%, and Bulgaria for 1%.

ArcelorMittal, Evraz, and the tandem of Smart and Metinvest are the most likely candidates

to acquire KGOKOR as result of privatisation, given their strong capabilities to finance

M&A, heavy political weight, and interest in processing oxidized ore in the same location.

We believe that, as these business groups are already 100%- or higher self-sufficient in iron

ore and will be followed by the rest of Ukrainian steelmakers by the end of KGOKOR’s

construction, KGOKOR will become 100%-oriented towards exports.

Favourable geographical location and logistics

Ukraine’s geographical location, well-developed rail links to its western border, as well as well-

developed rail and river transportation links to the Black Sea ports, provide Ukrainian mining

businesses with a freight-cost advantage over their more distant competitors from Russia, Brazil,

and Australia in supplying merchant iron ore products to the markets of Europe and the Middle East.

This predisposes Ukrainian iron ore exports towards these markets, with the major

shipments traditionally going to Austria, Slovakia, the Czech Republic, Poland, Serbia, and

Turkey. Overall, Central and Eastern Europe accounted for 60-76% of the total exports of

Ukrainian iron ore from 2007-10.

Chart 12. Ukrainian iron ore exports by key destinations Chart 13. Ukrainian iron ore exports by key exporters

Notes: CEE - Central and Eastern Europe


However, proximity to the Black Sea also provides Ukrainian miners an opportunity for

export to the fast-growing Chinese market, where they are able to compete in transportation

costs with more distant Brazilian and North American producers. China’s share of the total

exports of Ukrainian iron ore increased from 16% in 2007 to 38% in 9M10.

Table 3. Shipping distance and freight rates to main China ports

Sea port of departure Company Country Distance (nautical

miles)

Sailing days Freight rate2

(US$/tonne)

Port Hedland BHP Billiton Australia 3,600 10 10

Saldanha Kumba S. Africa 8,000 n/d n/d

Yuzhny Ferrexpo Ukraine 8,600 30 28

Tubarao Vale Brazil 11,000 33 25

Seven Islands 1 Rio Tinto Canada 11,500 n/d 36

Notes: 1 - via the Panama Canal; 2- as of September 2010

Source: BHP, Ferrexpo, ICU estimates

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10

(mln tonnes)

CEE China Turkey Other

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

Jan-07 Jun-07 Nov-07 Apr-08 Sep-08 Feb-09 Jul-09 Dec-09 May-10

(mln tonnes)

Ferrexpo Metinvest Southern GOK Minerfin Kryviy Rih Iron Ore Combine Other

ArcelorMittal, Evraz, and

the tandem of Smart and

Metinvest are the most

likely candidates to

acquire KGOKOR

Well-developed

transportation

infrastructure and access

to the Black Sea allow

Ukrainian companies not

only to dominate in

Central and Eastern

Europe, but also compete

for market share in the

Middle East and China

19


Favourable market environment World demand for iron ore correlates closely with steel demand, driven by global economic growth. Unlike

steel demand, however, the demand for iron ore is additionally affected by the oligopolistic nature of the

global iron ore market, which is concentrated around few regions, with China being the largest one. The iron

ore oligopoly enables Ukrainian iron ore producers to have the highest profit margins in the steelmaking

industry. China’s urbanisation and industrialisation is the key driver of the global iron ore demand and is also

a good opportunity for the expansion of Ukrainian iron ore exports.

Iron ore and steel demand

Similar to steel prices, world iron ore prices are substantially driven by the demand for steel.

Steel demand, in turn, depends to a considerable degree on the heavy machinery and

construction sectors, which have accounted for 15% and 50% of the world steel

consumption, respectively, in 2008-10E. Consequently, both iron ore and steel prices are

closely related to the availability of finance for governments and businesses to implement

industry, infrastructure, and real estate projects.

Chart 14. Major trade flows of iron ore in 2009

Notes: 1) Data in brackets – (“the region’s iron ore production”/”the region’s iron ore net exports/- net imports”); 2) Data under trade flow arrows – “days of seaborne transportation”,

“average estimated freight rates per t of iron ore product as of September 2010”; 3) For CIS, we use estimated days of seaborne transportation from Black Sea ports; 4) JKT – Japan,

S.Korea and Taiwan; 5) Data over trade flow arrows – iron ore shipments in 2009, mln tonnes.

Source: BHP Billiton, CRU, ICU estimates

However, the global demand for iron ore is different from the demand for steel in that the

bargaining power of iron ore companies is stronger than that of their steelmaking

customers, mainly due to regional imbalances in iron ore supply and demand, as well as

higher concentration of the iron ore industry compared to the steel industry.

S. America

(336/276)

CIS (149/32)

Australia

(371/365)

China

(258/-629)

Europe

(28/-96)

India

(204/114)

JKT

(0/-160)

The demand for steel and

demand for iron ore have

a common base…

…however, iron ore

companies have stronger

bargaining power than

steelmakers

20


Several key steelmaking regions, China, Japan, South Korea, and the EU, are in shortage

of iron ore and depend on its imports from Australia, Brazil, India, and the CIS, which have

an iron ore overcapacity. As the world key steelmaking regions need to import high volumes

of iron ore from overseas, seaborne trade dominates in the global extra-regional exports of

iron ore, which accounted for 79% of the world iron ore trade in 2008. On the other hand,

steel production is more oriented towards intraregional consumption, with 60% of the world

steel trade volumes relating to extra-regional exports in 2008.

Chart 15. Major extra-regional trade flows of iron ore versus steel in 2008 (mln tonnes)

50mln tonnes of iron ore 50mln tonnes of steel

Source: World Steel Association

In 2009, the top ten steelmakers’ share was 44% in China’s steel output, and slightly less

than 23% in the total world steel output, while the top three iron ore companies produced

33% of the world total output of iron ore and exported 73% of the world total seaborne trade

volumes of iron ore.

As a result of the higher bargaining power of iron ore companies, the growth in iron ore

prices tended to be more prolonged and outpaced the growth in steel prices more often

during demand hikes in 2007-10. Furthermore, iron ore prices have an additional

inflationary effect on steel prices, as steelmakers strive to pass on increasing costs to their

consumers.

Chart 16. Change in iron ore and steel prices to the basis at March 2006

Source: Bloomberg

-50.0

0.0

50.0

100.0

150.0

200.0

250.0

300.0

Mar-06 Sep-06 Mar-07 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10

(%)

China iron-ore fines (spot) BHP iron-ore fines (contract) CIS export billets US import rebar

Extra-regional exports

of iron ore exceed steel

exports by 2.7-3.0x, and,

unlike steel exports, are

highly concentrated in

Southeast Asia and

Europe

The top ten steelmakers

produce 23% of the world

steel output, while the

top three iron ore

companies control 73%

of the seaborne trade of

iron ore

21


China drives the global demand for iron ore

Ukrainian iron ore miners will capitalise on the buoyant global demand for iron ore, as the

Commodity Research Unit (CRU) expects world consumption of iron ore to grow strongly in

2010-13, to around 2.5bln tonnes. The key region driving this increase will be China, which

is estimated to account for 64% of the total world consumption in 2010.

Chart 17. World consumption of iron ore by country or region

Note: Oceania consists of Australia, New Zealand and the Pacific Island nations. Source: CRU

Chinese consumption of iron ore is estimated by the CRU to grow at 15% CAGR during

2010-15, as the country’s industrialisation and urbanisation is underway, requiring further

growth in steelmaking capacity. India, mainly responsible for iron ore consumption growth in

the rest of Asia, is on the same track of economic development, targeting a 35% growth in

steelmaking capacity from 2010 to 2012. The Middle Eastern countries are poised to

demonstrate the fastest growth in iron ore consumption, driven by more than US$1trn worth

of industry and infrastructure projects. Rising iron ore demand will be further supported by

the emerging-industry economies of South America, led by Brazil, and of CIS, led by

Russia.

Table 4. World consumption of iron ore by country or region, 2005-15 (mln tonnes)

Country/region 2005 2006 2007 2008 2009 CAGR

2005-09

(%)

2010E 2011E 2012E 2013E 2014E 2015E CAGR

2010-15

(%)

China 687.7 897.7 1,069.9 1,248.9 1,261.9 16.4 1,399.7 1,511.1 1,556.9 1,579.5 1,504.3 1,529.0 1.8

Rest of Asia 251.5 261.4 289.0 294.1 257.4 0.6 301.0 323.5 354.5 374.4 392.4 407.1 6.2

Europe 168.0 175.4 177.7 167.4 121.7 -7.7 149.1 156.7 162.5 169.0 173.5 175.2 3.3

CIS 136.8 145.2 148.6 137.7 121.4 -2.9 131.3 145.3 157.2 162.0 166.8 170.6 5.4

North America 86.6 87.1 88.3 84.1 51.9 -12.0 67.8 74.6 80.3 83.6 85.5 88.3 5.4

South America 72.2 70.1 72.7 69.9 48.7 -9.4 61.7 70.3 75.7 79.7 83.4 86.1 6.9

Middle East 20.0 19.7 22.3 23.1 25.9 6.7 32.2 37.2 40.6 42.8 44.0 47.0 7.8

Africa 23.0 22.9 21.2 19.0 17.5 -6.6 20.0 22.5 23.7 25.0 26.0 27.5 6.6

Oceania1 9.2 9.6 9.5 9.0 6.4 -8.7 8.9 9.3 9.8 10.3 10.8 10.9 4.1

Total 1,455.0 1,689.1 1,899.2 2,053.2 1,912.8 7.1 2,171.7 2,350.5 2,461.2 2,526.3 2,486.7 2,541.7 3.2

Notes: 1- Oceania consists of Australia, New Zealand and the Pacific Island nations.

Source: CRU

0.0

0.5

1.0

1.5

2.0

2.5

3.0

2005 2006 2007 2008 2009 2010E 2011E 2012E 2013E 2014E 2015E

(bln tonnes)

China Rest of Asia Europe CIS N. America S. America Middle East Africa Oceania*

The world consumption

of iron ore will grow in

2010-13, mainly due to

emerging markets, led by

BRIC and the Middle East

22


The growing global consumption of iron ore will in turn further boost volumes of seaborne

trade of iron ore due to inherent regional supply-demand imbalances, with the key one

developing in the East Asia, where rising steelmaking capacities will become increasingly

insufficient in iron ore resources. The region’s leader, China, will be able to satisfy only 45%

of its steel production needs in 2010 with its local iron ore supplies. Despite being one of

the countries with the highest iron ore reserves in the world (62.4bln tonnes), China is still

unable to effectively ramp up its domestic iron ore production, since Chinese iron ore has a

low iron content (20-30%) and is costly to mine and process. Hence, Metalytics expects

China’s domestic iron ore production to level off in 2011-12, while iron ore imports will

account for as high as two-thirds of the country’s total iron ore consumption. Moreover, the

CRU predicts that Chinese iron ore production will slip down at 2.5% CAGR in 2012-15,

while Chinese steelmakers will increasingly rely on Australian and Brazilian iron ore.

Chart 18. China’s consumption of iron ore Chart 19. China’s sources of iron ore

Source: Metalytics Source: Metalytics

The growing iron ore consumption in ore-sufficient South America, the CIS, and particularly

India, which accounted for 20% of iron exports to China in 2009, will add tension to the

Southeast Asian iron ore market. For Ukrainian iron ore miners, the Southeast Asian

market, with its significant capacity, growth potential, and relative scarcity of high-quality

ore, will therefore play the key role in the region in building up sales volumes, despite its

remoteness.

Pricing: oligopoly benefits

While Ukrainian iron ore companies do not play any role in setting global iron ore prices,

they capitalise on the oligopolistic nature of both the domestic and the international iron ore

markets, which puts additional pressure on iron ore prices.

The Big Three

In the foreseeable period of 2011-15, the world seaborne market for iron ore will continue to

be controlled by the three largest international mining companies: Vale, BHP Billiton, and

Rio Tinto (the “Big Three”), which accounted for 73% of the seaborne ore trade volume and

for 30% of the world iron ore production in 2009 and also dominate the world iron ore

industry in capacity expansion projects. The high bargaining power of the Big Three allowed

them to raise global iron ore prices 100%, to $143-150 a tonne, in April 2010. On the

opposite side of negotiations, Asian steelmakers have so far failed to provide strong

arguments in the negotiation process, mainly due to the high fragmentation of the steel

industry in China and China’s remaining high dependence on iron ore imports.

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1992 1997 2002 2007 2012

(bln tonnes)

Imports Domestic

0.0

0.2

0.4

0.6

0.8

1.0

1.2

2004 2005 2006 2007 2008 2009 2010E

(bln tonnes)

China Australia Brazil India S.Africa CIS Oth. Asia Oth. S.America Others

High volumes of

seaborne trade of iron

ore are mainly supported

by flows from Australia

and Brazil to the EU and

Southeast Asia

China’s dependence on

imported iron ore will

increase in the future

Ukrainian iron ore

producers benefit from

the global iron ore

oligopoly

23


Chart 20. Key world iron ore exporters Chart 21. Key world seaborne trade off-taker countries/regions

Source: Metalytics Source: Metalytics

Benchmark system

The majority of the world seaborne iron ore trade has traditionally been sold through long-

term contracts, also called framework agreements, with tonnages and prices negotiated

between the Big Three and their main steelmaking customers. The latter have been

dominated by the European and Southeast Asian steelmakers. In Southeast Asia, Chinese

companies now lead the negotiations, having replaced Japanese companies. A price for

fines is usually settled first, and then premiums for lumps and pellets are negotiated,

depending on supply-demand balances. Once agreed upon by one market, iron-ore price

movements flow to other markets, and then to less significant markets; hence they are

called benchmark prices for the whole industry.

A smaller portion of the world seaborne iron ore trade is represented by the spot market,

where sales are individually negotiated, and one-time contracts are made directly between

a buyer and a seller. The spot market is dominated by Indian and Australian sales to China,

which is in fact the key driver for spot prices, due to its significant demand for iron ore

imports. The rapid growth in this demand has caused international spot prices to be

generally higher than benchmark prices in the last three years.

Pricing mechanism

Iron ore producers other than the Big Three usually set their prices by adjusting the

benchmarks for “value-in-use” and freight costs in a calculation process called a netback.

Value-in-use is a term used to describe the adjustment made to benchmark prices to

account for differences in chemical structure between a particular iron ore product and its

relevant benchmark, as these differences lead to differing costs at steel mills. To account

for different Fe and free moisture content from different mines, iron ore is priced in US cents

per dry metric tonne unit, or US¢/dmtu, so, to change a price in US¢/dmtu to US$/tonne,

one can just multiply US¢/dmtu by the relevant Fe content fraction.

Ukrainian iron ore producers also follow this mechanism in agreeing upon their prices for

both domestic sales and exports. On the domestic market, iron ore prices for Ukrainian

customers are set much in accordance with the trends of the international benchmarks,

mainly due to the oligopoly similar to the one on the international market, as Metinvest

dominates the Ukrainian market, with a ~60-70% share. For export destinations, the

netback mechanism is also actively used by Ukrainian companies in applying their specific

adjustments. Ferrexpo, for instance, applies a premium over the Vale FOB Tubarao

benchmark price for its European customers due to its ability to provide pellets on a just-in-

time basis in smaller continuous lot sizes.

0.0

0.2

0.4

0.6

0.8

1.0

1.2

2004 2005 2006 2007 2008 2009 2010E

(bln tonnes)

Vale Rio Tinto BHP Billiton LKAB CSN Kumba FMG SNIM Indian Exporters Others

0.0

0.2

0.4

0.6

0.8

1.0

1.2

2004 2005 2006 2007 2008 2009 2010E

(bln tonnes)

China Japan EU-16 S.Korea Taiwan Others

Benchmark prices agreed

upon among the Big

Three have a critical

influence on world prices

for iron ore

Ukrainian iron ore

producers closely follow

international benchmark

price trends in setting

prices for both domestic

sales and exports

24


Chart 22. Spot prices for iron ore products in China Chart 23. Key global benchmark contract prices for iron ore

Source: Bloomberg Source: Bloomberg

Transition of the benchmark system

The gap between spot and benchmark prices for iron ore has ultimately led to changes in the

benchmark system. Until the recent economic downturn, benchmark prices of iron ore were

determined at four benchmark locations on an annual basis, usually in April. However, during

the downturn of 2008-09, when spot prices collapsed by 55% and benchmark prices dropped

by 33-45%, this system stopped functioning effectively, and reliance on spot prices increased

dramatically. As a result, the largest iron ore producers have agreed to use quarterly pricing,

effective from April 2010. The new methodology does not appear to have stabilised yet, as

some steelmakers are calling for a return to the annual pricing method, while, on the other

hand, some miners led by BHP Billiton even insist on transitioning to the monthly basis. We

believe, however, that the return to the annual pricing is not likely in the nearest term.

Competitive environment

On their way to expanding sales to the markets of Western Europe and Southeast Asia,

Ukrainian iron ore companies face increasing competition not only from the Big Three ore-

mining companies, but also from other mid-tier companies located in Europe, the CIS, and

Australia. While long-standing relations with customers and technical compatibility with their

steel mills provide little or no competition against Ukrainian companies in Central and

Eastern Europe and Turkey, additional factors, such as price, quality, range of products,

reliability, and transportation costs significantly affect the competitiveness of Ukrainian

companies for other export destinations.

Russian iron ore producers are also main competitors of Ukrainian companies on the

Ukrainian market, particularly Mikhailovsky GOK and Lebedinsky GOK, which are

controlled by Metalloinvest and are Russian plants located closest to the Ukrainian border.

Amounting nearly to an average of 20% in 2009 and 8M10, the market share of Russian

iron ore miners is not stable in Ukraine, and used to rise during aggravating price disputes

between Metinvest and the IUD, and fall after these disputes are settled. However, it may

significantly increase in case some of Russian steelmaking groups takes over control

stakes in key Ukrainian buyers of iron ore, the IUD and Zaporizhstal, after these stakes

have been acquired by Russian state bank, Vneshekonombank.

0.0

50.0

100.0

150.0

200.0

250.0

300.0

350.0

400.0

Mar-05 Dec-05 Sep-06 Jun-07 Mar-08 Dec-08 Sep-09 Jun-10

(US$c/dmtu)

China fines (63.5% Fe) China Pellet (66% Fe)

Indian fines to China (63% Fe) China concentrate (66% Fe)

0.0

50.0

100.0

150.0

200.0

250.0

300.0

350.0

400.0

Mar-05 Nov-05 Jul-06 Mar-07 Nov-07 Jul-08 Mar-09 Nov-09 Jul-10

(US$c/dmtu)

Australian lump to Japan (64% Fe) Vale pellets (67% Fe)

BHP fines (63% Fe)

The financial crisis

prompted the

convergence of the

benchmarking and the

spot-price systems

On their move to new

markets, Ukrainian iron

ore companies face

increasing competition

The market share of

Russian miners in

Ukraine may

substantially increase

due to a changing

ownership structure in

the IUD and Zaporizhstal

25


Table 5. Key international competitors of Ukrainian iron ore producers

Company Share of iron ore export

market in 2009 (%)

Country of

incorporation

Affiliates - key competitors with

Ukrainian producers

Markets of competition with Ukrainian producers

Vale 26 Brazil Tubarao, Carajas, Fabrica Western Europe, South East Asia

Samarco1 Western Europe, South East Asia

BHP Billiton 14 Australia Samarco1 Western Europe, South East Asia

Newman, Yandi, Yarrie, Area C South East Asia

Rio Tinto 24 Australia Iron Ore Company of Canada Western Europe

Hamersley, Robe River South East Asia

Fortescue Metal Group 4 Australia Cloudbreak, Christmas Creek South East Asia

Kumba 4 South Africa Sishen, Thabazimbi, Kolomela Western Europe, South East Asia

Luossavaara Kiirunavaara (LKAB) 1 Sweden Kiruna, Malmberget Western Europe

Metalloinvest 1 Russia Lebedinsky GOK, Mikhailovsky GOK Ukraine, Central Europe, Western Europe, South East Asia

NLMK <1 Russia Stoilensky GOK Ukraine

Notes: 1 - Samarco is jointly controlled by Vale and BHP Billiton.

Sources: Ferrexpo, Metinvest, Metalytics, CRU, ICU estimates

26


Production costs pose key concerns For the most value-added iron ore products, pellets, Ukrainian producers are positioned close to the middle

of the global rating of production cash costs. Furthermore, if one adds transportation costs to production

costs, Ukrainian miners have a clear cost advantage over their overseas competitors in the markets of

Ukraine, Europe, and the Middle East, and are able to compete with their North and South American

competitors on the markets of Southeast Asia. In terms of cost competition, the main weaknesses of

Ukrainian mining companies─high energy consumption and low labour productivity compared to non-CIS

competitors─are partly compensated for by lower prices for electricity and fuel, as well as extremely low

costs of labour. Ukrainian miners have an opportunity to improve their cost competitiveness and strengthen

their market position by implementing efficiency improvement programs, especially as because energy prices

in Ukraine are likely to grow, getting closer to international averages in the next five years.

Chart 24. FOB cash costs1 for pellets in 2010

Note: 1- Including delivery costs to frontier/sea port.

Source: Ferrexpo, Metalytics

Chart 25. CFR China cash costs for pellets in 2010

Source: Ferrexpo, Metalytics

50.554.6 57.0

43.446.8

43.650.2

53.356.0

59.5

45.050.9 52.6

65.6 66.1

54.4

0.0

10.0

20.0

30.0

40.0

50.0

60.0

70.0

Lebe-dinsky GOK

Carajas SSGPO Mikhai-lovsky

Tubarao Poltava GOK

Mont Wright

Middle-back

Fabrica Carol Lake Central GOK

Kiruna Northern GOK

Malm-berget

North-shore

Savage River

(US$/dry tonne)

Ferrexpo Metinvest Metalloinvest Vale LKAB Other Rio Tinto

0.0

20.0

40.0

60.0

80.0

100.0

120.0

140.0

160.0

Middleback Carajas Lebe-dinsky GOK

Tubarao Poltava GOK

Fabrica Mikhai-lovsky

Central GOK

Savage River

Northern GOK

SSGPO Kiruna Mont Wright

Malm-berget

Carol Lake North-shore

(US$/dry tonne)

FOB Sea Freight

Ferrexpo (Ukraine) Metinvest (Ukraine)

27


Inferior quality of iron ore deposits implies costlier mining

Ukrainian iron ore deposits are characterised by uneven quality distribution, and the

majority of reserves contain so-called “lean ores,” the iron content of which do not exceed

34%, while Brazilian, North American, South African, and Australian miners have deposits

with around 60% of iron content. Ukrainian lean ores, therefore, require further iron

concentration in order to make them usable for steelmaking. On the other hand, Ukrainian

deposits containing ores with iron content over 50% require underground mining, which in

many cases requires water drainage and gas offtake, thus also rendering them more costly

than open-pit mining in the leading ore-mining countries.

The 125-plus-year history of iron ore extraction in Ukraine has left today’s domestic miners

with less economically profitable deposits, with mining depth often reaching 350 meters for

open pits and 1,300 meters for underground mines. Hence, Ukrainian iron ore stripping

ratios, which refer to the amount of overburden removed per tonne of iron ore extracted, are

on average by 3-4x higher than corresponding stripping ratios in Australia, Brazil, Canada,

and the US, thus implying a larger consumption of labour, energy, and other resources. At

currently exploited deposits, as companies deepen and widen the pits in order to increase

their useful lives, the stripping ratios should further increase.

Energy inefficiency creates the main risks for costs

The inferior quality of iron ore deposits, obsolete equipment, and severe winters make

mining and processing of iron ore, particularly the production of sinter and pellets, much

more energy-intensive for Ukrainian companies compared to non-CIS competitors. This

relative energy inefficiency is partly compensated for by relatively cheap prices for

electricity and fuel available to Ukrainian companies. Nevertheless, energy costs account

for 45-55% in production costs of Ukrainian sinter and pellets. At the same time, energy

prices are mostly non-controllable by Ukrainian iron ore producers, and pose one of the

biggest threats to producers’ competitiveness.

Chart 26. Structure of Ferrexpo production costs of in 2009 (%) Chart 27. Energy use by mining companies in 2009

Note: 2009 cash costs of Ferrexpo were US$37.80 per t of pellets Notes: (1) - CNR - Cliff Natural Resources, 2007 usage ratios were taken;

(2) Canadian - Canadian iron ore mining companies on average, 2008 usage

ratios were taken

Source: Ferrexpo Source: Company data, Ministry of Industrial Policy of Ukraine, Natural Resources

Canada, ICU estimates

Electricity26.1

Natural gas12.0

Diesel fuel10.0

Grinding media10.0

Other materials10.0

Labor13.0

Spare parts8.0

Maintenance8.9

Royalties2.0

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

Ferrexpo Metalloinvest CNR (1) LKAB Canadian (2) BHP

(GJ/tonne)

Natural gas Purchased electricity Fuel oil Diesel & distillate Coal & coke Other

The average iron content

of Ukrainian iron ore

deposits is 30%

Stripping ratios on

Ukrainian iron-ore mines

are on average 3-4x

higher than In Australia,

Brazil, and Canada

Energy costs account for

45-55% of production

costs of Ukrainian sinter

and pellets

28


Natural gas

Natural gas is used by Ukrainian iron ore companies primarily in the agglomeration process

for making sinter and pellets. A distinctive feature of agglomerated ore production at

Ukrainian plants is the intensive consumption of natural gas; on average, Ukrainian pellet-

makers, Ferrexpo and Metinvest, use 16-18m3 of natural gas per tonne of pellets, versus

zero used by Australian, Swedish and North American pellet-makers, who are focused on

using electricity and fuel. While natural gas prices for Ukrainian industrial consumers are

set by the state-owned Naftogaz and regulated by the Ukrainian Cabinet of Ministers, their

level is mainly affected by Gazprom, the Russian monopoly supplying natural gas to

Ukraine. In the last five years, Gazprom has been pursuing a policy of converging natural

gas prices for Ukraine with prices for European countries. Though in 2010, Ukraine

bargained for a 30% discount to the previous pricing scheme in exchange for allowing

stationing the Russian Black Sea Fleet in the Crimea, there is no guarantee that this

discount will remain in the future. According to the current pricing scheme, natural gas

prices for Ukraine follow the trend in international oil prices. Ukrainian pellet-makers

Ferrexpo and Metinvest are capable of substantially decreasing their natural gas

consumption by modernising their equipment. Ferrexpo, in particular, plans to cut its usage

of natural gas by around 20% through installing a heat recovery system in its pelletising

facilities.

Chart 28. Natural gas prices for industry Chart 29. Usage of natural gas by iron ore companies in 2009

Notes: (1) - CNR - Cliff Natural Resources, 2007 usage ratios were taken;

(2) – at BHP, pellets are produced at Samarco only (3) Canadian - Canadian

iron ore mining companies on average, 2008 usage ratios were taken

Source: US Energy Information Administration, ABARE, ICU estimates Source: Company data, Ministry of Industrial Policy of Ukraine, Natural Resources


Electricity

The largest share of electricity is used by Ukrainian companies for grinding and crushing

iron ore during the beneficiation. At the same time, Australian and Brazilian competitors, not

needing to increase iron content of their ores, are able to save electricity at least at this

stage. Furthermore, the Big Three are able to consume part of needed electricity from in-

house power stations at cost. Electricity tariffs charged to Ukrainian iron ore producers are

currently regulated by the National Energy Regulation Commission, which sets tariffs for

both industrial and household consumers. Ukraine’s reliance on nuclear and hydro energy,

as well as the state’s policy of industry support, provides industrial consumers with

electricity prices cheaper than those in Europe, the US, and Brazil. However, the Ukrainian

government plans to liberalise electricity tariffs, making them likely to rise in the next three-

to-five years. We expect that the liberalisation mechanism will make for a gradual increase

in electricity tariffs.

0.0

50.0

100.0

150.0

200.0

250.0

300.0

350.0

400.0

Australia Russia Ukraine Canada United States Northern Europe

(US$/1000m3)

2005 2006 2007 2008 18.0

16.3

14.313.1

9.1

0.0 0.0 0.0

0.0

5.0

10.0

15.0

20.0

Metinvest Ferrexpo Vale Metallo-invest

CNR (1) BHP (2) Canadian (3)

LKAB

(m3/t)

The consumption of

natural gas in Ukrainian

production of sinter and

pellets is high compared

to main competitors

As a result of

liberalisation, electricity

tariffs for Ukrainian

industrial consumers

should rise in the next

three-to-five years

29


Ukrainian iron ore companies are also able to achieve savings on electricity by integrating

up-stream into power generation companies. The 75%-shareholder of Metinvest, System

Capital Management, also controls DTEK, which supplies to Metinvest approximately 68%

of Metinvest’s electricity requirements. The majority shareholder of Ferrexpo, Kostyantin

Zhevago, also has an ownership interest in Komsomolsk Cogeneration Company, which

has completed a definitive feasibility study for construction of electricity generation facilities

near the Yeristovo deposit. Provisionally scheduled to be constructed in 2010-14, these

facilities may supply electricity to Ferrexpo upon the project completion. However, prices

charged to iron ore miners by affiliated gencos are subject to transfer-pricing policies of

their parent companies and regulations of the state, which sets the minimum tariffs for both

industrial and household customers. The regulations may change upon tariffs liberalisation.

Chart 30. Electricity prices for Industry Chart 31. Usage of purchased electricity by iron ore companies

in 2009

Notes: (1) - CNR - Cliff Natural Resources, 2007 usage ratios were taken; (2) Canadian - Canadian iron ore mining companies on average, 2008 usage ratios were taken

Source: US Energy Information Administration, ABARE, ICU estimates Source: Company data, Ministry of Industrial Policy of Ukraine, Natural Resources


Fuel

Fuel is used by Ukrainian iron ore producers mainly to run mining equipment and transport

iron ore and overburden. More complex mining conditions reflected in higher stripping ratios

force Ukrainian companies to consume more fuel than their Australian and Brazilian

competitors. However, the proximity of a large oil supplier, Russia, and low excise taxes,

make fuel prices for Ukrainian companies 15-40% cheaper than in Brazil, Australia, and

Europe. Supplied by Ukrainian private oil companies, fuel is priced based on market

factors, and follows trends in international oil prices.

0.00

0.02

0.04

0.06

0.08

0.10

0.12

0.14

Russia Australia Canada Ukraine US North. Europe

Brazil

(US$/kWh)

2005 2006 2007 2008

184.6

166.2

144.0

120.9

26.5

6.4

0.0

50.0

100.0

150.0

200.0


(kWh/t)

Fuel prices for Ukrainian

industrial consumers are

15-40% cheaper than for

Brazilian, Australian, and

European companies

30


Chart 32. Diesel oil prices for commercial use Chart 33. Usage of fuel by iron ore companies in 2009

Source: US Energy Information Administration, ABARE, ICU estimates Notes: (1) CNR - Cliff Natural Resources, 2007 usage ratios were taken; (2) Canadian

- Canadian iron ore mining companies on average, 2008 usage ratios were taken; (3)

for non-CIS companies, usage of fuel includes usage of diesel fuel, fuel oil, distillate

and gasoline (4) for Ferrexpo, usage of fuel means usage of diesel fuel only.

Source: Company data, Ministry of Industrial Policy of Ukraine, Natural Resources


Labour structure needs further optimisation

Ukrainian production of iron ore remains inefficient in terms of labour use compared to the

world industry leaders and Western companies, as domestic miners produce 5-20x less per

employee than their non-CIS competitors. However, the extremely low cost of labour per

employee of Ukrainian companies, being 3-10x cheaper than for non-CIS competitors,

partially compensates for that inefficiency. As a result, while Ukrainian miners’ per-tonne

labour costs are higher than for Australian companies, there is still a cost advantage over

North American, Brazilian, and West European producers.

One of the main reasons for such low labour productivity is the large number of support

personnel inherited from the times of the state ownership. The majority of Ukrainian iron ore

companies plan to reduce their workforces through outsourcing ancillary services and

changing their organisational structure; however, they still have to introduce these changes

gradually due to statutory, political, and social constraints. Therefore, labour productivity is

one of the areas where Ukrainian iron ore producers can achieve cost savings, though

more likely in the long term.

Table 6. Labour productivity and labour costs of iron ore producers for the financial year 2009

Company Net revenue per

employee (US$ 000)

Production per

employee (000' tonnes)

Labour cost per

employee (US$ 000)

Labor cost per tonne

(US$)

BHP 3087.9 35.2 101.2 2.88

LKAB 324.2 4.7 86.0 18.35

Rio Tinto 1107.5 15.1 60.8 3.17

Vale 594.5 10.2 32.3 5.56

Ferrexpo 77.7 1.0 10.5 4.03

Metinvest 87.7 1.4 9.6 4.72

Metalloinvest 88.3 1.7 9.3 6.82

Sources: Company data, ICU estimates

0.00

0.25

0.50

0.75

1.00

1.25

1.50

1.75

Russia Ukraine US Brazil Canada Australia North. Europe

(US$/litre)

2005 2006 2007 2008

5.535.20

4.13

3.61 3.48

2.63

0.0

1.0

2.0

3.0

4.0

5.0

6.0


(liters/t)

Ukrainian iron ore

producers generally have

an excessive labour

force, but low labour

costs per employee

The optimisation of the

labour structure may take

a long time, due to

political and social

issues

31


Modernisation is time-consuming and capital-intensive

The leading Ukrainian iron ore miners are planning development projects that are aimed to

increase production capacity, enhance efficiency and improve quality of iron ore products.

These projects are commonly complex in terms of their overall scope, technology,

engineering, procurement, construction, and commissioning requirements. The complexity

and lengthy time span of these projects also increases the likelihood of completion delays

and cost overruns. As a consequence, Ukrainian companies in most cases find their

operating cash flows insufficient to finance their capex, and need to raise additional

financing through debt or equity.

Table 7. Highlights of the main Ukrainian iron ore development projects

Parent group/operating asset Project Project aim Capex required (US$m) Timeline

METINVEST

Northern GOK Construction of new beneficiation facilities and a new

pellet plant Lurgi 278-B, modernisation of existing

pellet plant OK 306-1

21% increase in pellet-making capacity to 14.3mtpa,

improved safety and environmental standards

520.7 2012

Ingulets GOK Construction of two flotation modules improved output quality 105.1 2012

FERREXPO

Poltava GOK Extension of the current pit Extending the useful life of the pit to 2038, increasing

the mining capacity by 25% to 35mtpa

168.0 1Q13

Poltava GOK Upgrade of the existing concentrator facilities Increase of 65% Fe pellets share from 50% to 100%

in the total sales

212.0 End of 2014

Yeristovo GOK Development of a new pit, construction of new

beneficiation facilities and a pellet plant

Achieving new production capacity of 28mtpa of iron

ore, 10mtpa of concentrate and 7.5mtpa of pellets

1,500.0 2015

DONETSKSTAL1

Vasinovsky GOK Development of an underground mine Achieving new production capacity of 20mtpa of iron

ore

1,500.0 2017

Notes: 1- Donetskstal is in process of obtaining the appropriate mining license, capex figure is an approximate estimate, while the officially approved capex program is still pending.

Sources: Ferrexpo, Metinvest, Rusmet

Cpml kj

Compared to large Australian and Brazilian miners, investment projects of Ukrainian iron

ore producers are more capital-intensive per tonne of output increase due to the larger

portion of investments needed to upgrade/install processing equipment, as well as due to

the smaller scope of mining capacity expansion.

Chart 34. Capex per tonne of iron ore on iron ore projects announced in 2009-10

Source: Company data

69.181.3

108.1

125.5

166.7

209.8

234.1

0.0

50.0

100.0

150.0

200.0

250.0

Rio Tinto Fortesque BHP Vale Ferrexpo Metinvest Metalloinvest

(US$/tonne)

Development projects of

the Ukrainian iron ore

producers are complex,

require substantial

capex, and take a long

time for implementation

32


Appendixes

Appendix 1. SWOT analysis

Table 8. SWOT analysis of Ukrainian iron-ore sector

STRENGTHS OPPORTUNITIES

Favourable geographical location and developed infrastructure: Proximity

to the markets of Europe and the Middle East, as well as developed railway and

river transportation routes, provide Ukrainian producers with competitive advantage

over its international rivals in freight cost component in these regions.

Large underexploited reserves: Ukrainian companies have an access to mineral

resources of at least 30bnt of iron ore, being among the largest iron ore resources

in the world.

Oligopoly on the domestic and international markets of iron ore: Allows for

high bargaining power and provides domestic iron ore producers with the highest

profit margins in the Ukrainian steel industry.

Relatively low electricity prices in Ukraine compared to US, European and

Brazilian competitors.

Relatively low diesel fuel prices in Ukraine compared to non-CIS competitors.

Low labour costs compared to non-CIS competitors.

Recovery of the global economy and the resulting growth in the world demand

for steel and steelmaking inputs, including iron ore products of Ukrainian

companies.

Increasing demand for iron ore in Southeast Asia: Ukrainian iron ore

producers may benefit from growing steel output in Southeast Asia, particularly

China, which should increase iron ore imports and boost overall demand for iron

ore.

Increasing presence on the markets of Western Europe and Southeast Asia.

Increasing sales volumes through production capacity expansion, as a

result of implementing projects on introduction of new mining sites and ore

processing facilities.

Improving cost efficiency through introduction of new energy-saving

technologies.

Optimisation of transportation costs, as Ukrainian companies may build up

their own railway rolling stock and sea port facilities.

Increasing labour productivity through optimisation of organizational structure

is achievable in the long term.

WEAKNESSES THREATS

Inferior quality of iron-ore deposits: Lean ore deposits with less than 30% of

iron content are dominating, complicated mining conditions imply stripping ratios

3-4 times higher than in Brazil, Australia, Canada, and the US.

Energy inefficiency: Higher energy consumption compared to non-CIS

competitors is caused by inferior quality of iron ore deposits, obsolete processing

equipment and severe winters in the region.

Low bargaining power in purchasing energy: Ukrainian companies heavily

depend on supply from oligopoly market of electricity and fuel in Ukraine, as well

as the monopoly of Gazprom in supplying natural gas to Ukraine.

Low labour productivity due to inefficient organization structure is

inherited from state ownership and is hard to change quickly due to statutory,

social and political constraints.

Low bargaining power in purchasing transportation services: Dependence

on the monopoly of state-owned Ukrzaliznytsia to provide railway transportation

services in Ukraine and volatile international freight rates in the international

seaborne trade.

Possible recurring recession may adversely affect global iron ore prices, thus also

hitting profitability of Ukrainian iron ore producers.

Rising energy prices: Rising natural gas prices charged by Gazprom to Ukraine,

growth in electricity tariffs as a result of tariff liberalization, rising prices for diesel fuel

on the back of growing international prices for oil.

Increasing competition against Ukrainian companies on their way to expanding

sales to Western Europe and South east Asia.

Undermined ability to increase production capacity and upgrade equipment

Large scope, complexity and long time span of development projects may cause

completion delays and cost overruns. This may be aggravated by the inability of

Ukrainian companies to raise additional financing.

Appreciation of hryvnia versus US dollar – may negatively impact Ukrainian

companies’ cost competitiveness

Source: Investment Capital Ukraine LLC.

33


Appendix 2. Financial market exposure

Table 9. Ukrainian iron ore sector exposure to debt and equity markets

Parent group/Plant Parent

control (%)

Securities

listed

Eurobonds

(US$m)

Security exchange Ticker Shares

outstanding (mln)

Market cap1

(US$m)

Free float

(%)

Metinvest -- Eurobonds 500.0 -- -- -- -- --

Northern GOK 63.3 Shares -- PFTS, RTS Ukraine SGOK UK, SGOK UZ 2,304.1 3,621.9 0.5

Central GOK 75.9 Shares -- PFTS, RTS Ukraine CGOK UK, CGOK UZ 1,171.8 810.5 0.5

Ingulets GOK 82.5 -- -- -- -- -- -- --

Ferrexpo -- Shares -- LSE FXPO LN 588.6 3,442.0 24.0

Poltava GOK 97.3 Shares -- PFTS, RTS Ukraine PGOK UK, PGOK UZ 191.0 1,060.2 2.7

Minnerfin (Slovakia)2 -- -- -- -- -- -- -- --

Zaporizhzhia Iron Ore Combine2 75.0 -- -- -- -- -- -- --

Privat -- -- -- -- -- -- -- --

Krivorizhsky Iron Ore Combine3 50.0 -- -- -- -- -- -- --

Smart -- -- -- -- -- -- -- --

Southern GOK4 50.0 Shares -- PFTS, RTS Ukraine PGZK UK, PGZK UZ 2,143.6 -- 0.0

Evraz -- GDRs 650.0 LSE EVR LI 146.0 15,378

Sukhaya Balka 99.3 Shares -- PFTS SUBA UZ 837.6 -- 0.3

Notes: 1 - Market capitalisation as of 8 December 2010; 2 - Zaporizhzhia Iron Ore Combine is also 25%-controlled by Zaporizhstal; 3 - the remaining 50% stake in Kryviy Rih Iron Ore

Combine is controlled by System Capital Management; 4 - another nearly 50% stake in Southern GOK controlled by Evraz.

Sources: Bloomberg, Company data, PFTS, RTS Ukraine, ICU estimates

Appendix 3. Financial performance highlights

Table 10. Highlights of Ukrainian iron ore companies’ financial performance in 2009

US$m Metinvest1 5 Ingulets GOK2 Northern GOK2 Central GOK2 Ferrexpo1 South GOK2 ZIOC2 3 KrIOC2 4

Revenues 1,825.0 562.7 753.5 292.5 648.7 273.2 135.4 144.6

COGS n/d 276.8 428.4 188.1 341.1 198.2 94.7 93.4

Gross profit n/d 286.0 325.0 104.4 307.6 75.0 40.6 51.2

Gross margin n/d 51% 43% 36% 47% 27% 30% 35%

EBITDA 811.0 257.1 331.0 105.9 138.1 5.2 36.0 47.8

EBITDA margin 44% 46% 44% 36% 21% 2% 27% 33%

Operating profit n/d 211.1 258.7 78.3 105.4 (8.0) 30.7 39.1

Net income n/d 119.8 160.0 33.6 71.0 (9.4) 24.6 25.8

Net margin n/d 21% 21% 11% 11% n/a 18% 18%

Notes: 1- According to IFRS; 2- According to Ukrainian national accounting standards; 3- Zaporizhzhia Iron Ore Combine; 4- Kryviy Rih Iron Ore Combine; 5 – Metinvest’s financial

performance highlights relate to the company’s Iron Ore Division only

Sources: Company data.

34


Glossary The following is the list of terms, phrases and abbreviations that are frequently used in this report.

Agglomeration: a process used to turn iron ore fines/concentrate into larger, lumpy pieces

with/without additives such as limestone, dolomite, etc. Two types of products made as a

result of agglomeration process are sinter and pellets

Basin of iron ore: A general region with an overall history of subsidence and thick

sedimentary accumulation of iron ore

Benchmark price: International seaborne traded iron ore benchmark price agreed between

the major iron ore producers and specific West European or Asian steel producers for a

given year

Beneficiation: a process adopted for upgrading iron ore to increase its iron content and

reduce gangue content

BF: blast furnace

BOF: basic oxygen furnace

Cash costs: production costs ex-works, excluding non-cash items (e.g., depreciation and

amortization), administrative and distribution costs

CFR: Delivery including cost and freight

Fe: Iron

Flotation: A means of separating one type of mineral from another using reagents after

milling, commonly separating sulphide minerals from silicate minerals

FOB: free on board

GKZ standards - classification system and estimation methods for reserves and resources

established by the Former Soviet Union and last revised in 1981

GOK: Russian abbreviation standing for OMEP, ore mining and processing plant

Grinding: Further reduction, after crushing, of size of mined rocks by mechanical action

Iron ore concentrate: product of the flotation process with an enriched iron content

Iron ore fines: Fine ground iron ore

Iron ore pellet: Dried and hardened agglomerate of iron ore concentrate, whose physical

properties are well suited for transportation and downstream processing in a blast furnace

IUD – the Industrial Union of Donbass

JORC - Australasian Joint Ore Reserves Committee, which has issued the Australasian

Code for Reporting of Exploration Results, Mineral Resources and Ore Reserves used by

international mining companies

LKAB: Luossavaara Kiirunavaara AB

Lump iron ore: In mining, the term is given to naturally occurring high-grade iron ore

mtpa: million tonnes per annum

35


Netback: A calculation process used for adjusting the benchmark prices of iron ore for

value-in-use and freight costs

OMEP: Ore mining and processing plant, a common legal entity/business unit engaged in

iron ore production in Ukraine

Open pit: Surface mining in which the ore is extracted from a pit or quarry

Overburden: Material of any nature, consolidated or unconsolidated, that overlies a deposit

of useful materials

Ore reserves: Ore reserves are sub-divided in order of increasing confidence into probable

ore reserves and proved reserves. Probable reserves are the economically mineable part of

indicated and, in some circumstances, measured resources of iron ore. Proved reserves

are the economically mineable part of measured resources

Pulverized coal injection (PCI) technology: involves injecting pulverized coal directly into

a blast furnace through tuyeres, which reduces the consumption of coke and increases

blast furnace productivity

Mineral resources: A mineral resource is a concentration or occurrence of material of

intrinsic economic interest in or on the earth’s crust (a “deposit”) in such a form, quality and

quantity that there are reasonable prospects for eventual economic extraction. The location,

quantity, grade, geological characteristics and continuity of a mineral resource are known,

estimated or interpreted from specific geological evidence and knowledge. Mineral

resources are further divided, in order of increasing geological confidence, into three

categories: an inferred mineral resource (whose geological characteristics can be estimated

with a low level of confidence), an indicated mineral resource (whose geological

characteristics can be estimated with a reasonable level of confidence) and a measured

mineral resource (whose geological characteristics can be estimated with a high level of

confidence)

Pellet plants: Processing facility that takes as its input iron concentrate and produces iron-

ore pellets

Pig iron: Crude iron obtained directly from the blast furnace and cast in molds

Sinter: An aggregate which is normally produced from relatively coarser fine iron ore and

other metallurgical return wastes used as an input/raw material in blast furnaces

Spot price: The current price of a metal for immediate delivery

Stripping ratio: The unit amount of overburden/waste that must be removed to gain

access to a unit amount of ore or mineral material

Value-in-use: A term used to describe the adjustment made to benchmark prices to

account for differences in chemical structure between a particular iron ore product and its

relevant benchmark, as these differences lead to differing costs at steel mills

36


37


38


39


Disclosures

ANALYST CERTIFICATION

This research publication has been prepared by the analyst(s), whose name(s) appear on the front page of this publication.

The analyst(s) hereby certifies that the views expressed within this publication accurately reflect her/his own views about

the subject financial instruments or issuers and no part of her/his compensation was, is, or will be directly or indirectly

related to the inclusion of specific recommendations or views within this research publication.

LEONARDO Business Centre

19-21 Bogdan Khmelnytsky Street

Kiev, 01030 Ukraine

Tel./fax +38 044 2200120 www.icu.ua

CHAIRMAN OF THE BOARD OF DIRECTORS

Valeria Gontareva

[email protected]

CORPORATE FINANCE

TEL. +38 044 2200120

Makar Paseniuk, Managing Director

[email protected]

Volodymyr Demchyshyn, Director

[email protected]

FIXED-INCOME SALES AND TRADING

TEL. +38 044 2201621

Konstantin Stetsenko, Managing Director

[email protected]

Sergiy Byelyayev, Fixed-Income Trading

[email protected]

EQUITY SALES AND TRADING

TEL. +38 044 2201621

Vlad Sinani, Director, Equities

[email protected]

Javier Reyes, Director, International Equity Sales

[email protected]

Svetlana Shevchun, Equity Trading

[email protected]

Julia Pecheritsa, International Equity Sales

[email protected]

RESEARCH DEPARTMENT

TEL. +38 044 2200120

Alexander Valchyshen, Head of Research

[email protected]

Olga Nosova, Analyst (Economy)

[email protected]

Lee Daniels, Editor

[email protected]

Andriy Tovstopyat

Equity analyst (Food & Agribusiness)

[email protected]

Maksym Nikulyak

Equity analyst (Electric Utilities)

[email protected]

Alexander Martynenko

Equity analyst (Metals & Mining)

[email protected]

Investment Capital Ukraine is regulated by Securities and Stock Market State Commission of Ukraine (licence numbers: dealer activity AB

440399, broker activity AB 440398, underwriting activity AB 440400, securities management activity AB 440401 dated 17 November 2008).

DISCLAIMER

This research publication has been prepared by Investment Capital Ukraine solely for information purposes for its clients. It does not

constitute an investment advice or an offer or solicitation for the purchase of sale of any financial instrument. While reasonable care has

been taken to ensure that the information contained herein is not untrue or misleading at the time of publication, Investment Capital Ukraine

makes no representation that it is accurate or complete. The information contained herein is subject to change without notice. Copyright

and database rights protection exists in this report and it may not be reproduced, distributed or published by any person for any purpose

without the prior express consent of Investment Capital Ukraine. All rights are reserved. Any investments referred to herein may involve

significant risk, are not necessarily available in all jurisdictions, may be illiquid and may not be suitable for all investors. The value of, or

income from, any investments referred to herein may fluctuate and/or be affected by changes in exchange rates. Past performance is not

indicative of future results. Investors should make their own investigations and investment decisions without relying on this report. Only

investors with sufficient knowledge and experience in financial matters to evaluate the merits and risks should consider an investment in

any issuer or market discussed herein and other persons should not take any action on the basis of this report.

Additional information is available upon request.

http://www.icu.ua/

mailto:[email protected]








10_12_16_ICUSectorPrimer-IronOre

Documents

Transcript of 10_12_16_ICUSectorPrimer-IronOre