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July 1, 2011

Too Much, Too Fast

Think unimpeded, rapid growth is inevitable in those fast-developing BRIC economies? Take a look at Brazil's steel business and think again.

If you've ever wondered what it would be like to lead a company that remains beholden to the government that created it, consider the fate of Roger Agnelli, who was chief executive officer of the Brazilian mining company Vale S.A., previously known as Companhia Vale do Rio Doce (CVRD), from July 2001 until May of this year. Among other things, Vale (pronounced Val-'lay), produced nearly 308 million tons of top-quality iron ore in 2010, and still has reserves of nearly 9.8 billion tons, including nearly 5 billion tons of the world's best iron ore, rated at 66.7% iron content, held within its Carajás mine in northern Brazil.

CVRD's sales in 2001 were $3.94 billion, producing net income of nearly $1.3 billion. In 2010, after a decade of growth orchestrated by Agnelli, Vale's revenues totalled $46.5 billion, with net income of almost $17.3 billion. On Agnelli's watch, Vale directors proposed a minimum 2011 dividend of $4 billion, or more than the company's total revenue when Agnelli took charge.

Of course, the company had the global economic wind at its back for much of the last five years. China's emergence as a huge steel producer, hungry for iron ore, has been one significant factor. Brazil, like other developing nations, has grown and modernized rapidly, increasing its own appetite for iron ore. Australia, Vale's No. 1 iron ore competitor, has ramped up the output of its mines amid unremitting competition between its two mining giants, Rio Tinto and BHP-Billiton. But India, a major iron ore resource, has consciously reduced exports to retain as much iron capacity as possible for its own growing steel sector.

Even so, in the hands of a lesser executive, Vale could easily have slipped and failed to rise to the iron-ore production occasion. It didn't. Agnelli's reward? He was shown the door, because Brazil's government, which still exercises great control of Vale through various ownership means, was displeased that Agnelli didn't plunge more aggressively into steel production, which the company mostly exited when it privatized in 1997.

In some countries, a record such as Agnelli's would be regarded as a national treasure. Internationally, Vale is Brazil's best-known and most respected company because of his work. The wealth he has squeezed from Brazil's natural resources—not just iron ore, but a rich mix of coal, nickel, copper, bauxite, alumina, aluminium and potash—has added significantly to the nation's well-being. A reluctance to spend major money on steel should be understandable, even laudable.

Not so in Brazil, where former President Luiz Inácio Lula da Silva, whose eight years in office expired earlier this year, and his successor, former Lula chief of staff Dilma Vana Rousseff, want more of the nation's iron ore used to make steel, and thus steel jobs, in Brazil.

“What I ask of Vale is that they should turn iron ore into steel in Brazil, and at the same time, it should buy the machinery and ships it needs in Brazil, because that's how you bring technology to the country,” Lula said in a published interview. “Now, if you don't do that, what happens? We're going to sell all our iron ore to China. China will build the big ships. . We need to export a little bit of added value, too.”

Two of the more perplexing aspects of Brazil's steel production policy are these:

  • Although he may have been slower than politically prudent to develop a large steel capacity, Agnelli did, in fact, move Vale on the road toward increased Brazilian steel production through joint ventures with foreign producers for new projects.
  • But, if there's anything Brazil doesn't need right now, it's more steel. The Brazilian steel industry already seems on course to double its production, to perhaps 66 million tons or more, by 2016. Yet Brazilian demand for steel, even when judged optimistically, will reach no more than 33 million tons that year. And Brazilian steel's appeal in export markets is very, very limited, for reasons we will soon describe.

“In reality,” says Marco Polo de Mello Lopes, executive president of the Brazilian Steel Institute, “there is no market demand for Brazilian steel at the moment.”

Oriented Toward Growth

In 2010, Brazil's 27 steel mills pumped out 32.8 million tons of steel, or 23.8% more metal than in 2009, the World Steel Association says. Through April of this year, Brazilian steel production of 11.5 million tons is up 7.8% from April 2010 output, but is an astonishing 70.1% above April 2009 production. Brazil ranks ninth among steel-producing nations, but, at its current rate of growth, will likely surpass Ukraine this year and will threaten to jump past Germany in total output in another two years. Only about 65% of Brazilian production is purchased and used domestically. The top five producers—ArcelorMittal, Usiminas, Gerdau, CSN and Techint—together command more than 90% of sales by Brazilian companies.

In terms of capacity utilization, Brazil's growth isn't stellar. Counting a new ThyssenKrupp-Vale mill in Rio de Janeiro state, Brazil's installed annual steel production capacity was 49 million tons, for an indicated capacity utilization rate in 2010 of just 66%—wretchedly low for a period of global economic expansion.

Add in other announced projects, plant expansion and joint ventures, and Brazil's 2016 capacity grows by another 28 million tons, to a total of 77 million tons. A train wreck, in other words, unless domestic or export demand rise substantially and unexpectedly.

Let's consider how this disconnect came about.

Vale, in response to the political pressure, began signing joint venture steel-production deals with foreign partners beginning in 2004. The first of these was with ThyssenKrupp AG of Germany. Vale holds 26.9% of ThyssenKrupp Companhia Siderúrgica do Atlântico, a steel slab production facility located in Santa Cruz, Rio de Janeiro. Operations began during the 2010 third quarter at the plant, with a planned capacity of 5 million tons of steel a year for shipment to rolling mills in Germany and Alabama. Vale provides all of the iron ore and iron pellets used in the plant.

Vale begins construction this year of a new steel mill, with an eventual annual capacity of 6 million tons, in partnership with South Korea's Dongkuk Steel Mill Company and POSCO, in the Brazilian state of Ceará. Yet another Vale joint venture, this one with Brazil's Aço Cearense, scheduled for completion in 2013, is located in Marabá, in Pará state, with a planned capacity of 2.5 million tons annually in slabs and semi-finished steel. Finally, Vale is studying a proposed integrated slab plant, with an annual capacity of 5 million tons, in Espírito Santo state. “We are looking for potential partners for the project,” Vale says in its 2011 capital spending plan. The project was originally conceived as a joint venture with Baosteel, which backed out over, ironically, environmental concerns, and a second potential joint venture partner, ArcelorMittal, said in June that it isn't interested, either.

Vale isn't the only company adding capacity in Brazil. Vallourec, the French tubular steel producer, has joined with Japan's Sumitomo Metals Group to build a seamless pipe mill, with an annual capacity of 600,000 tons, in Jeceaba.

Additional ventures that have been announced include Companhia Siderúrgica de Suape, which plans a plant with 1 million tons of capacity annually; and two steel facilities, one with joint venture partner Wuhan Iron and Steel Group of China and the other with Luxembourg-based Ternium, planned by LLX, a Brazilian logistics company owned by billionaire Eike Batista, both to be located at Superporto do Açu. The Brazilian Development Bank (BNDES) and others say at least seven additional projects are now under review, none of them announced publicly.

So far, just one of the planned new steel plants has been cancelled outright. That project, for a $6.1 billion, 5 million ton steel mill in Santana do Paraiso, Minas Gerais, was cancelled by Brazilian steelmaker Usiminas in November. Usiminas cited adverse market conditions for its decision.

“Because of industry over-capacity,” says de Mello Lopes of the steel association, “people are showing a lot more restraint about going forward with these projects.” Additional project cancellations are expected, he says.

An Economy in Distress

The reason isn't just overcapacity. Brazil's economy is not what it should be to support growth of this kind. In the wake of the Great Recession, the unsettled economy makes Brazilian steel less attractive on global markets.

The Brazilian economy grew by 7.5% last year, but Brazilian inflation is about 6.5%, well above the government's target of 4.5%. Interest rates have been pushed by the Central Bank of Brazil's Monetary Policy Committee (COPOM) to 12.0% in efforts to dampen demand and reduce inflation. Industrial production is up, growing in the first quarter at an annual rate of 4.6%. But exports have been hurt by the steadily rising value of the Brazilian Real (BRL). Two years ago, a U.S. dollar would fetch more than two Reals; today, the dollar buys about 1.58 Reals. In the last year alone, the Real has appreciated nearly 40% against the U.S. dollar, leading the Financial Times to declare recently that it is the world's most overvalued currency.

“The world after the (economic) crisis is a different world,” says de Mello Lopes. “It's much more competitive. It is not that our steel is not competitive, it is that Brazilian manufacturing is not competitive.”

BNDES, the country's national development bank, has already built the expectation of more steel mill cancellations into its five-year forecasts. The bank finances some or all of every long-term project in the country, and fulfills a pivotal role in the largely state-run economy by deciding which projects and industries live and which die.

“It's true, there is little market for basic steel,” says Pedro Landim, a BNDES economist who specializes in the industry along with colleague Jose Guilhmere Cardoso. Cardoso says that the strong Real “increases the propensity for Brazil to import its raw steel.” In 2010, for example, Brazil imported an estimated 8 million tons of steel, a record.

Cardoso and Landim believe that the immense oversupply of Brazilian steel will, eventually, sort itself out because domestic demand will inevitably rise to absorb the nearer-term surplus. Brazil needs steel for basic infrastructure, which outside of the major cities can be inadequate, as well as for the 2016 Olympic Games in Rio de Janiero, the 2014 FIFA World Cup, and a surge in oil exploration. Two large government programs to build housing, electrical capacity, highways and other projects are expected to spend billions of dollars in the near term, but Brazil has a long road to match other BRIC and developed-nation steel consumption rates. For example, per-capita steel consumption in Brazil was less than 300 pounds in 2008, compared with 918 pounds in the European Union, 751 in China, 743 in the United States and 639 in Russia.

“The level of consumption is well below the country's potential. It also indicates a lack of infrastructure in the last two decades,” said Lakshmi Mittal, CEO of ArcelorMittal, the world's largest steel company, speaking at last year's Brazilian Steel Congress in São Paulo. “An economy aiming to be the fifth largest in the world should perhaps have done—and be doing—more to prepare itself for that position.”

This means, if everything goes according to BNDES's plan, the industry's over-capacity will shrink. “Things are tough now for Brazilian steel because of the strong Real, tight margins and depressed global prices,” says Cardoso. “We expect and hope that in the next five years our production level could reach the historic high of around 85% of installed capacity.” But the two economists nonetheless expect Brazilian domestic consumption to fall by 2016 to about half of output.

“We're optimistic,” says Landim. “But not very.”

The Politics of Metals in Brazil

Strictly speaking, very few Brazilian manufacturing sectors are actually very competitive on the international market. For decades, the Brazilian government intentionally tried to develop traditional industralization through a set of import-substitution policies, including high tariffs on imports. The Brazilian state always had a heavy hand in its economy, and this was true for the steel industry, as well.

“Before the process of privatization (in the 1990s) of the country's steel companies, 70% of production was done by state companies,” says Rita Mundim, professor of capital markets and an expert in the country's steel industry at Fundaçao Dom Cabral, a business school. “We had politicians running the companies, and they were not as efficient as they should have been. After privatization, a huge amount of money came in from foreign investors, and they began to grow very quickly. That was the first main factor that made Brazil the great steel industry country that we are today.”

Although Brazilian industry remains closely tied to state policy, it's unclear the extent to which President Rousseff will continue the socially conscious industrial policies of Lula. The business community hopes Rousseff will be reasonable.

“We think that a decision to expand steel production should be based on market conditions, not political pressure,” says de Mello Lopes. Says Mundim, “Moving into steel is a big movement, especially when pig iron prices are so high. It's not Vale's core business. As a shareholder, I would say they should invest into producing as much pig iron as they can.”

Adds Pedro Galdi, steel analyst at SLW Corretora, a São Paulo brokerage, “Margins are simply too high in iron ore” to justify investments in steel. “I think eventually they will sell off those steel assets again,” he says.

Agnelli's successor as Vale CEO, former company executive Murilo Pinto de Oliveira Ferreira, was the personal pick of Rousseff and, for that reason alone, the shift in the company's leadership was seen as a wholly political event. Neither Rousseff nor anyone in her government has commented on the situation.

During his introductory news conference in May, Ferreira declared his intention to run the company transparently, then did his best to come down, opaquely, on all sides of the mining vs. steel issue. “Vale is a mining company, period,” he declared. But then he added, “To have a steel industry in this country is very important thing, and we believe we should follow that path.” How's that again?

As for government influence, Ferreira said Vale's relationship would “remain open, honest and constructive. We have a good relationship, and it will stay that way.” Both Ferreira and Vale's chairman, Ricardo Flores, repeated that the company's $24 billion capital investment plan for 2011—a plan, generated by Agnelli, that calls for spending just 1.25% of the total on steel—will be followed to the letter, and that no signficant changes of course should be expected in 2012, either.

“Before the crisis, we had all kinds of international companies coming, banging on Vale's door, trying to set up joint ventures,” de Mello Lopes says. “Now, the situation is quite different.”