Russia’s steel- and pipemakers were devastated by the collapse of the domestic market following the Soviet breakup. Now, however, they’re poised to move forward, with consolidation looming on the horizon.

In Moscow, the Russians say, they ring the bells often – but not for dinner.

This is a reference to the great alarms that have struck the city. The invasions of Napoleon’s and Hitler’s armies are the best-known.

But for Russian steelmakers, the alarms have been ringing almost non-stop, since, after the fall of the Soviet Union in December 1991, the collapse of Russia’s domestic economy – and of internal demand for steel – began.

At its Soviet peak in 1989, Russia was producing 68 million metric tons of steel products a year. Almost all of it, 66 million tons, was consumed in the domestic market. That amounted to about 445 kg of steel consumed per capita per year. (The current American average is 344 kg, and the EU’s average is 300 kg.)

At the time of the breakup of the U.S.S.R. in 1991, Russia produced 57 million tons of steel a year, the largest producer by tonnage in the world at the time. It consumed slightly more, 59 million tons. Steel exports to the rest of the world at that time were modest and, in some categories, insignificant.

What has happened in the Russian steel industry over the ensuing years has been dramatic.

Russian production declined sharply every year since 1991 and reached its low point for the decade at 35.2 million tons in 1998. Domestic consumption continued falling through 1997 to less than 17 million tons. Average annual steel consumption fell during this period to 140 kg per capita. Export of steel was the industry’s lifeline, at around 24 million tons per annum through to 1998.

The financial crisis of 1998 produced a turnaround for steelmakers, as it did for almost every sector of Russian industry. The collapse of Russia’s banking system, triggered by commercial and treasury defaults, led the government at the time to free the ruble from its narrow limits. The free float that began on Aug. 17, 1998, and the fourfold devaluation that followed resulted in a significant improvement in terms of trade for steel exports. At the same time, these began to stimulate domestic industrial demand for steel through import substitution. In 1999, crude steel production was 51.5 million tons and exports–26.1 million tons.

Growth has continued, but statistical series from different sources are not quite comparable. In the most recent data available from the State Statistics Committee for 2002, production of rolled products has grown to 48.7 million tons, up 4 percent since 2001. Exports in 2001 were 22.4 million tons. The data for exports in 2002 are not yet available. Per capita consumption of steel has recovered to 170 kg a year, but this is still far behind the Soviet level or that of the United States or Europe.

Last year’s production results for each of the steel products and for the major Russian steel- and pipemakers show the magnitude of the turnaround, although some of the pipemakers reached their peak in 2001 and were forced into cutting output in 2002.

Many of the steelmakers use the classic example of a roller coaster to describe production, prices and revenues during the past year. At Severstal, for example, the first half of last year marked the low point for export prices, while profits were squeezed by rising production costs. In the second half of the year, fuelled by rising prices and growth in Asian demand for exports, the company’s revenues pulled up and exceeded the total for 2001.

European experts have observed that it took Germany 30 years to rebuild its war-devastated steel industry from 1945 to its post-war peak in 1975. A study prepared by Roland Berger and Sofres Conseil for the European Commission and the Russian State Metallurgy Committee in 1996 suggested it would take Russia at least that long, probably longer, to reach the level of steel consumption that is average today for the United States and the European Union.

What the European Commission study omitted to declare is that it is European policy to ensure that, if the Russian steelmakers are to survive and then grow, the revenues they will require will not come from significantly increased exports of Russian steel to Europe.

In fact, as the events of recent years make plain, it is the policy of the EU, the United States, China and of steel importers everywhere in the world to ensure that Russian steel exports are not permitted to grow in a way that threatens domestic steelmaking. Until last year, this protectionism had a uniformly negative impact on Russian steel trade. However, as we shall see, in 2002, the impact of additional U.S. steel-trade restrictions helped drive up world prices, at the same time as Chinese steel policy created an accelerated demand for Russian imports at rising prices.

This, then, is the story of the three shocks.

Starting from the first shock of the collapse of domestic demand, Russian steel ran into the second shock of protectionism and market exclusion, starting with the EU, spreading in Asia, moving to the United States and, finally, in the last major Russian steel market, to China. The third shock began in March 2002, with the redoubling of U.S. protectionism and the introduction a few weeks later of Chinese import restrictions. Their combined effect has been an unanticipated boom for Russian steel exporters. This is generally understood as unlikely to last.

Over the decade, protectionist measures against Russian steel have also become more comprehensive, making it difficult, if not impossible, for Russian producers to change their product mix to evade restrictions on deliveries.

The windfall of the 1998 devaluation came at a price. In 1999, the Russian government began collecting a 5 percent tax on export value. This lasted until the ruble began firming against the dollar in 2002 and until the government heeded lobbying from the steelmakers to abolish the tax after the United States and EU imposed tighter limits on Russian imports. The government had already tempered the export-tax measure, however, with a 15 percent export tax on ferrous scrap and the opening of domestic-injury investigations of imports of steel products and pipes from Ukraine and Kazakhstan. Indirectly, in the case of scrap, and directly, in the case of C.I.S. imports, the government sought to assist the domestic steel industry.

According to MAIR, Russia’s dominant scrap collector and exporter, the export tax led to a decline in scrap volume collected in 2001 to 18.2 million tons, a fall of 7 percent year on year. Export volume fell 15 percent, to 6.7 million tons. In 2002, the decline continued. Volume of collection was about 17 million tons, according to preliminary estimates, and exports were down in volume by another 12 percent.

The introduction of domestic protection duties and quotas on C.I.S. imports – starting with Reba and other construction steels, followed by pipes, and most recently galvanized steel – has had the effect the domestic steel- and pipemakers were seeking. In 2001, steel imports from the C.I.S. countries totaled 2.4 million tons, comprising 91 percent of all steel imports to Russia. But the next year, the total fell to 1.7 million tons, a drop of 31 percent. Pipe imports from the C.I.S. totaled 656,000 tons (69 percent of the aggregate) in 2001 and just 363,000 tons in 2002, an even sharper fall of 51 percent.

Russian steelmakers buy foreign assets

Once the post-1998 recovery generated a pickup in revenues for Russia’s steelmakers, the way lay open to deal with protectionism by using some of the fresh cash to buy access to markets that would otherwise be closed. Acquiring mills in the United States, Europe or Asia is a natural defensive stratagem but it requires the readiness to retain mill earnings and spend cash. So long as Russian steelmakers remain relatively insecure politically, as well as commercially, and so long as the major players expect a further round or two of consolidation of existing properties, cash will tend to go straight to shareholders offshore and will not be reinvested.

The acquisition strategy pursued by the Russians generally focuses on plants abroad that are already consumers of Russian semis. Trade restrictions on semis are usually looser than those on the higher value-added products. Consequently, this provides an opportunity for Russian steelmakers to capture a downstream source of demand whose location and nationality enables it (and its Russian owner) to sell into markets that would otherwise exclude or restrict Russian-made products.

Asset consolidation and instability of proprietorship

As long as the ownership of Russia’s major steelmaking assets remains undecided and unstable, the shareholders of today will continue to feel vulnerable to takeover tomorrow. The election campaign for parliament and the president between now and March 2004 increases the uncertainty proprietors are bound to feel.

From 1991 until now, there have been nine major Russian steelmakers and seven major pipemakers. The investment bankers and traders who supply finance to the sector, as well as the steelmakers themselves, expect that within five years, most likely sooner, the numbers will shrink to three or four major steelmakers and two, perhaps three, pipemaking groups.

The consolidation is financed by the windfall profits that followed ruble devaluation. It has been made possible also by the collapse of several of the domestic banking groups, which had been holding equity stakes in steel companies and lost them, and by the forced exit of offshore traders like the Transworld group of London. Until 2002, Glencore, which had a controlling stake in Mechel, and Duferco, with a sizeable but non-controlling stake in Nizhny Tagil, were the exceptions. But by the end of last year, they too had sold out to domestic interests and liquidated their equity positions.

The process is far from predictable. At present, for example, the most stable and profitable of the steelmakers, Severstal, has agreed to an alliance with Magnitogorsk in a common effort to ward off takeover threats from the EvrazHolding group, which already controls three major steelmakers – Nizhny Tagil, Zapsib and Kuznetsk – and is likely to absorb a fourth, Nosta, in the future. Nosta is once again the object of a tug of war between rival shareholders, each alleging legal violations against the other.

Oskol, the weakest of the major-league steelmakers, is controlled by a Moscow entrepreneur named Alisher Usmanov, who took over the plant and its iron-ore supplier, Lebedinsky Ore-Concentration Plant, in an alliance with the Gazprom group of companies. The Gazprom management has been purged by the Kremlin, and its non-core assets are in the process of being sold. What exactly will happen to Usmanov and Oskol in this process is uncertain. It is unlikely Oskol will be able to remain independent.

In these circumstances, it is not surprising that Russia’s steelmakers are continuing to try to reduce the risk of hostile raids by cementing alliances along vertical lines and assure reliable supplies of iron-ore, coking coal and other inputs at advantageous prices. They are also engaged in doing this horizontally with other steel- and pipemakers to limit the damage that market competition, as well as share raiding, can do. How stable these alliances will be is another matter.

In September 2001, for example, Severstal allied with Magnitogorsk to take control of coal supplier Kuzbassugol over rival bidding from Evraz Holding and Novolipetsk. A month later, Evraz and Novolipetsk announced an alliance between their mills, primarily, executives announced at the time, to exert common pressure on the federal and regional governments to hold down rail and power tariffs. Securing coal supplies was another goal.

Twelve months later, in the autumn of 2002, Magnitogorsk and Novolipetsk announced they were forming a new alliance, this time to defend against a hostile takeover attempt expected this year.

Viktor Rashnikov, the general director of Magnitogorsk, joined Vladimir Lisin, chairman of the board at Novolipetsk, to say that they had agreed to coordinate their export marketing activities and their investment in new production facilities. According to Lisin, "It doesn’t make sense for us to compete with Magnitogorsk on the same markets or invest into construction of similar production facilities." He cited production of galvanized sheets (mostly for auto manufacture) as an example in which Magnitogorsk already has a production line and against which a new venture by Severstal with the international company Arcelor will compete. "The situation on the Russian steel market will not change radically in the next several years," Lisin said, "and so competition between different producers can only result in decrease of prices and profitability."

Lisin and Rashnikov acknowledge that they expect further consolidation of Russia’s steelmakers, but they will not predict the details. "Consolidation of the steel industry is a worldwide tendency," Rashnikov said last November, "which demonstrates that companies that have merged into greater entities work effectively. Consolidation of the Russian steel sector is inevitable, but so far it is not yet clear when it will happen – today, tomorrow, or the day after tomorrow."

In 2001, Lisin warded off a threat of a takeover of his plant by Vladimir Potanin, the controlling shareholder of the mining company Norilsk Nickel, who sold Lisin back a 32 percent stake he had earlier acquired from the Reuben brothers and Transworld of London. Potanin had been lured by financier Boris Jordan into believing he could knock Lisin out of the business. Jordan walked away with his reward, and Lisin taught Potanin that he could outflank the attack, taking an 11 percent shareholding, plus a seat on the board, of Potanin’s treasure, Norilsk Nickel. If there ever comes a time when Russian steel and nickel can be combined to produce more than stainless steel, Potanin should worry about a takeover from Lisin’s direction.

It goes without saying that, without an assured supply of coal, the furnaces of steelmakers go cold. Magnitogorsk and Severstal, now allied at Kuzbassugol, have also said that they intend to resist a hostile takeover bid for Magnitogorsk that has already been launched by Iskander Makhmudov, one of the controlling shareholders of Evraz.

The latest announcement by Lisin and Rashnikov turns the tables on Evraz and reinforces the impression that Magnitogorsk is expecting a fierce fight from Makhmudov when the state shareholding of 17.9 percent in Magnitogorsk is scheduled to be auctioned. Makhmudov has lodged a court claim asserting that he already owns a substantial stake in Magnitogorsk. The addition of the state shareholding to his possessions would give him majority control and make him the undisputed master of Russian steel.

Commenting on the planned privatization, Rashnikov said his company will participate in the auction and is hoping to win and "guarantee a smooth transfer of the shares from the state to new shareholders." According to Rashnikov, the Magnitogorsk management "now has an agreement with the holders of about 83 percent of the shares of the plant, including the 17.9 percent of shares held by the state." Lisin and Rashnikov hint that they are ready to act jointly in the privatization bidding.

Lisin has claimed that a merger between his company and Magnitogorsk is possible, though there are other alternatives for consolidation. "The main issue is the economic efficiency of such consolidation," he said, "while the forms of this consolidation may be varied." For the time being, he claimed, "the companies have agreed to carry out a coordinated investment policy [by not investing into similar types of production] and coordinate their export policies, where competition leads only to a situation in which buyers can play with prices, which leads to decrease of profitability of the steel plants’ operations."

Makhmudov does not mince words when he says he wants Magnitogorsk. Other Evraz executives say that, for the time being, they prefer to concentrate on solidifying their control of the iron ore they draw from the mines and enhance their bargaining power with the government over the cost of rail and port transportation. Winning the government over on costs and on tolerating vertical integration of production has so far proven easier than gaining the Kremlin approval that is required before Magnitogorsk can be sold off.

For several years, it has been easier for the federal government to postpone the privatization of the remaining Magnitogorsk stake and avoid taking sides in Makhmudov’s litigation against Rashnikov. Officials close to Makhmudov say they cannot say much about the bidding because there is no telling whether the government will again postpone the sale. Nor does Makhmudov want to risk a test of strength in case the Kremlin rules against him. Thus, the most convenient outcome for all players in this game of musical chairs is to make sure the music does not stop.