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. Last Updated: 07/27/2016

Ukraine Steel Faces Price Squeeze

bloombergMittal Steel CEO Lakshmi Mittal
Faced with higher gas prices that could hit their profitability, Ukrainian steelmakers may resort to challenging their Russian rivals on the more lucrative European market.

As Ukraine's recent gas dispute with Gazprom escalated, the country's leading steelmakers indicated they would cut back on their gas consumption -- a step that will likely eat into their profits and play into the hands of Russian steelmakers.

Ukraine's biggest steel mill, Kryvorizhstal, which produces 20 percent of Ukraine's metal output, said Tuesday that it would switch to using more coke and higher-grade iron ore and less gas. The plant was bought at an auction in October for $4.8 billion by the world's largest steelmaker, Mittal Steel.

"Kryvorizhstal is currently fine-tuning technologies that will partly replace the use of natural gas with solid fuel in the production process," Kryvorizhstal energy director Vladimir Romanenko said Tuesday in an e-mailed response to questions about the impact of higher gas prices.

At present, 7 percent of Kryvorizhstal's production costs are gas-based, he said.

In Moscow, however, some industry analysts cast doubt on the company's figure.

"Considering how uneconomic most Ukrainian metallurgy plants are, a 10 percent to 12 percent figure is much closer to the truth," said Denis Nushtayev, an analyst with brokerage Metropol. The higher price of gas would likely increase steel production costs by up to 15 percent to over $185 per ton, he said.

Given the price Mittal Steel Germany, a subsidiary of Lakshmi Mittal's steel empire, paid for Kryvorizhstal, the company's profitability could almost disappear, said Eric Kraus, chief strategist at Sovlink Securities.

The plant's profitability "would disappear with gas prices above $100" per 1,000 cubic meters, Kraus said in an e-mailed comment.

A loss in profitability for Kryvorizhstal would work to the advantage of Russian steelmakers making foreign acquisitions, said Timothy McCutcheon, a metals and mining analyst at brokerage Aton.

"Ukrainian steel companies are pretty similar to their Russian counterparts -- they are cash-rich, low-debt and with aggressive management. They posed major competition to Russian acquisitions in EU countries, but that will change once they take less profit at home," he said.

Ukraine has been the largest steel importer into Russia, selling at knockdown prices thanks partly to Ukrainian government subsidies, cheap labor and cheap energy.

"In effect, the Russian government through Gazprom was subsidizing Ukrainian steel companies with cheap gas. To add insult to injury, Ukrainians were then dumping their steel in Russia at knockdown prices," McCutcheon said.

Although Ukrainian producers have tended to fill gaps left by domestic steelmakers, their Russian competitors lobbied against cheap Ukrainian imports as damaging to the Russian steel industry.

In April 2005, four of Russia's top five steelmakers called on the government to maintain a customs duty of 21 percent on Ukranian steel rods that was due to expire in mid-2005, citing unfair competition, said Alexei Sotskov, a spokesman for the No. 5 steelmaker, Mechel.

"The Ukrainian government obviously used to subsidize its producers, in part with tax breaks, the effects of which are still being felt," Sotskov said.

Facing a future without government subsidies and higher gas costs, Ukrainian steel mills will need to modernize, cut staff and divert exports from Russia to Europe, where steel prices are higher, Nushtayev said.

"Yet even then, Europe's wallet is not elastic," he said.

Ukraine could lobby the EU to reduce Russia's steel imports quota in an effort to give Ukrainian steelmakers a bigger slice of that market, Nushtayev said.

"Either way, if you believe that gas prices will remain high, Ukrainian steel mills are less interesting than before. And this is forever," McCutcheon said.