2021's year-end results in the European steel industry outshone the most wildly optimistic forecasts. Steel producers benefited from strong demand as the economy recovered, coupled with decreased capacity due to production issues and restocking. This forced up prices. For the first time in years, the balance of power benefited steel producers.

As a result, steelmakers were able to increase prices by well above cost inflation and the increasing cost of raw materials. Prices started rising in mid-2020 and peaked in June 2021. They have since eased as the backlog of orders started to shrink and the price of iron ore lessened. The price of hot-rolled coil steel dropped to €850 per ton on Dec. 31, 2021, from a €1,060 per ton on June 30, 2021. EBITDA has already started to reflect this (see chart 1).

Chart 1

Much of resulting abundance of cash was allocated to debt reduction. As a result, net debt fell to zero at some companies while others reported negative net debt (see chart 2). However, we don't think those levels of debt are sustainable over time, and they will releverage over time. In the first half of 2021, the steel companies ArcelorMittal, SSAB AB, Metinvest B.V., Interpipe Ltd., and Vallourec saw aggregated operating cash flows of $6 billion, up from $1.5 billion in the first half of 2020. The industry's unprecedented free operating cash flows were supported by previous decisions at many companies to cut back on capital expenditure (capex) in 2020 and 2021, as a precautionary measure ahead of a potential crisis.

Chart 2

Early Indicators Suggest That 2022 Will Be Another Healthy Year

Steelmakers are unlikely to maintain the margins they achieved in 2021. Nevertheless, margins are unlikely to drop straight back to historical levels. Steel buyers face a dilemma: should they secure supply for 2022 at the current high prices, or wait in case prices collapse? If another COVID-19 variant sweeps the globe, production could be disrupted again, forcing up prices. In our view, if there is no crisis, prices are likely to fall further. The tail winds of demand will likely support margins during the first half of 2022.

We project that apparent demand (calculated as production minus exports, plus imports) for steel in Europe will be 1.5%-2.5%, based on the EU's economic and industrial recovery. Our economists expect the EU to see uneven GDP growth in 2022, averaging 4.5% and led by Spain and Greece. Countries such as Finland and Sweden are likely to see slower growth. Industries that rely on global supply chains may continue to experience shortage of components and rising shipping costs. Some will also be hit by skyrocketing energy prices.

Steelmakers are backed by cheap electricity and typically exposed to clients that are less energy-sensitive, giving them an advantage in this environment. At present, their manufacturing clients have a high order backlog and the construction sector is continuing to recover. The jury is still out on how recovery in the automotive industry will play out; about 25% of the demand for European steel comes from this market. We understand that in recent months, steel players have been able to secure new contracts with auto manufacturers that offered slightly better profitability.

The demand for steel will continue to be driven by the European economy, and unless GDP grows by more than 2% in the medium term, demand for steel will be muted and may even decrease (see chart 3).

Chart 3

Healthy Balance Sheets Enable Higher Shareholder Distributions

Having funneled their 2021 profits into debt reduction, most companies are likely to shift their focus to improving returns for shareholders. Before 2021, the industry had experienced more than a decade of low returns. We anticipate that management at most companies will be sensible about distributions in 2022, and will probably become more generous starting 2023, potentially redirecting a higher proportion of free operating cash flow to the shareholders. At the same time, we expect capex will grow modestly, by about 30% in 2022 compared with 2021. Steel players will focus on maintenance, product mix, and decarbonization initiatives.

The assumptions backing our base-case scenarios remain very prudent--we hypothesize that companies will take an aggressive approach and distribute sizable amounts. This would reduce the headroom on their balance sheets to their medium-term objectives by the end of 2023. In practice, we believe that companies are more likely to increase leverage very gradually, and to hit financial policy ceilings well after 2023. We will continue to monitor if and how companies address their financial policies, given their new debt positions. Neither ArcelorMittal nor SSAB have yet revised their public financial policies.

Given that the ongoing pandemic could alter market conditions and dent the economic recovery, we have limited visibility beyond the coming six months. In our base case, we therefore assume that market conditions will largely revert to the multiyear average by the end of 2022. That said, our base-case scenario doesn't capture the effect on metals of the global energy transition that targets a net-zero economy. The steel industry may need deep pockets to keep up with changes needed to meet new environmental regulations.

The Push For Net Zero Exacerbates The Uncertainty Of Our Forecasts

Steel producers in Europe face significant pressure to curb their environmental impact. Much of the steel produced in the region still uses blast furnaces, which release a large amount of carbon dioxide (CO2), nitrogen oxide, and particulate matter into the air. ArcelorMittal, SSAB, and TK Steel--the three leading steel companies in Europe--have already announced their intention to become carbon neutral over the next few decades.

It is far less obvious how steel producers will meet this target. Improving their raw materials mix, executing efficiency programs, replacing less-efficient furnaces, and increasing the use of sustainable power will have an impact on the industry's emissions, but it is not going to be enough. The technologies needed to produce significantly "greener" steel have yet to reach maturity (see chart 4).

Chart 4

For example, switching to more environmentally-friendly options, such as EAF-DRI powered by hydrogen, rather than blast furnaces, would require huge investments and are not seen as justified (see "The Hydrogen Economy: Steel Producers Have A Long Way To Go," published on April 22, 2021). Instead, we expect to see companies embark on smaller-scale pilot projects. For example, converting basic oxygen furnaces (BOFs) to electric arc furnaces (EAFs) that can use scrap or direct reduced iron (DRI) would reduce the industry's dependance on coal.

We anticipate that, although companies are likely to spend considerable time and effort on meeting environmental, social, and governance (ESG) challenges, their level of investment will remain on the low side. In addition, we understand that many of the companies tie their investment in ESG programs to the receipt of governmental subsidies.

Lastly, we notice that customers are demonstrating greater interest in "green steel" and may even be willing to pay a premium for it. However, at this stage, the volumes are only a fraction of total demand.

Russian Steelmakers Have Different Problems

In Russia, there is less pressure to support national ESG targets, but much more pressure to support the state. Russian steelmakers had a very successful 2021 and are predicted to have a strong 2022, despite an expected softening in steel prices. The rated Russian steelmakers (NLMK PJSC, Severstal PAO, Magnitogorsk Iron and Steel Works PJSC [MMK], EvrazHolding Finance LLC, and Holding Co. Metalloinvest JSC) have reported some of their strongest cash flows in years. If the current high profits persist, steel companies could face additional taxes in the form of export duties, or taxes on their dividends or "extra profits."

The sector's main risk remains potential sanctions and the introduction of cross-border carbon taxes. Both threaten exports to Europe. As early as 2026, Russian steel exports to Europe could be affected by the European Carbon Border Adjustment Mechanism (CBAM). This equalizes the price of carbon between domestic products and imports to ensure that carbon-intensive production is not relocated to countries outside the EU.

Production costs in Russia have benefitted from favorable foreign exchange movements and, except for MMK, Russian steelmakers also have a high level of vertical integration, reducing the impact of rising raw material costs. Their strong cash flows and very comfortable credit metrics headroom (net debt to EBITDA below 1x) give the companies substantial flexibility over capex and dividends. We expect dividends to remain high in 2022.

Incentivized by the government, and unlike their EU peers, Russian steel companies are likely to make heavy investments in the coming years. The main areas of focus are:

• Improving efficiency, for example, by introducing new coking batteries and blast furnaces or by implementing smaller programs to improve raw material consumption. Those investments will close some of the technological gap between them and their European peers.
• Reducing emissions and waste, and introducing greener products, as part of their ESG agenda.

For example, NLMK has announced plans to build a $3.5 billion hot-briquetted iron facility by 2027. Some companies even restructured their business so that they could more efficiently achieve their environmental goals. Evraz deconsolidated its coal business in early 2021 and Severstal aims to sell its coal business in late 2022.

Steelmakers Don't Expect The Bonanza To Last

The long period of low returns made steel producers financially cautious. At the onset of the pandemic, they used their flexibility to reduce capex. Therefore, when they saw unprecedented profitability, they took the opportunity to reduce debt first. Much stronger balance sheets will ensure that credit metrics remain robust, even if the market environment becomes less favorable, or if shareholder distributions increase.

In response to this prudent approach, we have taken several rating actions on European steel companies:

• We raised our long-term issuer credit rating on French recycler Derichebourg to 'BB+' from 'BB' with a stable outlook in February 2022.
• We raised our long-term issuer credit rating on Sweden-based SSAB AB to 'BBB-' from 'BB+' with a stable outlook in January 2022.
• We affirmed our long-term issuer credit rating on Germany-based Thyssenkrupp AG at 'BB-' with a stable outlook in December 2021.
• We raised our long-term issuer credit rating on Ukraine-based Metinvest B.V. to 'B+' from 'B' with a stable outlook in October 2021.

Although they know there are heavy investments to come, steelmakers are likely to test green steelmaking technology first, and ensure it can scale up before they commit.

ArcelorMittal (BBB-/Stable/A-3)

ArcelorMittal reported exceptional results in 2021, supporting a quick recovery in its credit metrics. At the current debt level, the company will have comfortable headroom at the 'BBB-' rating level, based on mid-cycle EBITDA. Pending final adjustments, we estimate funds from operations (FFO) to debt of more than 100% in 2021, well above the target of 25% during normal industry conditions. Management is not prioritizing improving balance sheet strength further and the current financial policy targets of net debt below $7 billion and net debt to EBITDA below 1.5x support the 'BBB-' rating. At the end of 2021, ArcelorMittal's net debt was $4 billion and its net debt to EBITDA was 0.2x. In our view, without changing the financial policy and committing to an even stronger balance sheet, any upgrade would depend on the company demonstrating that its profitability had become less volatile over the cycle. Further investments in added-value products and cost-reduction initiatives could give additional support to a potential upgrade.

In 2022, we expect ArcelorMittal will maintain a strong balance sheet, while investing in the business and distributing cash to its shareholders. ArcelorMittal plans to step up capex to $4.5 billion in 2022, from $3.0 billion in 2021, with a much higher focus on strategic projects to grow EBITDA. At the same time, the company is gradually ramping up the decarbonization program to achieve 25% reduction in its global carbon emissions by 2030. It estimates the gross investment of $10 billion by 2030 and will require support from governments.

SSAB AB (BBB-/Stable/A-3)

SSAB, like all steel producers, experienced very strong EBITDA growth in 2021 on the back of record prices and recovery in demand. Given its net cash position at year-end 2021 and the strong cash flows expected in 2022, we anticipate that SSAB will have enough headroom to accommodate market volatility in the next downturn. We have raised the rating to 'BBB-', based on our expectation that SSAB will continue to pursue a prudent financial policy. We predict that its dividend payments will remain within its dividend policy limits and that its capex will rise by a measured amount. The company has now shifted its focus from deleveraging to ESG projects. Its aspiration is to become the first steel producer to produce fossil-free steel by 2026.

Derichebourg (BB+/Stable)

We upgraded Derichebourg to 'BB+' after exceptionally favorable market conditions enabled the company to report stronger-than-expected results in the financial year ending Sept. 30, 2021. Prices and demand rose to record levels, giving the company a strong cash position. Under our base case (pro forma the acquisition of Ecore), we project EBITDA of about €400 million in 2022 compared with €506 million in 2021, very modest capex, and that the company will generate material cash flows. We understand that the company will continue to prioritize reducing leverage over returns to shareholders in the short term. This should allow it to build more headroom under its new rating.

Thyssenkrupp AG (BB-/Stable/B)

2021 saw the macroeconomic environment rebound from the weakness of the first year of the pandemic. In December, we revised our outlook on Thyssenkrupp to stable, based on its stronger-than-expected performance in the financial year to Sept. 30, 2021. We anticipate that Thyssenkrupp will benefit from cash flow and margin support from its holding company Steel Europe and the favorable conditions in the steel industry.

Thyssenkrupp is also undergoing various restructuring efforts, notably in the multitracks and steel segment. Although these should help it perform in line with our expectations for the current rating, they suggest that the conglomerate has yet to define its strategic future. For example, the company has announced that it will prepare its steel segment to operate on a stand-alone basis and is considering an initial public offering (IPO) of its hydrogen electrolysis business. We expect to gain more clarity on this development during 2022.

Metinvest B.V. (B+/Stable/--)

We upgraded Metinvest to 'B+' after record high iron ore and steel prices led to an exceptionally strong performance in 2021. We expect performance to normalize by 2023. We also assume that the creditworthiness of Metinvest's main shareholder, SCM Ltd., will not deteriorate.

The company will also benefit from its recent acquisitions. For example, it bought the remaining stake in Pokrovske Coal, one of the largest coking companies in Ukraine, as well as assets which were formerly owned by Dneprovsky Iron & Steel Integrated Works. As a result, its over-the-cycle EBITDA is about $2 billion. Metinvest's strong cash flow should allow it to increase shareholder returns, to the extent allowed by its debt documentation. We expect the company to maintain its prudent stance regarding shareholder returns and its capex program.

Interpipe Ltd. (B/Stable/--)

Bucking the trend, Ukraine-based Interpipe's 2021 results are expected to be lower than previously expected. Its profitability was hit by trade barriers and extreme cost inflation, particularly on its key raw materials, scrap, and energy. The company lost volumes because Russia imposed an embargo on the import of Ukrainian railway products in February 2021. Interpipe has to divert sales to other geographies. We now expect EBITDA of $150 million in 2021, improving to $150 million-$180 million in 2022.

Sales in its pipe division should be supported by the recovery in the oil and gas sector. In railway wheels, volumes stabilized into the 2021 year-end and should pick up as the post-pandemic recovery continues. The rating is supported by the relatively low level of reported debt and lack of material maturities in the coming years. Interpipe's main risks into FY2022 are geopolitical, given that its assets are in Ukraine.

Vallourec (B/Stable/B)

We raised our rating on Vallourec to 'B' in July 2021 after the company completed its debt restructuring, thereby halving its gross debt. This has opened up a new chapter for the company, allowing it to focus on structural improvements going forward. It plans to achieve €400 million in gross cost savings by 2025 mainly through a mix of site closures, headcount reduction, and resolving bottlenecks in its processes.

The high iron ore prices that prevailed in 2021 were the main driver of our projected EBITDA of €450 million-€500 million (before restructuring costs of about €65 million). As oil price recovery continues, demand for Vallourec's products is due to pick up further, but the timing across divisions will be uneven. Assuming that market conditions remain favorable and it achieves operational improvements, we expect that Vallourec's EBITDA in 2022 will be broadly the same as in 2021. That said, its free cash flow is likely to only break even, before changes in working capital. The company is maintaining a high cash balance in the meantime (€552 million as of Sept. 30, 2021).

Vallourec has long suffered from low profitability in its European operations. Therefore, the company recently announced the disposal of its German assets and the use of capacity in Brazil to serve customers in Europe, Africa, the Middle East, and Asia, which, if successful, should boost Vallourec from 2024 onward.

Writer: Heather Bayly.

Related Research

• Derichebourg Upgraded To 'BB+' On Strong Results And Debt Reduction; Outlook Stable, Feb. 2, 2022
• Sweden-Based SSAB Upgraded To 'BBB-' On Net Debt-Free Balance Sheet; Outlook Stable, Jan. 28, 2022
• Industry Top Trends 2022: Metals and Mining, Jan. 25, 2022
• thyssenkrupp Outlook Revised To Stable From Negative On Stronger-Than-Expected Operating Performance; Affirmed At 'BB-', Dec. 13, 2021
• ESG Credit Indicator Report Card: Metals And Mining, Nov. 30, 2021
• Ukrainian Steelmaker Metinvest Upgraded To 'B+' From 'B' On Operational Improvements And Deleveraging; Outlook Stable, Oct. 14, 2021
• French Steel Tube Producer Vallourec Upgraded To 'B/B' From 'SD/D' On Successful Debt Restructuring; Outlook Stable, July 1, 2021
• The Hydrogen Economy: Steel Producers Have A Long Way To Go, April 22, 2021