Indian steel companies are on an expansion spree. They will add about 40 million metric tons of crude steel capacity over the next three years. The balance sheets of these companies are in a much better shape to undertake this expansion than they would have been a few years ago.

The Indian steel industry will increasingly rely on its domestic market to absorb the incremental supply. This is because much of the expansion will be through the development of carbon-intensive blast furnace capacity, which is increasingly facing carbon abatement headwinds in international trade. A slow ramp-up in domestic demand could soften steel spreads and test the credit metrics of Indian steel producers. This is a key risk, in our view.

Indian Leading Steel Producers' Long-Term Plans Are Ambitious

India's top five steel producers are planning to double capacity to more than 200 million tons by 2030. Out of this, about 30 million tons will come onstream in the next three years and balance 78 million tons by 2030.

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The two-fold increase in capacity will require an investment of about US$100 billion over the next seven to eight years. This equates to an annual capex of US$13 billion, which is more than double the total capex of about US$6 billion incurred by these companies in fiscal 2023 (year ending March 31, 2023). They will likely rely heavily on cash flow from operations to fund a major part of this given their financial policy of operating at lower leverage. We believe the steel companies will have some flexibility to defer the capacity expansion in case the cash flows deteriorate, or demand dissipates.

While the capacity expansion plans over the next three years are manageable, doubling the capacity by 2030 will be an uphill task. The successful ramp-up of the 30 million tons capacity addition over the next three years will decide the fate of the next leg of expansion.

Healthy Balance Sheets Of Steel Companies Favor The Ongoing Capacity Expansion

Rising steel prices have strengthened the balance sheets of steel companies, which used the healthy earnings for debt reduction. As a result, the consolidated gross debt of select steel companies accounting for 70% of India's total steel output is now 25% lower than pre-2020 level. On the other hand, EBITDA is 35% higher. These companies are in a much better position to expand capacity.

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India's annual steel capacity remained stagnant at about 140 million tons between 2017 and 2020 because of weak demand and elevated debt levels at steel companies. Strong domestic demand has boosted steel prices since 2020. Average steel prices increased 40% to Indian rupee (INR) 57,500 per ton between 2021 and 2023, compared with an average price of INR40,700 per ton between 2017 and 2020.

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Earnings To Improve Further

We expect average steel prices in India to rise 10% in the second half of fiscal 2024, compared with the first half. A strong rebound in domestic demand, following the weak monsoon quarter could aid such a recovery. At the same time, lower coking coal prices will alleviate the input cost pressures. A rise in steel prices and a reduction in raw material costs could potentially improve the steel spreads by 15%-20%, in our assessment. Beyond fiscal 2024, the spread will likely improve further as we expect coking coal and iron ore prices to correct by 20% and 10%, respectively.

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That said, if the domestic market is unable to absorb the incremental supply, capacity additions could soften steel spreads. This is a key risk, in our view. This in turn could weaken the credit metrics of steel companies compared with our base case. A 10% softening in steel prices from our base case could increase the ratio of debt-to-EBITDA above the mid-cycle level of 3x, all else being equal.

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Green Steel Is Still A Way Off

India is unlikely to move away from blast furnaces any time soon. The country has abundant iron ore reserves, which will cover the raw material requirement for the new blast furnaces. Indian steel players are incentivized to increase vertical integration by leveraging captive iron ore supply, as this improves cost competitiveness.

On the other hand, supplies of high-grade steel scrap required in induction furnaces remain limited. The preferred mode of expansion for Indian steel companies is via blast furnaces, with scrap-based induction furnace accounting for less than 5% of the proposed 40 million tons expansion. At present, 90% of India's total crude steel production occurs via blast furnace and coal-based direct reduced iron (DRI).

India's steel sector emission intensity of 2.5 tons of carbon dioxide (tCO2) per ton of steel is higher than the global average of 1.85 tCO2 per ton of steel. This is likely to remain elevated because India will use carbon-intensive blast furnaces to produce a large part of its incremental capacity. This could put Indian steel exports at a disadvantage as the world moves toward net zero carbon emissions. On the other hand, exporters like China, Japan, Turkey, South Korea will be better off as their steel-making carbon intensity is lower than that of India.

The EU is set to introduce a tariff on carbon emissions from steel imports from 2026 under its Carbon Border Adjustment Mechanism (CBAM). Under this rule, companies importing select products--including steel--will be required to buy carbon credits. These represent the difference between the carbon price paid in the country of production and the carbon price in countries participating in the EU emissions trading system. Once implemented, free carbon emission allowances will be phased out over a 10-year period.

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The EU is the largest importer of Indian steel. It accounted for 30% of India's total exports in fiscal 2023. India has the highest carbon-emission intensity among the top five steel exporters to the EU. The CBAM could hurt India's export prospects as the additional carbon cost will dent the profitability of steel mills.

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India could potentially divert a part of its exports from the EU to other areas such as the Middle East, and Southeast Asia. We observed this during the height of the pandemic. However, these regions may not be able to absorb this entirely given their limited market size. This could place increasing reliance on India's domestic market to absorb incremental supply. While the absolute quantum of exports to the EU remains modest at 3.6 million tons in 2022, Indian steelmakers' ability to divert volumes to alternate markets would depend on the prevailing supply-demand dynamics.

Infrastructure Will Be Key In Absorbing Incremental Supply

In our assessment, domestic demand should be able to absorb the incremental supply. However, the industry could be left with overcapacity of more than 10 million tons in the event demand fails to pick up as we anticipate. This assumes steel consumption growth at a historical five-year compound annual growth rate (CAGR) of 5.3% as against our base case of 8%.

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The Indian government launched the National Infrastructure Pipeline (NIP) in 2019 to achieve the target of US$5 trillion economy by 2025. At present, India's nominal GDP is US$3.7 trillion. The NIP envisages a total capital outlay of INR100 trillion (US$1.2 trillion) in various infrastructure projects between 2020 and 2025, up from INR50 trillion spent between 2014 and 2019. This includes roads, housing, urban infrastructure, railways, power, and irrigation. These sectors account for close to 70% of total steel consumption in India.

The sharp increase in infrastructure spending under the NIP should boost domestic steel demand. At the same time, steel companies will have adequate debt-capacity thanks to their healthy balance sheets. This should support their growth plans over the next three years.

Editor: Lex Hall

Digital design: Halie Mustow/Evy Cheung