I’ll be the first to say that I spend little if any time pouring over a company’s financial data. We’ll save that for the Wall Street analysts. But from a supplier risk management perspective, the debt to capital ratio becomes a useful tool to determine the financial health of a company’s publicly traded suppliers. Now that may appear as a rather obvious “duh” but let me put this analysis in context. Sure, it makes sense that this key ratio would provide some insight as to a company’s overall financial strength and even perhaps a company’s overall financial structure. But that ratio becomes even more important when considering some of the macroeconomic predictions for 2010.

Consider these notes taken from a recent economic forecast we attended presented by Alan Beaulieu & Brian Beaulieu of ITR (ITR claims to have a 96% accuracy rating looking four quarters out):

• 2010 mild recovery. Broad based U, no V and no W. No double dip
• Unemployment disconcerting. Much higher and longer than previously thought. Negative impact on consumer spending
• Bottlenecks in the supply chain pervasive
• Won’t be like 2008 for several years
• Next flat to recessionary years 2013 – 2014
• Must be profitable now
• Inflationary headwinds. M2 out of control
• US debt level – horrible. By 2015 34.1% of GDP will go toward debt service that’s why we’ll inflate our way out of it (plus taxes on individuals and businesses)

We could probably write several posts on many of these points but we’ll focus in on just a couple – bottlenecks in the supply chain and must be profitable now. My other half wrote a piece on Caterpillar’s strategy to reduce bottleneck risk where he cited the fact that Cat in some instances would provide prompt payment or financing to suppliers to secure parts and materials for Cat orders and thereby reduce potential bottlenecks. The second point the Beaulieu brothers make – that companies must be profitable now relates to the fact that finding any new or additional credit from banks will remain a key challenge for all companies both private and public.

Now turning back to that debt to capital ratio defined as: Debt to capital ratio = Debt/Shareholder’s Equity + Debt. Reliance Steel and Aluminum reported a ratio of 28.3% back in November. Nucor recently reported a ratio of 28% (and along with it a comparison chart showing its “best in class” financial leverage). You can check out your publicly traded suppliers yourself using the  Altman Z Score. For privately held companies, the challenge becomes how does one gain access to this type of information? Perhaps a candid discussion of potential supply chain bottlenecks may help break the ice. Getting a handle on a company’s financial leverage could provide buying organizations with early warning signs and potential problems before they arise. At a very minimum, the debt to equity ratio analysis can provide another tool in the supply risk management toolkit.

–Lisa Reisman

Last year, metals producers far and wide had to make tough decisions over a range of issues from temporary plant closures to permanent shutdowns. In the wake of those decisions remain a series of less talked about but not necessarily any less controversial set of issues that have recently crept into the mainstream news headlines. For example, shipping company Ingram Barge recently filed a lawsuit against Century Aluminum for canceled contracts relating to the shipment of alumina and calcined coke from it’s now closed Ravenswood, West Virginia smelter. The suits cover contracts formulated in 2006 for the annual shipment of 360,000 tons of alumina from 2007 – 2010 and 77,000 tons of coke for shipments from 2008 -2010. Ingram claims Century only shipped 41,000 tons of aluminum and no coke.

The Ravenswood facility ceased to operate in early 2009. Century Aluminum is not the only producer to have broken prior commitments. We reported on a contract Corus reneged on last year. If this involved a bankruptcy, Ingram would likely stand in the cold with all of the other creditors. Though Century had a $40m profit in the third quarter, the company still reports a net loss of $182m through the third quarter. In addition, the company has not shown a profit since 2005. But the fact that the company remains a viable on-going concern means the case can proceed through the legal system.

Unfortunately, the Ravenswood plant shutdown has created an additional series of unintended consequences impacting other metals producers and even consumers. Appalachian Power Co has applied for a base rate increase on top of multiple previous increases since August according to this story from the Roanoke Times. According to the article, “Virginia law gives electric utilities an opportunity to recover reasonable and prudent costs and what is determined to be a fair profit.” Century Aluminum, contributed $40m in revenue to Appalachian Power Company. Now Steel Dynamics Roanoke Bar Division has mobilized its lawyers to contest the rate hikes. But no matter what Steel Dynamics achieves or doesn’t achieve, “if any or all of the revenue loss associated with the aluminum plant is not recovered as a result of the current case, Appalachian could seek recovery in a future rate case.” Ironically, the decision to close the Century Aluminum plant came in part due to the “relatively high operating cost at Ravenswood and the depressed global price for primary aluminum,” according to the company’s SEC filings.

It looks like another company’s cost structure just went up as well…

–Lisa Reisman

Following on from an article we wrote a week or so back regarding the oil majors cooling interest in Canadian Tar Sands we started a fascinating exchange with Jim Baird inventor of the Nuclear Assisted Hydrocarbon Production Method. For anyone remotely following the tar or oil sands resource extraction debate the issue of environmental damage is well known. The problem with these hydrocarbons is the low viscosity makes separating the bitumen-based oil from the sands in which they reside almost impossible unless the oil can be heated and its viscosity reduced. For deposits at the surface this is bad enough, resulting in widespread environmental damage, but as some 80% of deposits are at depths too great to surface mine bore holes have to be sunk and superheated steam forced down to essentially melt the tar so it can be forced up adjacent holes. This is known as the Steam Assisted Gravity Drainage (SAGD) technique and is the technology used for all sub surface oil or tar sands extraction. Without a source of heat, the hydrocarbons in their natural state are too viscose to flow and hence be pumped out. To heat the steam, pump it down under pressure and then separate the resulting slurry involves vast amounts of energy and requires a huge investment in water treatment facilities if extensive environmental damage is to be contained let alone avoided. Even after billions of dollars being spent by the oil majors, environmental groups are still vehemently against exploitation of these vast reserves solely on the grounds of the carbon footprint of every gallon of oil produced being five times that of conventional oil and the environmental damage caused around the mine sites.

So much for the problem, what is the solution? The US is holding in storage approximately a quarter of the global spent nuclear fuel (SNF) inventory with no long-term solution for storage or re-use. The generally held wisdom is storage in secure underground salt mines or a geologically static cavern is the only solution. The slowly cooling SNF rods give off huge amounts of heat – between 30 and 50 times the heat produced by the Geysers Geothermal reservoir according to estimates by the California Energy Commission. Assuming only a 30 times multiplier that puts the heat potential of the US SNF reserve at 390 GW hours of energy. If this SNF was encased in standard drill pipe it could be lowered deep underground into the tar sands deposits where the heat would melt the viscous bitumen oil into a higher viscosity liquid, which could be conventionally pumped out of adjacent boreholes.  A degree of ionization from the radioactive emissions would have the beneficial effect of breaking the long chain molecules in the oil improving the yield of higher value hydrocarbons. Standard drill pipe would keep the SNF rods safely encased for hundreds of years by which time the oil would have been extracted and the deposit resealed. Even if drill cases began to corrode, hundreds of years into the future the impermeable covering rock layers, which for millions of years have kept gas at high pressure trapped underneath them, would contain the SNF for eternity.

For anyone worried about nuclear proliferation depositing SNF rods hundreds or thousands of feet underground would be the most effective way of ensuring they never fell into the hands of terrorists, much better than storing them in an open, if geologically stable, cavern.

So when I asked Jim Baird where is the imperative for us to be considering this technology he pointed me to the following article in the Calgary Herald as to why at least Canada should be taking the option seriously. Suncor Energy, one of the country’s largest oil sands operators, announced quarterly results, which were a disappointment to its investors. Taking into account the Energy Return on Investment for SAGD extraction techniques at current prices roughly $15 worth of energy is used to produce a barrel of bitumen. If Suncor/Petro-Canada had produced the 318,200 bpd it reported in its last quarter using the Nuclear Assisted Hydrocarbon Production Method they could have increased their profits by some US$430m -almost double what they did make – and would have produced zero CO2 and polluted not one gallon of surface water. Some imperative!

–Stuart Burns

Various noted market commentators were interviewed at the 16^th annual Mining Indaba in Cape Town this week and the sentiment appears to be largely bullish. Playing safe most predictions were pitched at the long term such as Kevin Norrish, Managing Director of commodities research at Barclays Capital who said he could see prices rising steadily in 2010 and through into 2011 due to demand from China and the “financialization” of the metals sector. By which we take him to mean the flows of investment money into metals commodities. “China’s commodity demand has reached critical mass, with global demand for copper from China rising to 35% last year from 15% in 2001. China is the most important factor in copper and commodity production,” he said in a local paper www.businessday.co.za, “We expect price increases to hit fresh highs by 2012, driven especially by insatiable demand from China as well as an expected rise in demand from members of the OECD.” Norrish went on to say he expected the copper market to be in deficit in the next couple of years and prices to reach US$8,000 per metric ton.

Iron ore was also singled out for attention, this time by Magnus Ericsson of Raw Metals Group who observed China’s steel demand would drive iron ore imports up by 10% this year and the new benchmark would be 10-15% higher than last year – we would pitch it higher than that but we will see.

Guy Elliott, CFO of Rio Tinto was particularly bullish for the long term saying to Reuters economic growth in China would double global demand for aluminum, iron ore and copper over the next 15 years. Rio is said to be increasing iron ore production by 10% in 2010 over 2009 but interestingly still have some of their aluminum smelters running at below capacity.

Last, on precious metals Tom Kendal, a precious metals strategist at Mitsubishi said platinum would reach $1,700/ounce in H2 2010 on the back of a global recovery in vehicle manufacturing and increasing emissions regulations.

–Stuart Burns

Britain could be about to strike oil, again. Not in the North Sea this time but around the Falkland Islands in the South Atlantic. Desire Petroleum, Rockhopper Exploration, Falklands Oil & Gas (in partnership with BHP Billiton) and Borders & Southern have between them raised £170m (US$272m) to begin drilling later this month according to the Financial Times. Desire has leased the drill ship Ocean Guardian to build on work done in 1998 in which six wells were drilled in the North Falklands Basin and five of them yielded oil and gas, but at prevailing oil prices were not considered economically viable. Analysts say any discoveries now could be commercially viable at about $40 a barrel.

Needless to say Argentina is hopping mad about the news, Reuters reported that Argentina protested to Britain’s embassy in Buenos Aires this week over the plans to begin offshore oil exploration in the disputed Falkland Islands, which the two countries went to war over in 1982. Nearly 1000 people were killed in the Falklands war and Argentina still lays claim to the energy rich islands even though they have been under British control since 1833.

According to an article last year, drilling costs could be US$10m per hole so these small junior exploration companies are going to need big partners (like BHP) or deep pockets to fully explore the region. The prospects look positive though; testing a well drilled by Shell ten years earlier, British firm Rockhopper Exploration discovered a massive natural gas deposit – one that could be as big as 7.9 trillion cubic feet. But the problem is with no nearby market and the cost of laying a pipeline or building an LNG plant being immense the natural gas is of limited immediate value.

There are two areas being explored at the moment – the North and South Basins. Rockhopper made its gas discovery in the North, where the water is shallow at 100m-600m (300-2000ft) and the drilling conditions relatively benign. The South Basin, where fellow explorers Falkland Oil & Gas and Borders & Southern are active, is another matter. The water is up to 1,200m (4000ft) deep and the drilling conditions far trickier according to a report in Money Week. With Britain’s experience in the North Sea such depths would not be a major hindrance to developing any finds but they do raise the cost of exploration and development even before overcoming the logistical challenge of operating in the South Atlantic so far from major support services. Suppliers to the offshore oil industry will be watching developments closely; development would bring rich rewards for those with the expertise to meet the challenge.

–Stuart Burns

This is a follow-up post covering China’s steel industry

Compared to the rest of the world, China’s steel industry is dreadfully fragmented, the top four mills took just 23.9% of the market compared to 60% in the European Union and 80% in Japan, S Korea and the USA. China’s steel industry suffers from this fragmentation in many ways.  Here are just a few examples of the problems they have identified in a report by www.steelhome.cn/en:

• A fragmented structure means mills tend to invest blindly in market segments without the opportunity to coordinate with other producers. Consequently the market suffers from over investment in some sectors and occasionally under investment in others. Investment can be wasteful and sub optimized
• In addition when the market is in contraction or even when production exceeds consumption a small number of large mills are better able to react to over supply by cutting production and maintaining a market balance. US mills are doing this very capably at the moment and although none of them like operating at 60-70% capacity they know it is better to make a margin on ever reduced ton of steel than to make a loss on full production
• The larger the mill group the easier it is to access funding and technology. Larger producers tend to be able to borrow more cheaply and to invest more often in the latest technology making them more competitive in the longer term
• Although market collusion is against the law and there are strict rules against the formation of cartels, the reality is if a few large producers dominate a market it is easier for them to act in tandem even if they are not actually talking to each other. This reduces competitive pressures and allows a more orderly marketplace at least for the producers

So if all or even some of the above holds true why haven’t China’s steel producers formed into larger firms by mergers and acquisitions as they have done in OECD markets? Well broadly the reasons fall into two challenges the Chinese market faces. The first is the strength of regional or local governments that consider their state steel plants to be local champions. Local governments derive many benefits from their local producers and would not want to lose that income to a neighboring state. Apart from a six month period after the start of the financial crisis, Chinese mills have been making a lot of money. When enterprises are strongly profitable there is less incentive to sell out to a competitor, nor are enough of the shares of enough of the small to medium mills on stock exchanges where a hostile takeover is a viable options. Consequentially shareholders prefer to hold onto their assets and continue to take their profits – a sharp downturn may change that thinking, an eventuality some think we will see in the early part of this decade.

–Stuart Burns

China has rapidly become the largest steel producing country in the world, but it would be a mistake to look on it as a single entity even though we commonly refer to China’s steel producers in that way here on MetalMiner. According to the World Steel Association’s report dated January 22, global steel production contracted last year by 8% to some 1,220 million metric tons of which China produced 567.6 million tons or some 47% of global production. As this graph shows the headline figures don’t show the growing disparity in where steel is made and that is production has contracted in most markets but increased in China during the recession, down 21.1% in the rest of the world but up 13.5% in China.

Source: World Steel Association www.worldsteel.org

Under the pressure of repeated policy statements, government encouragement and downright coercion the major steel mills in China have undergone some consolidation over recent years. Although the industry has continued to grow in size, the number of steel mills has dropped from 500 in 2005 to something over 400 today according to steelhome, a Chinese domestic steel market website.

According to the chinese steel specialists www.steelhome.cn/en State owned steel mills while producing 55% of the nation’s output have lowered production capacity in recent years as private producers have expanded in size from just 10% of the market in 2000 to some 45% today. But there has been little or no mergers among the majors. Most mills prefer to expand organically building new greenfield plants encouraged by cheap bank loans, low cost land and minimal environmental or planning restrictions. The top four Chinese mills and the top 10 Chinese mills make up a lower percentage of total production today than they did in 2000, see chart below.

Source:www.steelhome.cn/en

In a follow-up post a little later this morning we’ll look at some of the problems fragmentation causes China’s steel industry.

–Stuart Burns

A BBC News report from the Singapore Air Show this week showcased a new Chinese airliner called the C919 due to be launched in 2016. The manufacturer is Commercial Aircraft Corporation of China, or Comac, China’s answer to Boeing and Airbus. The c919 is aimed squarely at the market currently dominated by Boeing’s 737 and the Airbus 320. Before anyone starts snickering that an emerging market could challenge such technologically sophisticated and well entrenched market leaders let us not forget most if not all of the technologies needed to make modern commercial jet airliners are available for sale from western suppliers to the same behemoths.

Western firms like Rockwell Collins, General Electric and Honeywell are queuing up to supply inertial navigation systems and advanced flight control equipment. Comac has already taken 240 orders for a twin engine regional jet called the ARJ-21 to domestic clients. China has spent billions with Boeing and Airbus during the last decade and with the Asian market growing faster than any other they clearly feel there is an opportunity for them to cash in on that demand.

The recent sale of military equipment to Taiwan has if anything helped the domestic aircraft industry. If China takes retaliatory action against the likes of Boeing, as has been threatened, and Boeing is banned from selling aircraft to domestic airlines it opens the door for Comac to take over in what has become the hub for the largest aviation market. The International Air Transport Association said at the Singapore Air show this week that Asia-Pacific air passengers numbered 647 million last year, surpassing North America’s 638 million and Europe’s 601 million.

Comac is not alone in having aspirations to service this rapidly expanding market. The Aviation Industry Corporation of China, or Avic, is in the process of developing the MA700, a four-engine turboprop regional airliner.

None of these offerings will be for delivery until 2012 on the ARJ-21 and 2016 for the C919 – possibly longer if Chinese firms hit the same problems western manufacturers have done with new models. But the Chinese are unlikely to be going for cutting edge designs or developing new technologies. They will more likely work with existing technology and leverage low capital and labor costs to bring a product to market that can compete on price with established producers. If P&W, GE and Rolls-Royce are as keen to sell them engines as they are or previous business there is no reason why fuel economy or running costs should be materially less than a western plane. No doubt Airbus saw this coming when they started production of the 320 in China. How competitive the Chinese assembled 320 will be compared to the C919 remains to be seen.

–Stuart Burns