10 12 16 ICUSectorPrimer-IronOre

Ukraine
Focus
Equity markets
Scope
Metals & Mining
Sector
Sector Primer
Iron ore 2010
Alexander Martynenko
Kiev, +38 044 2200120 alexander.martynenko@icu.ua
December
2010
READ FIRST THE DISCLOSURES SECTION FOR IMPORTANT DISCLOSURES AND ANALYST CERTIFICATION
December 2010
Sector Primer
Iron ore 2010
Contents
Executive summary Key drivers of profitability Key risks Supply chain and technology 4 5 7 9
Technology basics .........................................................................................................9 Key stages of iron ore processing ................................................................................ 10 Mining .................................................................................................................. 10 Beneficiation ........................................................................................................ 10 Agglomeration ...................................................................................................... 10 Supply chain ................................................................................................................ 10 Domestic iron ore market should further shrink.................................................... 10 Sales structure and key commercial products ..................................................... 12 Strong growth potential 15
Reserves: Underexploited and undistributed ............................................................... 15 The state controls ore reserves allocation ................................................................... 16 Industry players uneven control of reserves ................................................................ 16 Privatisation process nearly finalised ........................................................................... 17 Favourable geographical location and logistics ........................................................... 18 Favourable market environment 19
Iron ore and steel demand ........................................................................................... 19 China drives the global demand for iron ore ................................................................ 21 Pricing: oligopoly benefits ............................................................................................ 22 The Big Three ...................................................................................................... 22 Benchmark system .............................................................................................. 23 Pricing mechanism............................................................................................... 23 Transition of the benchmark system .................................................................... 24 Competitive environment ............................................................................................. 24 Production costs pose key concerns 26
Inferior quality of iron ore deposits implies costlier mining ................................... 27 Energy inefficiency creates the main risks for costs ............................................. 27 Labour structure needs further optimisation ......................................................... 30 Modernisation is time-consuming and capital-intensive ....................................... 31 Appendixes 32
Appendix 1. SWOT analysis ........................................................................................ 32 Appendix 2. Financial market exposure ....................................................................... 33 Appendix 3. Financial performance highlights ............................................................. 33 Glossary 34
December 2010
Sector Primer
Iron ore 2010
Executive summary
Our formal coverage of the Ukrainian metals and mining industry begins with the publishing of this Iron Ore Sector Primer, which we plan to follow up by a similar primer on Ukrainian steel sector. We focus on the key factors driving profitability of Ukrainian iron ore producers, both short- and long-term. We also examine the iron-ore supply chain, key commercial products, and production technology prevailing in Ukraine. Finally, we provide a SWOT analysis of the sector and the sectors significant risks.
Sector importance: The iron ore sector captures one of the main competitive advantages of Ukrainian steel mills on international steel markets by supplying the relatively cheap key steelmaking input, iron ore. At the same time, the sector itself plays an increasingly active role in the Ukrainian steel industry exports, having amounted to US$1.6bn in 9M10, or 13% of the total Ukrainian exports of ferrous metals & mining products and 2% of the corresponding Ukrainian GDP figure. One of the sector leaders, Ferrexpo, has its shares listed on the LSE, which are the most liquid among all the traded Ukrainian stocks. Also, the iron ore business segment accounted for 22% of US$6bn revenue and for 56% of US$1.4bn EBITDA of the leader of Ukraines metal-and-mining industry, Metinvest, in 2009. Strong growth potential: Having the third largest reserves of iron ore in the world based on iron ore content, Ukraine ranks just sixth in terms of the annual iron ore production. Privatization of the last state-owned iron ore company, KGOKOR, further development of reserves and introduction of additional processing capacities by private businesses have the potential to boost Ukrainian iron ore exports by at least 65% during 2011-15. Ukrainian iron ore companies are able to expand their market share in Europe and the Middle East, the regions where they have an edge over competitors in transportation costs and where they can supply the products with competitive quality. Ukrainian miners can also capitalize on the growing demand for iron ore in Southeast Asia, particularly China. Low production efficiency: On the back of volatile energy prices, energy-intensive production process is the main weakness of Ukrainian iron ore sector. High energy consumption is caused by significant mining depth and the low iron grade of local deposits, obsolete equipment, and cold winters. Producers also inherited an inefficient organisational structure and excessive headcount from the previous state ownership, which has led to low labour productivity. At the same time, modernisation and capacity increase are complex, time-consuming, and require substantial capex. Key drivers: In our view, the most significant factors affecting the profitability of Ukrainian iron ore producers are the world demand for steel, international benchmark iron ore prices, sales volumes, competitiveness in international markets, energy prices, transportation costs, the hryvnias exchange rate, and domestic inflation. Capex and the availability of financing are drivers affecting the sector in the longer term; however, they substantially influence Ukranian companies exposure to the other drivers mentioned above. Key risks: Highly volatile energy prices are the main threat to Ukrainian iron-ore companies profitability, as they face increasing competition on their way to foreign markets. At the same time, equipment upgrade aimed to improve energy efficiency and product quality, as well as production capacity increase may take longer than planned by companies due to possible scarcity of finance and technological complexity.
December 2010
Sector Primer
Iron ore 2010
Key drivers of profitability

We believe that the following factors significantly influence the profitability of Ukrainian iron-ore producers: World demand for steel and iron ore. World prices for iron ore are influenced to a considerable degree by global economic growth, which determines the world demand for steel and its inputs. At the same time, the oligopolistic international market for iron ore has an additional significant effect on iron ore prices, supporting them during economic downturns, and boosting them during growth phases. International iron ore benchmark prices are currently the key indicator of both steel and iron ore demand in the world. Ukrainian iron ore prices closely trace international benchmark prices on both the domestic and international market. Sales volumes. While driven by demand as a result of world economy growth, sales volumes also depend on Ukrainian companies ability to withstand competition on the international market. The key factors affecting competitiveness are production costs, transportation costs, and product quality. With their current exposure to these factors, Ukrainian companies are at least able to retain their current market share. Traditionally, Ukrainian producers have been highly competitive in Eastern and Central Europe and Turkey, due to the proximity of these markets to Ukraine and good transportation infrastructure, which minimise transportation costs, as well as due to their products technical compatibility with steel mills of their long-standing customer base. However, as Ukrainian companies are striving to expand their sales to Western Europe, the Middle East, and Southeast Asia, competition is increasing considerably. In order to further penetrate the markets of Western Europe and the Middle East, Ukrainian companies will have to produce more products with higher iron content. To become more cost-competitive in all targeted markets, Ukrainian mining companies have to improve their energy efficiency, labour productivity, and control over transportation costs. Energy prices. Due to the low iron content of deposits, significant depth of open/underground mining pits, obsolete equipment, and severe winters, Ukrainian production of iron ore is energy-intensive compared to non-CIS competitors. In pellets, which have the highest added value, energy costs of Ukrainian producers account for nearly 45-55% of their total production costs, according to our estimates. In particular, Ukrainian iron-ore-making costs are driven substantially by prices for natural gas, diesel fuel, and electricity. Transportation costs. Transportation costs add another 40-70% on top of the production costs of Ukrainian iron ore producers, according to our estimates. At the same time, transportation costs are largely out of Ukrainian iron producers control, as the railway services in Ukraine are provided by the state monopolist, Ukrzaliznytsia, and are tightly regulated by the state, while seaborne transportation services are provided by international carriers. As a result, Ukrainian iron ore producers railway transportation costs are driven mostly by domestic inflation and the governments policy, while seaborne transportation costs are driven by global demand, which in turn is significantly affected by China. We believe the share of seaborne transportation costs is likely to grow, as Ukrainian companies plan to build up their iron ore exports to Southeast Asia.
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Hryvnia exchange rate and domestic inflation. Most of the Ukrainian iron ore producers revenues are either denominated in US dollars (related to exports) or pegged to the UAH/USD exchange rate (in relation to domestic sales). At the same time, we estimate that 60-70% of the production costs of Ukrainian producers are denominated in and pegged to hryvnias, as they relate to the majority of labour costs, electricity, and consumable materials. As a result, hryvnia appreciation is directly related to growth in Ukrainian miners costs, translated into US dollars, and thus lowers their profit margins. Capex. For Ukrainian iron ore producers, the key capex projects at the moment are the development of new mines, upgrading existing ore-processing facilities, and introducing new ones. The main purpose of these projects is to increase production capacity, improve efficiency and productivity, improve product quality, and raise the share of products with higher added value. Domestic iron ore investment projects are capital-intensive, technologically complex, and time-consuming. Availability of financing. Given the scope of capex required, Ukrainian iron ore producers are quite often unable to finance their investment projects exclusively from operating cash flows, and therefore need to raise additional funding through debt and/or equity. This makes domestic miners dependent on the stability and cycles of the financial markets. Furthermore, the low credit ratings of Ukraine compared to developed markets and a significant portion of emerging markets result in attracting debt that is more expensive for Ukrainian companies compared to their foreign peers.
December 2010
Sector Primer
Iron ore 2010
Key risks
Rising energy costs. Although energy prices for Ukrainian industry have been lower than energy prices in Europe and South and North America during the last four years, they have nevertheless seen a converging trend, which is likely to continue in the next four-to-five years. Russias monopolist natural gas company, Gazprom, has pursued in recent years the policy of bringing its gas prices for Ukraine close to prices charged to European countries. Ukraines political concessions to Russia, such as the prolongation of stationing the Russian Black Sea Fleet on Ukraines territory have so far allowed Ukraine to receive additional discounts on the natural gas price. Electricity tariffs, which are charged to Ukrainian iron ore producers, are currently regulated by the state. The Ukrainian government plans to liberalise electricity tariffs, making them likely to rise in the next three-to-five years. We expect that the liberalisation mechanism will provide for a gradual increase in electricity tariffs. Probability: Medium to high Increasing competition. As Ukrainian producers are striving to expand their sales to the markets of Western Europe, the Middle East, and Southeast Asia, they face stronger competition from international competitors, particularly from Brazilian and Australian companies. In the cost competition area, such threats as rising energy prices, inflation in Ukraine, and competitors optimisation of their transportation costs, should prompt Ukrainian mining companies to improve their energy efficiency and labour productivity. In the product quality and product range area, Ukrainian iron ore producers should introduce technologies to allow both raising the share of products with higher iron content and improving energy efficiency. Probability: Medium to high Undermined ability to finance investment projects. Ukrainian iron ore producers may fail to raise sufficient funding for their capex, if international financial markets start tightening again. However, the shortage of liquidity on the financial markets is likely to be mitigated by quantitative easing measures taken by developed countries. Probability: Medium Increasing reliance of Ukrainian steel mills on iron ore imports from Russia. As Russias Vneshekonombank has acquired control stakes in the Industrial Union of Donbass (IUD) and Zaporizhstal for their further transferring to Russian businesses, these key Ukrainian consumers of domestic iron ore may reorient at least a part of their consumption towards imports of Russian iron ore. As a result, Ukraines iron ore market may shrink considerably. This risk is pertinent mostly to Metinvest, which is the key supplier of iron ore to the IUD and Zaporizhstal and controls about 70% of the domestic iron ore market. The risk is mitigated by the uncertainty in transferring the control stakes to well-integrated steelmaking groups of Russia, the existence of framework agreements between Metinvest and the IUD on ore supplies until 2015, and possible reorientation of Metinvests sales to the voracious Chinese market. Probability: Medium Decline in international benchmark prices for iron ore. World iron ore prices may decline due to the prospect of a double-dip recession and a resulting decline in steel demand. However, the industrialisation of developing countries mitigates the risk of the global demand for steel and steelmaking inputs falling again. The growing demand for seaborne iron ore from China will be the key factor supporting the international benchmark prices. Probability: Low
December 2010
Sector Primer
Iron ore 2010
Appreciation in the hryvnia may hurt competitiveness. An appreciation in the hryvnia versus the US dollar would raise Ukrainian ore miners costs denominated in dollars, and, as Ukrainian iron ore is priced in USD, would lower their cost competitiveness. Although we believe that the hryvnia will appreciate against the dollar in the next two years, the negative impact from this appreciation will be mitigated by the dollars depreciation against other currencies, including key competitor currencies the Australian dollar and Brazilian real. Probability: Low Possible shift of the global demand towards higher-grade iron ore products. To increase the iron content of their products, Ukrainian producers will have to raise energy consumption and thus inflate their production costs, with a likely decline of profit margins. This shift in demand, however, is most likely to be slow for another five years, given the current scarce financing of the modernisation of both steelmaking and iron ore processing caused by the financial crisis. Also, the sector leaders, Metinvest and Ferrexpo, are already planning to upgrade their equipment in order to increase the share of products with higher iron content. Probability: Low
December 2010
Sector Primer
Iron ore 2010
Supply chain and technology

The relatively low grade of Ukrainian iron ore necessitates its further processing through the consequent stages of beneficiation and agglomeration before being consumed by steel mills. Iron ore concentrate and pellets are the key commercial products sold by Ukrainian companies, with pellets playing an increasingly important role in exports. Ukrainian pellets are quality-competitive for the markets of Europe, Turkey, and Southeast Asia. Low integration of the domestic iron ore sector with Ukrainian steel mills has created the domestic market of iron ore, which is 60-70% controlled by one supplier, Metinvest, while a number of other producers, including Ferrexpo, are focused on exports. However, as Russian steelmakers are gaining control over the main Ukrainian ore-deficient steelmakers, Russian iron ore imports to Ukraine are likely to increase in the long term, which will cause the Ukrainian iron ore sector to reorient more towards exports.
Technology basics
Iron ore extracted in Ukraine typically needs beneficiation and agglomeration before being fed to a steel mills blast furnaces Ukrainian iron ore mining companies represent a constituent part of the domestic blast furnace/base oxygen furnace (BF/BOF) process chain used to produce steel. The behaviour of iron ore is determined by its chemical composition (content of iron, sulphur, phosphorus, etc) and by its structure of form (ore lump, fines, or pellets), each of which affects blast furnace (BF) productivity. Typically having a low iron content of 30-35% Fe, Ukrainian iron ore cannot be used in BFs directly, and needs preliminary upgrading. The process of iron ore upgrading used to obtain higher iron content and minimise chemical impurities is called beneficiation. Chart 1. Supply chain of Ukrainian iron ore companies
Lump ore, sinter ore (60-61% Fe)
ORE MINING AND PROCESSING PLANTS Agglomeration Mining

Drilling Blasting Excavating Iron ore (Fe<50%) Lump ore, sinter ore (60-61% Fe) Sintering
Sinter (47-58% Fe)
Beneficiation
Crushing and grinding Dry magnetic separation Flotation
Concentrate (65-67% Fe)
Combining sinter material Dewatering
RELATED STEEL
MILLS
Concentrate (65-67% Fe) Pelletizing Combining pellet material Dewatering
Pellets (58-67% Fe)
Lump ore, sinter ore (60-61% Fe)
Pellets (58-67% Fe)
Sinter (47-58% Fe)
EXTERNAL STEEL MILLS

Sources: Ferrexpo, Metinvest, ICU estimates
The main product of beneficiation, iron ore concentrate, cannot be charged in the BF directly, since it blocks the passage for ascending gas inside the BF, and thus blocks the smelting process. Hence, concentrate is agglomerated in high temperatures into larger, lumpy pieces with/without the mixing in of additives like limestone, dolomite, etc. Two types of products commonly made in the agglomeration process are sinter and pellets, made in the sintering and pelletising processes, respectively.
December 2010
Sector Primer
Iron ore 2010
Key stages of iron ore processing Mining

Open-pit mining of iron ore prevails in Ukraine Iron ore in Ukraine is extracted either from open-pit or underground mines. Open-pit mining is more common, and is performed by the sector leaders Metinvest, Ferrexpo, and Southern GOK. The open-pit mining process includes drilling blast holes, blasting, and shoveling massive amounts of dislodged ore. After extraction, iron ore is transported to the beneficiation stage. However, a number of Ukrainian miners, such as Kryviy Rih Iron Ore Combine, Sukha Balka, and Zaporizzhia Iron Ore Combine are engaged in the underground mining of relatively rich iron ore with Fe content of over 50%, which does not require beneficiation. Additionally processed through crushing and heating, such ore is ready for the sintering stage, and is most commonly termed sintering ore.
Beneficiation
Iron ore beneficiation is used to increase Fe content Upgrading iron ore to a higher iron content may involve several different techniques, such as washing, jigging, dry magnetic separation, advanced gravity separation, and flotation. The resulting product, concentrate, with a Fe content of 65-67%, apart from being directed to further processing stages, is marketed by Ukrainian miners to external customers.
Agglomeration
Sintering and pelletising are two common types of iron-ore agglomeration Agglomeration of concentrate in Ukraine is made through either sintering or pelletising. In the sintering process, iron ore, iron ore concentrate, and other iron-bearing materials, flux (limestone), and coke breeze, form the sinter burden, which is then granulated and heated. After crushing, screening, and cooling, the sinter is ready for use in BF. In pelletising, which is a more recent alternative to sintering, concentrate is mixed with water and other additives, and the resulting slurry is dried, mixed with binding agents, and baked. The output material is ball-like granules with an 8-10mm diameter called pellets. After the pellets have been screened and undersized material removed, they are prepared for use in BF.
Supply chain Domestic iron ore market should further shrink

As Ukrainian steel mills will be becoming more upstream-integrated, the domestic iron ore market will shrink, making iron ore producers increase their exports The existence of the iron ore market in Ukraine is possible due to the low integration of the Ukrainian iron ore sector with the domestic steel mills. However, acquisitions in the Ukrainian steel sector made by Russian companies are likely to reorient at least part of its iron ore consumption towards imports from Russia; otherwise, non-integrated Ukrainian steel mills will either develop their own mines, or merge with domestic iron ore suppliers. In both cases, the domestic iron ore market should considerably shrink, although we believe that this will mostly likely happen gradually, in a three-to-five-year term. Correspondingly, the role of exports in Ukrainian iron ore producers sales structures should substantially increase. The Ukrainian iron ore sector remains poorly integrated with domestic steel mills All the Ukrainian iron ore companies evolved from formerly state-owned ore-mining and processing plants (OMEP, an abbreviation that is the equivalent of GOK in Russian), which were privatised by the Ukrainian government in 1999-2004. As this privatisation was carried out in a non-transparent and corrupt fashion, the previous economic relations between domestic OMEPs and steel mills were mostly destroyed. In the process of ownership concentration, which followed privatisation, the key event occurred in 2007, when Metinvest Holding merged with the main iron ore-making and steel-making assets of Smart Holding. As a result, the addition of Ingulets GOK to Metinvests existing assets, Central GOK and Northern GOK, increased the holdings share in Ukraines production of merchant concentrate from 21% to 80%.
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At the moment, only ArcelorMittal Kryviy Rihs OMEPs and Metinvests Northern GOK, Central GOK, and Ingulets GOK are downstream-integrated to Ukrainian steel mills in one steelmaking holding. Of the rest of Ukrainian OMEPs, some have to sell their products on the open market either in Ukraine or abroad (Poltava GOK-Ferrexpo, Southern GOK, Kryvyi Rih Iron Ore Combine), while others export to their parents countries (Zaporizhzhia Iron Ore Combine, Sukha Balka). A high concentration of ownership in the iron ore sector has created an oligopoly in the Ukrainian iron ore market At the same time, only two steelmaking groups in Ukraine, Metinvest and ArcelorMittal Kryviy Rih, have upstream-integrated their steel mills to domestic OMEPs. Furthermore, having concentrated substantial ore-mining capacities with rich reserves, Metinvest is 130% sufficient in iron ore (based on its current steelmaking capacity, which includes Mariupol Illich Steel, acquired in 2010), and controls over 60-70% of the Ukrainian iron ore market. Chart 3. Suppliers to the Ukrainian iron ore market in 2009 (%)
Note: The volume of the Ukrainian iron ore market in 2009 15.69mln tonnes (excluding Mariupol Illich Steel, which merged with Metinvest in 2010)
Other domestic producers 5.0 Imports 23.6
Chart 2. Domestic external buyers of Ukrainian iron ore in 2009 (%)

Note: The volume of sales by Ukrainian companies to external domestic steel mills in 2009 11.99mln tonnes (excluding Mariupol Illich Steel, which merged with Metinvest in 2010)
Petrovsky Steel 3.1 Zaporizhstal 19.2
Donetskstal 17.0
IUD 60.6
Metinvest 71.4
Source: Metal-Courier
The biggest domestic buyers of iron ore, the IUD and Zaporizhstal, may substantially reorient towards imports from Russia
The domestic iron ore market, in fact, is currently formed by three Ukrainian steelmaking groups, which are not self-sufficient in iron ore: IUD, Zaporizhstal, and Donetskstal. Mainly due to this dependence on external iron ore, control stakes in the IUD and Zaporizhstal were acquired by Russian companies through Russias state-owned Vneshekonombank in 2010. With the acquirers most likely acting as mediators, these control stakes may finally go to Russian steelmaking groups, of which Metalloinvest looks to be the main candidate, due to its significant excessive iron ore-making capacity. The possible reorientation of Zaporizhstal and the IUD towards the iron ore imports from Russia will further squeeze the domestic iron ore market, with Metinvest and other Ukrainian producers having to focus more on exports of iron ore. The whole process, however, may take several years, as Russian steelmakers currently have deleveraging issues as their first priority, while Metinvest has a framework agreement on supplying iron ore to the IUD until 2015.
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Iron ore 2010
Sales structure and key commercial products

During the recession, the share of exports in iron ore sales of Ukrainian companies substantially increased Formed by steelmaking companies which are not self-sufficient in iron ore (the IUD, Zaporizhstal, Donetskstal), the domestic iron ore market accounts for only about 20% of Ukrainian iron ore producers total sales in 2010, after Mariupol Illich Steel, the secondlargest consumer without its own iron ore base, merged with Metinvest. Exports play an increasingly significant role in the iron ore sector operations: the share of iron ore exports in the sectors total sales volumes grew from 34% in 2008 to 45% in 2009, mainly at the expense of sales to poorly integrated steelmakers, which were hit the hardest by the global economic recession. Metinvest and Ferrexpo have emerged as the leading iron ore exporters in Ukraine, with Ferrexpo exporting 100% of its products in 2010. At the same time, the share of OMEPs internal sales to related steel mills within one steelmaking group grew from 24% in 2009 to 34% in 8M10. Chart 4. Ukrainian iron ore sales structure in 2009 (%)
Note: total amount of Ukraines iron ore sales in 2009: 73.2mln tonnes
Chart 5. Ukrainian iron ore sales structure in 8M10 (%)

Note: total amount of Ukraines iron ore sales in 8M10: 56.4mln tonnes
External domestic sales 17.9
External domestic sales 26.7

Exports 39.7
Exports 39.9
Internal domestic sales 33.7
Internal domestic sales 42.3
Concentrate and pellets are the key commercial products of Ukrainian iron ore producers
Different mining conditions, ore quality, and technological specifics have caused Ukrainian iron ore producers to market all the products created along the iron ore production chain. Sintering ore is traded mostly by the Kryviy Rih Iron Ore Combine, Sukha Balka, the Zaporizhzhia Iron Ore Combine, and other companies with deposits of iron ore with relatively high iron content (55-62% Fe). Sinter is mostly traded by Southern GOK, which is the only Ukrainian OMEP with a sinter plant on its premises, while other sinter plants belong to domestic steel mills. Nevertheless, concentrate and pellets are the key commercial products of Ukrainian iron ore companies, jointly accounting for 72% in the total sales volumes in 2009. These products are even more significant in terms of exports, accounting for 79% in total export volumes in 2009. Concentrate is traded by Metinvest only, both for domestic sales and exports, and pellets are traded by Metinvest and Ferrexpo, which specialises in the pellet segment only.
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Chart 6. Sales structure of key domestic iron-ore producers in 2009

Notes: (1) - Zaporizhzhia Iron Ore Combine (ZIOC) is 75%-controlled by Minerfin; (2) - Kryviy Rih Iron Ore Combine (KrIOC) is jointly controlled by SCM and Smart; while SCM owns a 75%-stake in Metinvest, KrIOC is not included in Metinvests assets and is deemed a separate business unit; (3)- Southern GOK is jointly controlled by Evraz (50%) and Smart (50%)
exports 30.0 25.0 internal domestic external domestic
Chart 7. By-product sales structure of key domestic iron-ore producers in 2009

Notes: (1) - Zaporizhzhia Iron Ore Combine (ZIOC) is 75%-controlled by Minerfin; (2) - Kryviy Rih Iron Ore Combine (KrIOC) is jointly controlled by SCM and Smart; while SCM owns a 75%-stake in Metinvest, KrIOC is not included in Metinvests assets and is deemed a separate business unit; (3)- Southern GOK is jointly controlled by Evraz (50%) and Smart (50%)
concentrate sinter 30.0 (mln tonnes) 25.0 20.0 sintering ore pellets lump ore
(mln tonnes)
20.0
15.0 10.0 5.0
15.0
10.0 5.0 0.0
0.0 Other Evraz ZIOC (1) KrIOC (2) Southern Ferrexpo Arcelor- Metinvest GOK (3) Mittal KR
Other
Evraz
ZIOC (1) KrIOC (2) Southern Ferrexpo Arcelor- Metinvest GOK (3) Mittal KR
The Ukrainian iron ore sector will further increase the share of pellets in its sales
Pellets are the iron ore product with the highest added value, and as such, their prices incorporate premiums related to other marketable products of iron ore. The main disadvantage of pellets is that during steel demand downturns, steel mills tend to switch to lower-quality iron ore products, as they focus instead on cost-cutting rather than productivity targets. Nevertheless, pellets should gain an increasing share in demand for iron ore products in Ukraine and the rest of the world, due to the following advantages: As opposed to sinter, pellets are considerably stronger, which makes them more transportable. Pellets physical and chemical characteristics enable steel mills to achieve the highest BF productivity. Due to their hardness, pellets are also more transportable than concentrate, which is more subject to spillage and tends to accumulate moisture and freeze during winters, thus causing serious transportation bottlenecks. Sintering plants are likely to face increasing sanctions and limitations due to substantial pollution produced by the sintering process, while on the European market, strict penalties already allow deliveries of Ukrainian pellets only. Further depletion of deposits of high-quality lump ore, which does not require agglomeration, will increase demand for pellets. The pulverised coal injection process, which is being actively introduced in steel mills BFs in Ukraine and other countries, puts additional quality requirements on iron ore feed, thus increasing demand for pellets. All over the world, steel mills are raising their shares of direct reduced iron production, which is largely pellet-based. Ferrexpo plans to keep pellets as its key merchandise product, while Metinvest plans to increase the pellet share in its total sales and decrease the share of concentrate.
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Chart 8. Product structure of Ukrainian iron ore sales in 2009 (%)

Total amount of Ukraines iron ore sales in 2009: 73.2mln tonnes
Sinter 12.3 Lump ore 0.2
Chart 9. Product structure of Ukrainian iron ore exports in 2009 (%)

Total amount of Ukraines iron ore sales in 2009: 29.0mln tonnes
Sinter 1.3 Lump ore 0.5
Sintering ore 18.9
Sintering ore 15.8
Concentrate 43.4
Concentrate 46.0
Pellets 28.3
Pellets 33.4
Ukrainian pellets have the competitive quality necessary for the markets of Europe, Turkey and Southeast Asia
Ukrainian pellets have the competitive quality necessary for the markets of Europe, Turkey, and Southeast Asia. Being long-standing customers of Ukrainian iron ore miners, the steel mills of Central and Eastern Europe have good technical compatibility with Ukrainian pellets. Furthermore, the low phosphorus content in Ferrexpos pellets make them particularly valuable for European and Asian flat steel producers delivering their products to automakers (such as BMW, Audi, and Toyota) and electronics manufacturers (such as Panasonic Corporation). Iron content of pellets produced by Metinvest is in the range of 60.5-63.5% Fe for Northern GOK and an average of 63.9% Fe for Central GOK, while Ferrexpo produces pellets of 62% Fe and 65% Fe. To further penetrate the market of Western Europe, the companies should increase the share of 65% Fe pellets produced, while for the Middle East other than Turkey, they should introduce 68% Fe pellets, which would require additional capex.
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Strong growth potential

Having the third-largest reserves of iron ore in the world based on iron ore content, Ukraine ranks just sixth in terms of the annual iron ore production. Privatisation of the last state-owned iron ore company, KGOKOR, further development of reserves, and introduction of additional processing capacities by private businesses have the potential to boost Ukrainian iron ore exports by at least 65% during 2010-15. Being traditionally dominant in Central and Eastern Europe, Ukrainian iron ore companies are able to further penetrate the markets of Western Europe and the Middle East, the regions where they also have an edge over competitors in transportation costs due to Ukraines favourable geographical location and well-developed transportation routes, and where they can supply the products with competitive quality. As the sole owner of Ukraines mineral resources, the state still plays a key role in distributing and regulating private businesses access to iron ore reserves.
Reserves: Underexploited and undistributed

Ukrainian iron ore reserves are substantially underdeveloped Substantial commercial underdevelopment of domestic iron ore reserves in Ukraine creates solid growth opportunities for Ukrainian mining businesses. Ukraine ranks No.1 in the world in terms of crude iron ore reserves, accounting for 19% of the world total. In the case of recalculating the countrys reserves based on iron ore content, this implies a No.3 position in the global ranking and a 12% share of the global reserves. At the same time, Ukraines share in global iron ore output in 2009 was just 2%. This places Ukraine among the countries that underproduce the most in terms of their reserves. Chart 10. Top 10 countries in the world in terms of iron ore reserves based on iron content
Russia Australia Ukraine Brazil China India Kazakhstan Venezuela Sweden United States Other 0.0 2.0 4.0 6.0 8.0 10.0 2.4 2.2 2.1 10.2 12.0 3.3 4.5 7.2 9.0 8.9 14.0 13.0 Brazil Australia India 0.26 0.38 0.37
Chart 11. Top eight countriesproducers of iron ore in 2009
China
0.90
Russia
Ukraine South Africa
0.09
0.06 0.05
(bln tonnes)
14.0 16.0
Other countries
0.0 0.2
0.21
0.4 0.6
(bln tonnes)
0.8 1.0
Source: U.S. Geological Survey
Source: U.S. Geological Survey
Ukrainian companies most actively exploit the Kryviy Rih Iron Ore basin, which accounts for nearly 56% of the total national reserves of iron ore in the region
Among proven Ukrainian iron ore deposit sites, the Kryviy Rih Iron Ore basin is the largest (56% of the total national reserves) and the most actively exploited, with the largest number of business groups involved in iron ore extraction, including national steelmaking leaders Metinvest and ArcelorMittal Kryviy Rih. The adjacent Kremenchuk Iron Ore region ranks second in terms of reserves accessed by just one business group, Ferrexpo, which plans to actively develop currently idle deposits in an attempt to more than double its output in the next five years.
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Other iron ore regions have a low presence of extraction activities, among which the Pryazovya region is the most prospective one, since its deposits have been prepared for further development since the 1970s, and can provide ore that is relatively easily beneficiated to concentrates, with 69-72% iron content. Currently, the likeliest candidate for obtaining the license to exploit Pryazovya regions reserves is Donetskstal, which plans to construct an OMEP with a 20mtpa iron ore capacity in the region. Table 1. Business groups presence in the top five iron-ore basins and regions of Ukraine
Iron ore basins/regions Kryviy Rih Basin Kremenchuk Region Bilozirka Region Pryazovya Region Kerch Basin Other Total Number of ore deposits (bln tonnes) Total 29 5 6 3 8 29 80 Exploited 21 2 1 6 30 Reserves bln tonnes 16.9 4.3 2.5 3.0 1.4 1.8 30.0 % of total 56% 14% 8% 10% 5% 6% 100% Fe content (%) 30-67 27.4-58.5 55.7-62.8 27-70 28.4 Business group presence
Metinvest, Privat, ArcelorMittal, Smart, Evraz Ferrexpo Zaporizhstal, Minerfin Donetskstal1 ---
Notes:1- Donetskstal is in the process of obtaining a mining license. Sources: Company data, ICU estimates.
The state controls ore reserves allocation

All mineral resources, including iron ore, are owned by the Ukrainian state, which gives out the rights for their exploitation to private businesses In order to obtain and sustain access to iron ore reserves in Ukraine, businesses are critically dependent on the Ukrainian states licensing system. According to the current Ukrainian legislation and regulations, the countrys mineral resources cannot be privately owned, and may only be granted for the use of legal entities or individuals. Correspondingly, companies in Ukraine may be authorised for mining activities by obtaining licenses and permits from relevant state authorities. For the development of an unexplored deposit, miners should obtain an exploration license for an initial period of five years, which may be further extended for another five years. A separate license is required for the extraction of minerals for an initial period of up to 20 years, and may contain special conditions relating to scope of work, technology, environment, and other issues. These licenses may be suspended or revoked if a company does not comply with existing regulations, or does not satisfy its license conditions, including adherence to mining schedules.
Industry players uneven control of reserves

Three companies currently control about 82% of the total iron ore reserves licensed by the Ukrainian state for exploitation Uneven access to iron ore reserves by the domestic industry players allows the ore-rich business groups (Metinvest, Ferrexpo, and ArcelorMittal) to expand their mining and production, while ore-insufficient steelmakers have either to depend on outsourcing, or seek mining licenses from the state to engage in costly greenfield projects. Metinvest, Ferrexpo, and ArcelorMittal together account for 82% of the iron ore reserves to be exploited under the current licenses. At the same time, the IUD and Donetskstal are so far totally deprived of their own iron ore mines, and Zaporizhstal has just a minority control (25%) stake in one of its iron ore suppliers, Zaporizhzhia Iron Ore Combine.
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Table 2. Business groups control of iron ore reserves and production assets in Ukraine
Group Control (%) Ore-mining and enriching JORC4 reserves JORC4 mineral resources plant/deposit (mln tonnes) (mln tonnes) 75.9 63.3 82.5 Central GOK Northern GOK Ingulets GOK 709 713 444 1,866 97.3 100.0 100.0 100.0 100.0 100.0 100.0 101.0 102.0 Poltava GOK Yeristovo GOK Belanovskoe deposit Galeshinskoe deposit Brovarkovskoe deposit Manuylivske deposit Kharchenkivske deposit Vasylyivske deposit Zarudnenske deposit 899 632 -------1,531 97.0 75.0 25.0 ArcelorMittal Kryviy Rih ZaZhRK ZaZhRK -------82 --2,689 3,807 937 7,433 3,648 1,192 1,702 326 -----6,868 ----------GKZ5 reserves (mln Iron content (%) tonnes) --------n/a3 n/a3 n/a3 n/a
3
Metinvest Metinvest Metinvest Metinvest total Ferrexpo Ferrexpo Ferrexpo Ferrexpo Ferrexpo Ferrexpo Ferrexpo Ferrexpo Ferrexpo Ferrexpo total ArcelorMittal Minnerfin (Slovakia) Zaporizhstal SCM1 Privat
1
32 32 34
29-31 30 30 55 ------
n/a3 15,169 900 300 300 266 266 300 300 n/d ---
33 58-66 58-67 59 59 35 35 56-59 ---
49.9 Krivorizhsky Iron Ore Combine 49.9 Krivorizhsky Iron Ore Combine 50.0 50.0 99.3 --Southern GOK Southern GOK Sukhaya Balka ---
Smart2 Evraz2 Evraz Industrial Union of Donbass Donetskstal
Notes: 1- Privat and System Capital Management (SCM) jointly control Kryviy Rih Iron Ore Combine. SCM also controls 75% in Metinvest, which does not include Kryviy Rih Iron Ore Combine in its Iron Ore Division; 2- Evraz and Smart jointly control Southern GOK; 3- there are no data available on GKZ reserves for separate deposits; 4- according to standards set by Australasian Joint Ore Reserves Committee (JORC); 5 GKZ standards - classification system and estimation methods for reserves and resources established by the Former Soviet Union . Sources: Company data, ICU estimates
Privatisation process nearly finalised

KGOKOR is the last nonprivatised large iron ore mining and processing plant in Ukraine Kryviy Rih Mining and Processing Plant of Oxidized Ore (KGOKOR) has so far remained the only non-privatised iron-ore-making company in Ukraine. However, in October 2010, the Ukrainian government announced its intentions to sell KGOKOR and initiated preparations for the plants privatisation. The privatisation and the consequent completion of the construction of KGOKOR could potentially result in more than a 100% increase in Ukrainian pellet export volumes, based on their 2009 level of 9.7mt, or a 34% increase in Ukrainian total export volumes of iron ore products, based on their 2009 level of 29mt. Once completed, KGOKOR alone will be able to add 34% to Ukraines total export volumes of iron ore based on the 2009 level KGOKOR has so far been the sole Ukrainian plant designed to process oxidized iron ore. Potential resources to be used by KGOKOR are the oxidized iron ore of Eastern Valiavkino deposit, with an estimated 1bn tonne reserves, as well as 724m tonnes of oxidized ore accumulated by neighbouring Southern GOK (jointly controlled by Smart and Evraz) and ArcelorMittal Kryviy Rih. The Soviet Union, the German Democratic Republic, Czechoslovakia, Hungary, and Romania began construction of KGOKOR in 1985, but froze the project in the early 1990s, so it is now 70% complete. About US$1.65bn of the projected US$2.4bn has been invested in the construction so far. In order to privatise KGOKOR,
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Iron ore 2010
Ukraine has to pay off debt to other countries-participants of the project. Of US$517m debt, Romania accounts for 68%, Slovakia for 22%, Germany for 9%, and Bulgaria for 1%. ArcelorMittal, Evraz, and the tandem of Smart and Metinvest are the most likely candidates to acquire KGOKOR ArcelorMittal, Evraz, and the tandem of Smart and Metinvest are the most likely candidates to acquire KGOKOR as result of privatisation, given their strong capabilities to finance M&A, heavy political weight, and interest in processing oxidized ore in the same location. We believe that, as these business groups are already 100%- or higher self-sufficient in iron ore and will be followed by the rest of Ukrainian steelmakers by the end of KGOKORs construction, KGOKOR will become 100%-oriented towards exports.
Well-developed transportation infrastructure and access to the Black Sea allow Ukrainian companies not only to dominate in Central and Eastern Europe, but also compete for market share in the Middle East and China
Favourable geographical location and logistics

Ukraines geographical location, well-developed rail links to its western border, as well as welldeveloped rail and river transportation links to the Black Sea ports, provide Ukrainian mining businesses with a freight-cost advantage over their more distant competitors from Russia, Brazil, and Australia in supplying merchant iron ore products to the markets of Europe and the Middle East. This predisposes Ukrainian iron ore exports towards these markets, with the major shipments traditionally going to Austria, Slovakia, the Czech Republic, Poland, Serbia, and Turkey. Overall, Central and Eastern Europe accounted for 60-76% of the total exports of Ukrainian iron ore from 2007-10. Chart 13. Ukrainian iron ore exports by key exporters
Chart 12. Ukrainian iron ore exports by key destinations

Notes: CEE - Central and Eastern Europe
CEE 4.0 China Turkey Other
Ferrexpo
4.0 3.5 3.0 2.5 2.0 1.5
Metinvest
Southern GOK
Minerfin
Kryviy Rih Iron Ore Combine
Other
(mln tonnes)
3.5
3.0 2.5
(mln tonnes)
2.0
1.5 1.0 0.5 0.0 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10
1.0
0.5 0.0 Jan-07 Jun-07 Nov-07 Apr-08 Sep-08 Feb-09 Jul-09 Dec-09 May-10
However, proximity to the Black Sea also provides Ukrainian miners an opportunity for export to the fast-growing Chinese market, where they are able to compete in transportation costs with more distant Brazilian and North American producers. Chinas share of the total exports of Ukrainian iron ore increased from 16% in 2007 to 38% in 9M10. Table 3. Shipping distance and freight rates to main China ports
Sea port of departure Company Country Distance (nautical Sailing days miles) 3,600 8,000 8,600 11,000 11,500 10 n/d 30 33 n/d Freight rate2 (US$/tonne) 10 n/d 28 25 36
Port Hedland Saldanha Yuzhny Tubarao Seven Islands 1
BHP Billiton Kumba Ferrexpo Vale Rio Tinto
Australia S. Africa Ukraine Brazil Canada
Notes: 1 - via the Panama Canal; 2- as of September 2010 Source: BHP, Ferrexpo, ICU estimates
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Favourable market environment

World demand for iron ore correlates closely with steel demand, driven by global economic growth. Unlike steel demand, however, the demand for iron ore is additionally affected by the oligopolistic nature of the global iron ore market, which is concentrated around few regions, with China being the largest one. The iron ore oligopoly enables Ukrainian iron ore producers to have the highest profit margins in the steelmaking industry. Chinas urbanisation and industrialisation is the key driver of the global iron ore demand and is also a good opportunity for the expansion of Ukrainian iron ore exports.
Iron ore and steel demand

The demand for steel and demand for iron ore have a common base Similar to steel prices, world iron ore prices are substantially driven by the demand for steel. Steel demand, in turn, depends to a considerable degree on the heavy machinery and construction sectors, which have accounted for 15% and 50% of the world steel consumption, respectively, in 2008-10E. Consequently, both iron ore and steel prices are closely related to the availability of finance for governments and businesses to implement industry, infrastructure, and real estate projects. Chart 14. Major trade flows of iron ore in 2009
CIS (149/32) Europe (28/-96) China (258/-629) JKT (0/-160)
India (204/114)
S. America (336/276)
Australia (371/365)
Notes: 1) Data in brackets (the regions iron ore production/the regions iron ore net exports/- net imports); 2) Data under trade flow arrows days of seaborne transportation, average estimated freight rates per t of iron ore product as of September 2010; 3) For CIS, we use estimated days of seaborne transportation from Black Sea ports; 4) JKT Japan, S.Korea and Taiwan; 5) Data over trade flow arrows iron ore shipments in 2009, mln tonnes. Source: BHP Billiton, CRU, ICU estimates
however, iron ore However, the global demand for iron ore is different from the demand for steel in that the companies have stronger bargaining power of iron ore companies is stronger than that of their steelmaking bargaining power than customers, mainly due to regional imbalances in iron ore supply and demand, as well as steelmakers higher concentration of the iron ore industry compared to the steel industry.
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Iron ore 2010
Extra-regional exports of iron ore exceed steel exports by 2.7-3.0x, and, unlike steel exports, are highly concentrated in Southeast Asia and Europe
Several key steelmaking regions, China, Japan, South Korea, and the EU, are in shortage of iron ore and depend on its imports from Australia, Brazil, India, and the CIS, which have an iron ore overcapacity. As the world key steelmaking regions need to import high volumes of iron ore from overseas, seaborne trade dominates in the global extra-regional exports of iron ore, which accounted for 79% of the world iron ore trade in 2008. On the other hand, steel production is more oriented towards intraregional consumption, with 60% of the world steel trade volumes relating to extra-regional exports in 2008.
Chart 15. Major extra-regional trade flows of iron ore versus steel in 2008 (mln tonnes)
50mln tonnes of iron ore 50mln tonnes of steel
Source: World Steel Association
The top ten steelmakers produce 23% of the world steel output, while the top three iron ore companies control 73% of the seaborne trade of iron ore
In 2009, the top ten steelmakers share was 44% in Chinas steel output, and slightly less than 23% in the total world steel output, while the top three iron ore companies produced 33% of the world total output of iron ore and exported 73% of the world total seaborne trade volumes of iron ore. As a result of the higher bargaining power of iron ore companies, the growth in iron ore prices tended to be more prolonged and outpaced the growth in steel prices more often during demand hikes in 2007-10. Furthermore, iron ore prices have an additional inflationary effect on steel prices, as steelmakers strive to pass on increasing costs to their consumers. Chart 16. Change in iron ore and steel prices to the basis at March 2006
China iron-ore fines (spot) 300.0
250.0
BHP iron-ore fines (contract)
CIS export billets
US import rebar
(%)
200.0
150.0
100.0
50.0
0.0
-50.0 Mar-06
Source: Bloomberg
Sep-06
Mar-07
Sep-07
Mar-08
Sep-08
Mar-09
Sep-09
Mar-10
Sep-10
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Iron ore 2010
China drives the global demand for iron ore

The world consumption Ukrainian iron ore miners will capitalise on the buoyant global demand for iron ore, as the of iron ore will grow in Commodity Research Unit (CRU) expects world consumption of iron ore to grow strongly in 2010-13, mainly due to 2010-13, to around 2.5bln tonnes. The key region driving this increase will be China, which emerging markets, led by is estimated to account for 64% of the total world consumption in 2010. BRIC and the Middle East Chart 17. World consumption of iron ore by country or region
China
3.0 2.5
Rest of Asia
Europe
CIS
N. America
S. America
Middle East
Africa
Oceania*
(bln tonnes)
2.0 1.5
1.0 0.5
0.0
2005 2006 2007 2008 2009 2010E 2011E 2012E 2013E 2014E 2015E
Note: Oceania consists of Australia, New Zealand and the Pacific Island nations. Source: CRU
Chinese consumption of iron ore is estimated by the CRU to grow at 15% CAGR during 2010-15, as the countrys industrialisation and urbanisation is underway, requiring further growth in steelmaking capacity. India, mainly responsible for iron ore consumption growth in the rest of Asia, is on the same track of economic development, targeting a 35% growth in steelmaking capacity from 2010 to 2012. The Middle Eastern countries are poised to demonstrate the fastest growth in iron ore consumption, driven by more than US$1trn worth of industry and infrastructure projects. Rising iron ore demand will be further supported by the emerging-industry economies of South America, led by Brazil, and of CIS, led by Russia. Table 4. World consumption of iron ore by country or region, 2005-15 (mln tonnes)
Country/region 2005 2006 2007 2008 2009 CAGR 2005-09 (%) 16.4 0.6 -7.7 -2.9 -12.0 -9.4 6.7 -6.6 -8.7 7.1 2010E 2011E 2012E 2013E 2014E 2015E CAGR 2010-15 (%) 1.8 6.2 3.3 5.4 5.4 6.9 7.8 6.6 4.1 3.2
China Rest of Asia Europe CIS North America South America Middle East Africa Oceania1 Total
687.7 251.5 168.0 136.8 86.6 72.2 20.0 23.0 9.2 1,455.0
897.7 261.4 175.4 145.2 87.1 70.1 19.7 22.9 9.6 1,689.1
1,069.9 289.0 177.7 148.6 88.3 72.7 22.3 21.2 9.5 1,899.2
1,248.9 294.1 167.4 137.7 84.1 69.9 23.1 19.0 9.0 2,053.2
1,261.9 257.4 121.7 121.4 51.9 48.7 25.9 17.5 6.4 1,912.8
1,399.7 301.0 149.1 131.3 67.8 61.7 32.2 20.0 8.9 2,171.7
1,511.1 323.5 156.7 145.3 74.6 70.3 37.2 22.5 9.3 2,350.5
1,556.9 354.5 162.5 157.2 80.3 75.7 40.6 23.7 9.8 2,461.2
1,579.5 374.4 169.0 162.0 83.6 79.7 42.8 25.0 10.3 2,526.3
1,504.3 392.4 173.5 166.8 85.5 83.4 44.0 26.0 10.8 2,486.7
1,529.0 407.1 175.2 170.6 88.3 86.1 47.0 27.5 10.9 2,541.7
Notes: 1- Oceania consists of Australia, New Zealand and the Pacific Island nations. Source: CRU
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Iron ore 2010
High volumes of seaborne trade of iron ore are mainly supported by flows from Australia and Brazil to the EU and Southeast Asia
The growing global consumption of iron ore will in turn further boost volumes of seaborne trade of iron ore due to inherent regional supply-demand imbalances, with the key one developing in the East Asia, where rising steelmaking capacities will become increasingly insufficient in iron ore resources. The regions leader, China, will be able to satisfy only 45% of its steel production needs in 2010 with its local iron ore supplies. Despite being one of the countries with the highest iron ore reserves in the world (62.4bln tonnes), China is still unable to effectively ramp up its domestic iron ore production, since Chinese iron ore has a low iron content (20-30%) and is costly to mine and process. Hence, Metalytics expects Chinas domestic iron ore production to level off in 2011-12, while iron ore imports will account for as high as two-thirds of the countrys total iron ore consumption. Moreover, the CRU predicts that Chinese iron ore production will slip down at 2.5% CAGR in 2012-15, while Chinese steelmakers will increasingly rely on Australian and Brazilian iron ore.
Chart 18. Chinas consumption of iron ore

Imports 0.9 Domestic
Chart 19. Chinas sources of iron ore

China
1.2
Australia Brazil India
S.Africa
CIS
Oth. Asia
Oth. S.America
Others
(bln tonnes)
0.8
(bln tonnes)
1.0 0.8 0.6 0.4 0.2
0.7
0.6 0.5 0.4 0.3 0.2 0.1 0.0 1992 1997 2002 2007 2012
0.0 2004 2005 2006 2007 2008 2009 2010E
Source: Metalytics
Source: Metalytics
Chinas dependence on imported iron ore will increase in the future
The growing iron ore consumption in ore-sufficient South America, the CIS, and particularly India, which accounted for 20% of iron exports to China in 2009, will add tension to the Southeast Asian iron ore market. For Ukrainian iron ore miners, the Southeast Asian market, with its significant capacity, growth potential, and relative scarcity of high-quality ore, will therefore play the key role in the region in building up sales volumes, despite its remoteness.
Pricing: oligopoly benefits

Ukrainian iron ore producers benefit from the global iron ore oligopoly While Ukrainian iron ore companies do not play any role in setting global iron ore prices, they capitalise on the oligopolistic nature of both the domestic and the international iron ore markets, which puts additional pressure on iron ore prices.
The Big Three

In the foreseeable period of 2011-15, the world seaborne market for iron ore will continue to be controlled by the three largest international mining companies: Vale, BHP Billiton, and Rio Tinto (the Big Three), which accounted for 73% of the seaborne ore trade volume and for 30% of the world iron ore production in 2009 and also dominate the world iron ore industry in capacity expansion projects. The high bargaining power of the Big Three allowed them to raise global iron ore prices 100%, to $143-150 a tonne, in April 2010. On the opposite side of negotiations, Asian steelmakers have so far failed to provide strong arguments in the negotiation process, mainly due to the high fragmentation of the steel industry in China and Chinas remaining high dependence on iron ore imports.
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Iron ore 2010
Chart 20. Key world iron ore exporters

Vale Rio Tinto BHP Billiton LKAB CSN Kumba FMG SNIM Indian Exporters Others 1.2 1.0
Chart 21. Key world seaborne trade off-taker countries/regions

1.2
1.0 0.8 0.6 0.4 0.2 0.0 China Japan EU-16 S.Korea Taiwan Others
(bln tonnes)
(bln tonnes)
0.8
0.6 0.4 0.2 0.0 2004 2005 2006 2007 2008 2009 2010E
2004
2005
2006
2007
2008
2009
2010E
Source: Metalytics
Source: Metalytics
Benchmark system
Benchmark prices agreed upon among the Big Three have a critical influence on world prices for iron ore The majority of the world seaborne iron ore trade has traditionally been sold through longterm contracts, also called framework agreements, with tonnages and prices negotiated between the Big Three and their main steelmaking customers. The latter have been dominated by the European and Southeast Asian steelmakers. In Southeast Asia, Chinese companies now lead the negotiations, having replaced Japanese companies. A price for fines is usually settled first, and then premiums for lumps and pellets are negotiated, depending on supply-demand balances. Once agreed upon by one market, iron-ore price movements flow to other markets, and then to less significant markets; hence they are called benchmark prices for the whole industry. A smaller portion of the world seaborne iron ore trade is represented by the spot market, where sales are individually negotiated, and one-time contracts are made directly between a buyer and a seller. The spot market is dominated by Indian and Australian sales to China, which is in fact the key driver for spot prices, due to its significant demand for iron ore imports. The rapid growth in this demand has caused international spot prices to be generally higher than benchmark prices in the last three years.
Pricing mechanism
Ukrainian iron ore producers closely follow international benchmark price trends in setting prices for both domestic sales and exports Iron ore producers other than the Big Three usually set their prices by adjusting the benchmarks for value-in-use and freight costs in a calculation process called a netback. Value-in-use is a term used to describe the adjustment made to benchmark prices to account for differences in chemical structure between a particular iron ore product and its relevant benchmark, as these differences lead to differing costs at steel mills. To account for different Fe and free moisture content from different mines, iron ore is priced in US cents per dry metric tonne unit, or US/dmtu, so, to change a price in US/dmtu to US$/tonne, one can just multiply US/dmtu by the relevant Fe content fraction. Ukrainian iron ore producers also follow this mechanism in agreeing upon their prices for both domestic sales and exports. On the domestic market, iron ore prices for Ukrainian customers are set much in accordance with the trends of the international benchmarks, mainly due to the oligopoly similar to the one on the international market, as Metinvest dominates the Ukrainian market, with a ~60-70% share. For export destinations, the netback mechanism is also actively used by Ukrainian companies in applying their specific adjustments. Ferrexpo, for instance, applies a premium over the Vale FOB Tubarao benchmark price for its European customers due to its ability to provide pellets on a just-intime basis in smaller continuous lot sizes.
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Iron ore 2010
Chart 22. Spot prices for iron ore products in China

China fines (63.5% Fe)
Indian fines to China (63% Fe) 400.0 350.0 300.0 250.0 200.0 150.0 100.0 50.0 0.0 Mar-05 Dec-05 Sep-06 Jun-07 Mar-08 Dec-08 Sep-09 Jun-10
Chart 23. Key global benchmark contract prices for iron ore
Australian lump to Japan (64% Fe) BHP fines (63% Fe) 400.0 350.0 300.0 250.0 200.0 150.0 100.0 50.0 0.0 Mar-05 Nov-05 Jul-06 Mar-07 Nov-07 Jul-08 Mar-09 Nov-09 Jul-10 Vale pellets (67% Fe)
China Pellet (66% Fe)

China concentrate (66% Fe)
(US$c/dmtu)
(US$c/dmtu)
Source: Bloomberg
Source: Bloomberg
Transition of the benchmark system

The financial crisis prompted the convergence of the benchmarking and the spot-price systems The gap between spot and benchmark prices for iron ore has ultimately led to changes in the benchmark system. Until the recent economic downturn, benchmark prices of iron ore were determined at four benchmark locations on an annual basis, usually in April. However, during the downturn of 2008-09, when spot prices collapsed by 55% and benchmark prices dropped by 33-45%, this system stopped functioning effectively, and reliance on spot prices increased dramatically. As a result, the largest iron ore producers have agreed to use quarterly pricing, effective from April 2010. The new methodology does not appear to have stabilised yet, as some steelmakers are calling for a return to the annual pricing method, while, on the other hand, some miners led by BHP Billiton even insist on transitioning to the monthly basis. We believe, however, that the return to the annual pricing is not likely in the nearest term.
Competitive environment
On their move to new markets, Ukrainian iron ore companies face increasing competition On their way to expanding sales to the markets of Western Europe and Southeast Asia, Ukrainian iron ore companies face increasing competition not only from the Big Three oremining companies, but also from other mid-tier companies located in Europe, the CIS, and Australia. While long-standing relations with customers and technical compatibility with their steel mills provide little or no competition against Ukrainian companies in Central and Eastern Europe and Turkey, additional factors, such as price, quality, range of products, reliability, and transportation costs significantly affect the competitiveness of Ukrainian companies for other export destinations. The market share of Russian miners in Ukraine may substantially increase due to a changing ownership structure in the IUD and Zaporizhstal Russian iron ore producers are also main competitors of Ukrainian companies on the Ukrainian market, particularly Mikhailovsky GOK and Lebedinsky GOK, which are controlled by Metalloinvest and are Russian plants located closest to the Ukrainian border. Amounting nearly to an average of 20% in 2009 and 8M10, the market share of Russian iron ore miners is not stable in Ukraine, and used to rise during aggravating price disputes between Metinvest and the IUD, and fall after these disputes are settled. However, it may significantly increase in case some of Russian steelmaking groups takes over control stakes in key Ukrainian buyers of iron ore, the IUD and Zaporizhstal, after these stakes have been acquired by Russian state bank, Vneshekonombank.
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Iron ore 2010
Table 5. Key international competitors of Ukrainian iron ore producers

Company Share of iron ore export market in 2009 (%) 26 14 24 4 4 1 1 <1 Country of Affiliates - key competitors with incorporation Ukrainian producers Brazil Australia Australia Australia South Africa Sweden Russia Tubarao, Carajas, Fabrica Samarco1 BHP Billiton Rio Tinto Fortescue Metal Group Kumba Luossavaara Kiirunavaara (LKAB) Metalloinvest NLMK Samarco1 Newman, Yandi, Yarrie, Area C Iron Ore Company of Canada Hamersley, Robe River Cloudbreak, Christmas Creek Sishen, Thabazimbi, Kolomela Kiruna, Malmberget Stoilensky GOK Markets of competition with Ukrainian producers
Vale
Western Europe, South East Asia Western Europe, South East Asia Western Europe, South East Asia South East Asia Western Europe South East Asia South East Asia Western Europe, South East Asia Western Europe Ukraine, Central Europe, Western Europe, South East Asia Ukraine
Russia Lebedinsky GOK, Mikhailovsky GOK
Notes: 1 - Samarco is jointly controlled by Vale and BHP Billiton. Sources: Ferrexpo, Metinvest, Metalytics, CRU, ICU estimates
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Iron ore 2010
Production costs pose key concerns

For the most value-added iron ore products, pellets, Ukrainian producers are positioned close to the middle of the global rating of production cash costs. Furthermore, if one adds transportation costs to production costs, Ukrainian miners have a clear cost advantage over their overseas competitors in the markets of Ukraine, Europe, and the Middle East, and are able to compete with their North and South American competitors on the markets of Southeast Asia. In terms of cost competition, the main weaknesses of Ukrainian mining companieshigh energy consumption and low labour productivity compared to non-CIS competitorsare partly compensated for by lower prices for electricity and fuel, as well as extremely low costs of labour. Ukrainian miners have an opportunity to improve their cost competitiveness and strengthen their market position by implementing efficiency improvement programs, especially as because energy prices in Ukraine are likely to grow, getting closer to international averages in the next five years.
Chart 24. FOB cash costs1 for pellets in 2010

Ferrexpo 70.0 60.0 50.0 40.0 Metinvest Metalloinvest Vale LKAB Other Rio Tinto 65.6
(US$/dry tonne)
43.4
43.6 45.0
66.1
46.8
50.2
50.5
50.9
52.6
53.3
54.4
54.6
56.0
57.0
59.5
30.0 20.0 10.0 0.0 Lebedinsky GOK Carajas SSGPO Mikhai- Tubarao lovsky Poltava GOK Mont Wright Middleback Fabrica Carol Lake Central GOK Kiruna Northern MalmGOK berget Northshore Savage River
Note: 1- Including delivery costs to frontier/sea port. Source: Ferrexpo, Metalytics
Chart 25. CFR China cash costs for pellets in 2010

FOB 160.0 140.0 Sea Freight
(US$/dry tonne)
Ferrexpo (Ukraine) Metinvest (Ukraine)
120.0 100.0 80.0 60.0

40.0 20.0 0.0
Middleback Carajas
LebeTubarao dinsky GOK
Poltava GOK
Fabrica
Mikhailovsky
Central GOK
Savage River
Northern GOK
SSGPO
Kiruna
Mont Wright
Malmberget
Carol Lake
Northshore
Source: Ferrexpo, Metalytics
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Iron ore 2010
Inferior quality of iron ore deposits implies costlier mining

The average iron content of Ukrainian iron ore deposits is 30% Ukrainian iron ore deposits are characterised by uneven quality distribution, and the majority of reserves contain so-called lean ores, the iron content of which do not exceed 34%, while Brazilian, North American, South African, and Australian miners have deposits with around 60% of iron content. Ukrainian lean ores, therefore, require further iron concentration in order to make them usable for steelmaking. On the other hand, Ukrainian deposits containing ores with iron content over 50% require underground mining, which in many cases requires water drainage and gas offtake, thus also rendering them more costly than open-pit mining in the leading ore-mining countries. Stripping ratios on Ukrainian iron-ore mines are on average 3-4x higher than In Australia, Brazil, and Canada The 125-plus-year history of iron ore extraction in Ukraine has left todays domestic miners with less economically profitable deposits, with mining depth often reaching 350 meters for open pits and 1,300 meters for underground mines. Hence, Ukrainian iron ore stripping ratios, which refer to the amount of overburden removed per tonne of iron ore extracted, are on average by 3-4x higher than corresponding stripping ratios in Australia, Brazil, Canada, and the US, thus implying a larger consumption of labour, energy, and other resources. At currently exploited deposits, as companies deepen and widen the pits in order to increase their useful lives, the stripping ratios should further increase.
Energy inefficiency creates the main risks for costs

Energy costs account for 45-55% of production costs of Ukrainian sinter and pellets The inferior quality of iron ore deposits, obsolete equipment, and severe winters make mining and processing of iron ore, particularly the production of sinter and pellets, much more energy-intensive for Ukrainian companies compared to non-CIS competitors. This relative energy inefficiency is partly compensated for by relatively cheap prices for electricity and fuel available to Ukrainian companies. Nevertheless, energy costs account for 45-55% in production costs of Ukrainian sinter and pellets. At the same time, energy prices are mostly non-controllable by Ukrainian iron ore producers, and pose one of the biggest threats to producers competitiveness. Chart 26. Structure of Ferrexpo production costs of in 2009 (%)
Note: 2009 cash costs of Ferrexpo were US$37.80 per t of pellets
Chart 27. Energy use by mining companies in 2009

Notes: (1) - CNR - Cliff Natural Resources, 2007 usage ratios were taken; (2) Canadian - Canadian iron ore mining companies on average, 2008 usage ratios were taken
Natural gas Purchased electricity Fuel oil Diesel & distillate Coal & coke Other
Maintenance 8.9 Spare parts 8.0
Royalties 2.0 Electricity 26.1
1.6
1.4 1.2 1.0
(GJ/tonne)
Labor 13.0 Natural gas 12.0 Other materials 10.0 Grinding media 10.0
0.8 0.6 0.4 0.2
Diesel fuel 10.0
0.0 Ferrexpo Metalloinvest CNR (1) LKAB Canadian (2) BHP
Source: Ferrexpo
Source: Company data, Ministry of Industrial Policy of Ukraine, Natural Resources Canada, ICU estimates
27
December 2010
Sector Primer
Iron ore 2010
Natural gas The consumption of natural gas in Ukrainian production of sinter and pellets is high compared to main competitors Natural gas is used by Ukrainian iron ore companies primarily in the agglomeration process for making sinter and pellets. A distinctive feature of agglomerated ore production at Ukrainian plants is the intensive consumption of natural gas; on average, Ukrainian pelletmakers, Ferrexpo and Metinvest, use 16-18m of natural gas per tonne of pellets, versus zero used by Australian, Swedish and North American pellet-makers, who are focused on using electricity and fuel. While natural gas prices for Ukrainian industrial consumers are set by the state-owned Naftogaz and regulated by the Ukrainian Cabinet of Ministers, their level is mainly affected by Gazprom, the Russian monopoly supplying natural gas to Ukraine. In the last five years, Gazprom has been pursuing a policy of converging natural gas prices for Ukraine with prices for European countries. Though in 2010, Ukraine bargained for a 30% discount to the previous pricing scheme in exchange for allowing stationing the Russian Black Sea Fleet in the Crimea, there is no guarantee that this discount will remain in the future. According to the current pricing scheme, natural gas prices for Ukraine follow the trend in international oil prices. Ukrainian pellet-makers Ferrexpo and Metinvest are capable of substantially decreasing their natural gas consumption by modernising their equipment. Ferrexpo, in particular, plans to cut its usage of natural gas by around 20% through installing a heat recovery system in its pelletising facilities. Chart 28. Natural gas prices for industry Chart 29. Usage of natural gas by iron ore companies in 2009
Notes: (1) - CNR - Cliff Natural Resources, 2007 usage ratios were taken; (2) at BHP, pellets are produced at Samarco only (3) Canadian - Canadian iron ore mining companies on average, 2008 usage ratios were taken
2005 400.0 350.0 2006 2007 2008 20.0
3
(m3/t)
18.0 16.3
(US$/1000m3)
15.0
14.3 13.1
300.0
250.0 200.0 150.0 100.0 50.0 5.0 10.0
9.1
0.0 0.0 Australia Russia Ukraine Canada United States Northern Europe 0.0 Metinvest Ferrexpo Vale Metallo- CNR (1) invest
0.0
0.0 LKAB
BHP (2) Canadian (3)
Source: US Energy Information Administration, ABARE, ICU estimates
Electricity As a result of liberalisation, electricity tariffs for Ukrainian industrial consumers should rise in the next three-to-five years The largest share of electricity is used by Ukrainian companies for grinding and crushing iron ore during the beneficiation. At the same time, Australian and Brazilian competitors, not needing to increase iron content of their ores, are able to save electricity at least at this stage. Furthermore, the Big Three are able to consume part of needed electricity from inhouse power stations at cost. Electricity tariffs charged to Ukrainian iron ore producers are currently regulated by the National Energy Regulation Commission, which sets tariffs for both industrial and household consumers. Ukraines reliance on nuclear and hydro energy, as well as the states policy of industry support, provides industrial consumers with electricity prices cheaper than those in Europe, the US, and Brazil. However, the Ukrainian government plans to liberalise electricity tariffs, making them likely to rise in the next threeto-five years. We expect that the liberalisation mechanism will make for a gradual increase in electricity tariffs.
28
December 2010
Sector Primer
Iron ore 2010
Ukrainian iron ore companies are also able to achieve savings on electricity by integrating up-stream into power generation companies. The 75%-shareholder of Metinvest, System Capital Management, also controls DTEK, which supplies to Metinvest approximately 68% of Metinvests electricity requirements. The majority shareholder of Ferrexpo, Kostyantin Zhevago, also has an ownership interest in Komsomolsk Cogeneration Company, which has completed a definitive feasibility study for construction of electricity generation facilities near the Yeristovo deposit. Provisionally scheduled to be constructed in 2010-14, these facilities may supply electricity to Ferrexpo upon the project completion. However, prices charged to iron ore miners by affiliated gencos are subject to transfer-pricing policies of their parent companies and regulations of the state, which sets the minimum tariffs for both industrial and household customers. The regulations may change upon tariffs liberalisation. Chart 30. Electricity prices for Industry Chart 31. Usage of purchased electricity by iron ore companies in 2009
Notes: (1) - CNR - Cliff Natural Resources, 2007 usage ratios were taken; (2) Canadian - Canadian iron ore mining companies on average, 2008 usage ratios were taken
2005 0.14 0.12 0.10 2006 2007 2008 200.0
(kWh/t)
184.6 166.2
(US$/kWh)
150.0
144.0
120.9 0.08 0.06

0.04 50.0 0.02 0.00 Russia Australia Canada Ukraine US North. Europe Brazil 0.0 Ferrexpo Metalloinvest CNR (1) LKAB Canadian (2) BHP 26.5 6.4 100.0
Fuel Fuel prices for Ukrainian industrial consumers are 15-40% cheaper than for Brazilian, Australian, and European companies Fuel is used by Ukrainian iron ore producers mainly to run mining equipment and transport iron ore and overburden. More complex mining conditions reflected in higher stripping ratios force Ukrainian companies to consume more fuel than their Australian and Brazilian competitors. However, the proximity of a large oil supplier, Russia, and low excise taxes, make fuel prices for Ukrainian companies 15-40% cheaper than in Brazil, Australia, and Europe. Supplied by Ukrainian private oil companies, fuel is priced based on market factors, and follows trends in international oil prices.
29
December 2010
Sector Primer
Iron ore 2010
Chart 32. Diesel oil prices for commercial use

2005 1.75 1.50 1.25 1.00 0.75 2006 2007 2008
Chart 33. Usage of fuel by iron ore companies in 2009

(liters/t)
6.0 5.53 5.20 5.0 4.13
(US$/litre)
4.0
3.0 2.0
3.61
3.48 2.63
0.50 0.25 0.00 Russia Ukraine US Brazil Canada Australia North. Europe
1.0 0.0 Ferrexpo Metalloinvest CNR (1) LKAB Canadian (2) BHP
Notes: (1) CNR - Cliff Natural Resources, 2007 usage ratios were taken; (2) Canadian - Canadian iron ore mining companies on average, 2008 usage ratios were taken; (3) for non-CIS companies, usage of fuel includes usage of diesel fuel, fuel oil, distillate and gasoline (4) for Ferrexpo, usage of fuel means usage of diesel fuel only. Source: Company data, Ministry of Industrial Policy of Ukraine, Natural Resources Canada, ICU estimates
Labour structure needs further optimisation

Ukrainian iron ore producers generally have an excessive labour force, but low labour costs per employee Ukrainian production of iron ore remains inefficient in terms of labour use compared to the world industry leaders and Western companies, as domestic miners produce 5-20x less per employee than their non-CIS competitors. However, the extremely low cost of labour per employee of Ukrainian companies, being 3-10x cheaper than for non-CIS competitors, partially compensates for that inefficiency. As a result, while Ukrainian miners per-tonne labour costs are higher than for Australian companies, there is still a cost advantage over North American, Brazilian, and West European producers. The optimisation of the labour structure may take a long time, due to political and social issues One of the main reasons for such low labour productivity is the large number of support personnel inherited from the times of the state ownership. The majority of Ukrainian iron ore companies plan to reduce their workforces through outsourcing ancillary services and changing their organisational structure; however, they still have to introduce these changes gradually due to statutory, political, and social constraints. Therefore, labour productivity is one of the areas where Ukrainian iron ore producers can achieve cost savings, though more likely in the long term. Table 6. Labour productivity and labour costs of iron ore producers for the financial year 2009
Company Net revenue per Production per Labour cost per employee (US$ 000) employee (000' tonnes) employee (US$ 000) 3087.9 324.2 1107.5 594.5 77.7 87.7 88.3 35.2 4.7 15.1 10.2 1.0 1.4 1.7 101.2 86.0 60.8 32.3 10.5 9.6 9.3 Labor cost per tonne (US$) 2.88 18.35 3.17 5.56 4.03 4.72 6.82
BHP LKAB Rio Tinto Vale Ferrexpo Metinvest Metalloinvest

Sources: Company data, ICU estimates
30
December 2010
Sector Primer
Iron ore 2010
Modernisation is time-consuming and capital-intensive

Development projects of the Ukrainian iron ore producers are complex, require substantial capex, and take a long time for implementation The leading Ukrainian iron ore miners are planning development projects that are aimed to increase production capacity, enhance efficiency and improve quality of iron ore products. These projects are commonly complex in terms of their overall scope, technology, engineering, procurement, construction, and commissioning requirements. The complexity and lengthy time span of these projects also increases the likelihood of completion delays and cost overruns. As a consequence, Ukrainian companies in most cases find their operating cash flows insufficient to finance their capex, and need to raise additional financing through debt or equity. Table 7. Highlights of the main Ukrainian iron ore development projects
Parent group/operating asset METINVEST Northern GOK Construction of new beneficiation facilities and a new 21% increase in pellet-making capacity to 14.3mtpa, pellet plant Lurgi 278-B, modernisation of existing improved safety and environmental standards pellet plant OK 306-1 Construction of two flotation modules improved output quality 520.7 2012 Project Project aim Capex required (US$m) Timeline
Ingulets GOK FERREXPO Poltava GOK Poltava GOK Yeristovo GOK
105.1
2012
Extension of the current pit Extending the useful life of the pit to 2038, increasing the mining capacity by 25% to 35mtpa Upgrade of the existing concentrator facilities Increase of 65% Fe pellets share from 50% to 100% in the total sales Development of a new pit, construction of new Achieving new production capacity of 28mtpa of iron beneficiation facilities and a pellet plant ore, 10mtpa of concentrate and 7.5mtpa of pellets
168.0
1Q13
212.0 End of 2014 1,500.0 2015
DONETSKSTAL1 Vasinovsky GOK
Development of an underground mine Achieving new production capacity of 20mtpa of iron ore
1,500.0
2017
Notes: 1- Donetskstal is in process of obtaining the appropriate mining license, capex figure is an approximate estimate, while the officially approved capex program is still pending. Sources: Ferrexpo, Metinvest, Rusmet
Cpml kj
Compared to large Australian and Brazilian miners, investment projects of Ukrainian iron ore producers are more capital-intensive per tonne of output increase due to the larger portion of investments needed to upgrade/install processing equipment, as well as due to the smaller scope of mining capacity expansion. Chart 34. Capex per tonne of iron ore on iron ore projects announced in 2009-10
250.0
200.0
(US$/tonne)
209.8 166.7
234.1
150.0 108.1
125.5 81.3
100.0
69.1 50.0 0.0
Rio Tinto
Source: Company data
Fortesque
BHP
Vale
Ferrexpo
Metinvest
Metalloinvest
31
December 2010
Sector Primer
Iron ore 2010
Appendixes
Appendix 1. SWOT analysis
Table 8. SWOT analysis of Ukrainian iron-ore sector
STRENGTHS Favourable geographical location and developed infrastructure: Proximity to the markets of Europe and the Middle East, as well as developed railway and river transportation routes, provide Ukrainian producers with competitive advantage over its international rivals in freight cost component in these regions. Large underexploited reserves: Ukrainian companies have an access to mineral resources of at least 30bnt of iron ore, being among the largest iron ore resources in the world. Oligopoly on the domestic and international markets of iron ore: Allows for high bargaining power and provides domestic iron ore producers with the highest profit margins in the Ukrainian steel industry. Relatively low electricity prices in Ukraine compared to US, European and Brazilian competitors. Relatively low diesel fuel prices in Ukraine compared to non-CIS competitors. Low labour costs compared to non-CIS competitors. OPPORTUNITIES Recovery of the global economy and the resulting growth in the world demand for steel and steelmaking inputs, including iron ore products of Ukrainian companies. Increasing demand for iron ore in Southeast Asia: Ukrainian iron ore producers may benefit from growing steel output in Southeast Asia, particularly China, which should increase iron ore imports and boost overall demand for iron ore. Increasing presence on the markets of Western Europe and Southeast Asia. Increasing sales volumes through production capacity expansion, as a result of implementing projects on introduction of new mining sites and ore processing facilities. Improving cost efficiency through introduction of new energy-saving technologies. Optimisation of transportation costs, as Ukrainian companies may build up their own railway rolling stock and sea port facilities. Increasing labour productivity through optimisation of organizational structure is achievable in the long term. WEAKNESSES Inferior quality of iron-ore deposits: Lean ore deposits with less than 30% of iron content are dominating, complicated mining conditions imply stripping ratios 3-4 times higher than in Brazil, Australia, Canada, and the US. Energy inefficiency: Higher energy consumption compared to non-CIS competitors is caused by inferior quality of iron ore deposits, obsolete processing equipment and severe winters in the region. Low bargaining power in purchasing energy: Ukrainian companies heavily depend on supply from oligopoly market of electricity and fuel in Ukraine, as well as the monopoly of Gazprom in supplying natural gas to Ukraine. Low labour productivity due to inefficient organization structure is inherited from state ownership and is hard to change quickly due to statutory, social and political constraints. Low bargaining power in purchasing transportation services: Dependence on the monopoly of state-owned Ukrzaliznytsia to provide railway transportation services in Ukraine and volatile international freight rates in the international seaborne trade.
Source: Investment Capital Ukraine LLC.
THREATS Possible recurring recession may adversely affect global iron ore prices, thus also hitting profitability of Ukrainian iron ore producers. Rising energy prices: Rising natural gas prices charged by Gazprom to Ukraine, growth in electricity tariffs as a result of tariff liberalization, rising prices for diesel fuel on the back of growing international prices for oil. Increasing competition against Ukrainian companies on their way to expanding sales to Western Europe and South east Asia. Undermined ability to increase production capacity and upgrade equipment Large scope, complexity and long time span of development projects may cause completion delays and cost overruns. This may be aggravated by the inability of Ukrainian companies to raise additional financing. Appreciation of hryvnia versus US dollar may negatively impact Ukrainian companies cost competitiveness
32
December 2010
Sector Primer
Iron ore 2010
Appendix 2. Financial market exposure

Table 9. Ukrainian iron ore sector exposure to debt and equity markets
Parent group/Plant Parent control (%) -63.3 75.9 82.5 -97.3 -75.0 -50.0 -50.0 -99.3 Securities listed Eurobonds Shares Shares -Shares Shares -----Shares GDRs Shares Eurobonds Security exchange (US$m) 500.0 -----------650.0 --PFTS, RTS Ukraine PFTS, RTS Ukraine -LSE PFTS, RTS Ukraine -----PFTS, RTS Ukraine LSE PFTS Ticker Shares outstanding (mln) -SGOK UK, SGOK UZ CGOK UK, CGOK UZ -FXPO LN PGOK UK, PGOK UZ -----PGZK UK, PGZK UZ EVR LI SUBA UZ -2,304.1 1,171.8 -588.6 191.0 -----2,143.6 146.0 837.6 Market cap1 Free float (%) (US$m) -3,621.9 810.5 -3,442.0 1,060.2 ------15,378 -0.3 -0.5 0.5 -24.0 2.7 -----0.0
Metinvest Northern GOK Central GOK Ingulets GOK Ferrexpo Poltava GOK Minnerfin (Slovakia)2 Zaporizhzhia Iron Ore Combine2 Privat Krivorizhsky Iron Ore Combine3 Smart Southern GOK4 Evraz Sukhaya Balka
Notes: 1 - Market capitalisation as of 8 December 2010; 2 - Zaporizhzhia Iron Ore Combine is also 25%-controlled by Zaporizhstal; 3 - the remaining 50% stake in Kryviy Rih Iron Ore Combine is controlled by System Capital Management; 4 - another nearly 50% stake in Southern GOK controlled by Evraz. Sources: Bloomberg, Company data, PFTS, RTS Ukraine, ICU estimates
Appendix 3. Financial performance highlights

Table 10. Highlights of Ukrainian iron ore companies financial performance in 2009
US$m Revenues COGS Gross profit Metinvest1 5 1,825.0 n/d n/d Ingulets GOK2 562.7 276.8 286.0 Northern GOK2 753.5 428.4 325.0 Central GOK2 292.5 188.1 104.4 Ferrexpo1 648.7 341.1 307.6 South GOK2 273.2 198.2 75.0 ZIOC2 3 135.4 94.7 40.6 KrIOC2 4 144.6 93.4 51.2
Gross margin
EBITDA
n/d
811.0
51%
257.1
43%
331.0
36%
105.9
47%
138.1
27%
5.2
30%
36.0
35%
47.8
EBITDA margin
Operating profit Net income
44%
n/d n/d
46%
211.1 119.8
44%
258.7 160.0
36%
78.3 33.6
21%
105.4 71.0
2%
(8.0) (9.4)
27%
30.7 24.6
33%
39.1 25.8
Net margin
n/d
21%
21%
11%
11%
n/a
18%
18%
Notes: 1- According to IFRS; 2- According to Ukrainian national accounting standards; 3- Zaporizhzhia Iron Ore Combine; 4- Kryviy Rih Iron Ore Combine; 5 Metinvests financial performance highlights relate to the companys Iron Ore Division only Sources: Company data.
33
December 2010
Sector Primer
Iron ore 2010
Glossary
The following is the list of terms, phrases and abbreviations that are frequently used in this report. Agglomeration: a process used to turn iron ore fines/concentrate into larger, lumpy pieces with/without additives such as limestone, dolomite, etc. Two types of products made as a result of agglomeration process are sinter and pellets Basin of iron ore: A general region with an overall history of subsidence and thick sedimentary accumulation of iron ore Benchmark price: International seaborne traded iron ore benchmark price agreed between the major iron ore producers and specific West European or Asian steel producers for a given year Beneficiation: a process adopted for upgrading iron ore to increase its iron content and reduce gangue content BF: blast furnace BOF: basic oxygen furnace Cash costs: production costs ex-works, excluding non-cash items (e.g., depreciation and amortization), administrative and distribution costs CFR: Delivery including cost and freight Fe: Iron Flotation: A means of separating one type of mineral from another using reagents after milling, commonly separating sulphide minerals from silicate minerals FOB: free on board GKZ standards - classification system and estimation methods for reserves and resources established by the Former Soviet Union and last revised in 1981 GOK: Russian abbreviation standing for OMEP, ore mining and processing plant Grinding: Further reduction, after crushing, of size of mined rocks by mechanical action Iron ore concentrate: product of the flotation process with an enriched iron content Iron ore fines: Fine ground iron ore Iron ore pellet: Dried and hardened agglomerate of iron ore concentrate, whose physical properties are well suited for transportation and downstream processing in a blast furnace IUD the Industrial Union of Donbass JORC - Australasian Joint Ore Reserves Committee, which has issued the Australasian Code for Reporting of Exploration Results, Mineral Resources and Ore Reserves used by international mining companies LKAB: Luossavaara Kiirunavaara AB Lump iron ore: In mining, the term is given to naturally occurring high-grade iron ore mtpa: million tonnes per annum
34
December 2010
Sector Primer
Iron ore 2010
Netback: A calculation process used for adjusting the benchmark prices of iron ore for value-in-use and freight costs OMEP: Ore mining and processing plant, a common legal entity/business unit engaged in iron ore production in Ukraine Open pit: Surface mining in which the ore is extracted from a pit or quarry Overburden: Material of any nature, consolidated or unconsolidated, that overlies a deposit of useful materials Ore reserves: Ore reserves are sub-divided in order of increasing confidence into probable ore reserves and proved reserves. Probable reserves are the economically mineable part of indicated and, in some circumstances, measured resources of iron ore. Proved reserves are the economically mineable part of measured resources Pulverized coal injection (PCI) technology: involves injecting pulverized coal directly into a blast furnace through tuyeres, which reduces the consumption of coke and increases blast furnace productivity Mineral resources: A mineral resource is a concentration or occurrence of material of intrinsic economic interest in or on the earths crust (a deposit) in such a form, quality and quantity that there are reasonable prospects for eventual economic extraction. The location, quantity, grade, geological characteristics and continuity of a mineral resource are known, estimated or interpreted from specific geological evidence and knowledge. Mineral resources are further divided, in order of increasing geological confidence, into three categories: an inferred mineral resource (whose geological characteristics can be estimated with a low level of confidence), an indicated mineral resource (whose geological characteristics can be estimated with a reasonable level of confidence) and a measured mineral resource (whose geological characteristics can be estimated with a high level of confidence) Pellet plants: Processing facility that takes as its input iron concentrate and produces ironore pellets Pig iron: Crude iron obtained directly from the blast furnace and cast in molds Sinter: An aggregate which is normally produced from relatively coarser fine iron ore and other metallurgical return wastes used as an input/raw material in blast furnaces Spot price: The current price of a metal for immediate delivery Stripping ratio: The unit amount of overburden/waste that must be removed to gain access to a unit amount of ore or mineral material Value-in-use: A term used to describe the adjustment made to benchmark prices to account for differences in chemical structure between a particular iron ore product and its relevant benchmark, as these differences lead to differing costs at steel mills
35
December 2010
Sector Primer
Iron ore 2010
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Sector Primer
Iron ore 2010
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Sector Primer
Iron ore 2010
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Sector Primer
Iron ore 2010
Disclosures
ANALYST CERTIFICATION
This research publication has been prepared by the analyst(s), whose name(s) appear on the front page of this publication. The analyst(s) hereby certifies that the views expressed within this publication accurately reflect her/his own views about the subject financial instruments or issuers and no part of her/his compensation was, is, or will be directly or indirectly related to the inclusion of specific recommendations or views within this research publication.
39
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This research publication has been prepared by Investment Capital Ukraine solely for information purposes for its clients. It does not constitute an investment advice or an offer or solicitation for the purchase of sale of any financial instrument. While reasonable care has been taken to ensure that the information contained herein is not untrue or misleading at the time of publication, Investment Capital Ukraine makes no representation that it is accurate or complete. The information contained herein is subject to change without notice. Copyright and database rights protection exists in this report and it may not be reproduced, distributed or published by any person for any purpose without the prior express consent of Investment Capital Ukraine. All rights are reserved. Any investments referred to herein may involve significant risk, are not necessarily available in all jurisdictions, may be illiquid and may not be suitable for all investors. The value of, or income from, any investments referred to herein may fluctuate and/or be affected by changes in exchange rates. Past performance is not indicative of future results. Investors should make their own investigations and investment decisions without relying on this report. Only investors with sufficient knowledge and experience in financial matters to evaluate the merits and risks should consider an investment in any issuer or market discussed herein and other persons should not take any action on the basis of this report.
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Ukraine

Metals & Mining

Iron ore 2010

Iron ore 2010

Iron ore 2010

Iron ore 2010

Key drivers of profitability

Iron ore 2010

Iron ore 2010

Iron ore 2010

Iron ore 2010

Supply chain and technology

ORE MINING AND PROCESSING PLANTS Agglomeration Mining

Sinter (47-58% Fe)

Concentrate (65-67% Fe)

Combining sinter material Dewatering

Concentrate (65-67% Fe) Pelletizing Combining pellet material Dewatering

Pellets (58-67% Fe)

Lump ore, sinter ore (60-61% Fe)

Concentrate (65-67% Fe)

Pellets (58-67% Fe)

Sinter (47-58% Fe)

EXTERNAL STEEL MILLS

Iron ore 2010

Key stages of iron ore processing Mining

Supply chain Domestic iron ore market should further shrink

Iron ore 2010

Chart 2. Domestic external buyers of Ukrainian iron ore in 2009 (%)

Iron ore 2010

Sales structure and key commercial products

Chart 5. Ukrainian iron ore sales structure in 8M10 (%)

External domestic sales 26.7

Internal domestic sales 33.7

Internal domestic sales 42.3

Iron ore 2010

Chart 6. Sales structure of key domestic iron-ore producers in 2009

Chart 7. By-product sales structure of key domestic iron-ore producers in 2009

Iron ore 2010

Chart 8. Product structure of Ukrainian iron ore sales in 2009 (%)

Chart 9. Product structure of Ukrainian iron ore exports in 2009 (%)

Sintering ore 18.9

Sintering ore 15.8

Iron ore 2010

Strong growth potential

Reserves: Underexploited and undistributed

Chart 11. Top eight countriesproducers of iron ore in 2009

Source: U.S. Geological Survey

Source: U.S. Geological Survey

Iron ore 2010

The state controls ore reserves allocation

Industry players uneven control of reserves

Iron ore 2010

33 58-66 58-67 59 59 35 35 56-59 ---

Smart2 Evraz2 Evraz Industrial Union of Donbass Donetskstal

Privatisation process nearly finalised

Iron ore 2010

Favourable geographical location and logistics

Chart 12. Ukrainian iron ore exports by key destinations

Kryviy Rih Iron Ore Combine

Port Hedland Saldanha Yuzhny Tubarao Seven Islands 1

BHP Billiton Kumba Ferrexpo Vale Rio Tinto

Australia S. Africa Ukraine Brazil Canada