Tata Steel Ltd’s quest to secure iron ore supplies for its European steel facilities has achieved a key milestone. It will invest Canadian $300 million, or Rs 1,350 crore, for buying an 80% stake in the direct shipping ore (DSO) project of New Millennium Capital Corp. (NMCC), a Canadian mineral explorer.
The joint venture will use the money to develop the mine, and in return, will supply all the output to Tata Steel.
The DSO project is expected to start supplies in 2012 to Tata Steel, which will pay benchmark world prices to the company. Thus, it will not get preferential pricing, though it may able to negotiate for longer term contracts.
The big iron ore mining companies, such as BHP Billiton Ltd and Rio Tinto Plc, have shifted to a quarterly pricing system. But Tata Steel will get assured supplies of specified grades, and it can also optimize on freight costs due to proximity to its European operations.
But what this investment will do is to give it an effective hedge. It may pay market-linked prices for the ore, but will also get a share in the profits of the joint venture. When iron ore prices rise sharply, but steel prices remain suppressed because of market conditions, lower margins from steel will be compensated for by higher profits from ore.
Graphic: Yogesh Kumar/Mint
But if both ore and steel prices slump, as in a recession, these investments tend to weigh down profits and the balance sheet. That is why, traditionally, steel companies had stuck to their core competence, leaving ore production to the miners.
Volatile market behaviour in the past few years and monopolistic behaviour by the mining companies—forcing a shift from annual to quarterly pricing contracts—has convinced steel companies to take the risk.
The current project will meet only part of Tata Steel’s European operations. It has yet another project in the works with NMCC, the Taconite projects, on which it has to decide by December. This is a much larger project, but the proposed investment details are not known.
Tata Steel would want to strike a balance between owning captive mining resources and buying from the market. One acts as a hedge against supply shortages and rising ore prices, while the other gives more operational flexibility.
As its captive resource capability improves, the next time the iron ore market turns volatile, Tata Steel will be less worried about how it will affect its European steel business.
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