Mumbai: Friday’s Supreme Court order allowing the auction of iron ore stockpiles in Karnataka provides JSW Steel Ltd some respite. The nation’s third largest producer of steel had just enough inventory to run its Vijayanagar plant for about 10 days.

Vice-chairman Sajjan Jindal will still be a worried man.

The Karnataka anti-graft watchdog’s report on illegal iron ore mining that forced B.S. Yeddyurappa to resign as chief minister accuses the company of avoiding hundreds of crores or rupees in state levies on the mineral.

Supply headwinds: Sajjan Jindal, vice-chairman, JSW Steel. Photo by Abhijit Bhatlekar/Mint.

The blows aren’t isolated events. They are a culmination of the company’s management waking up late to the reality of runaway commodity prices and its inability to extract captive mining concessions from a state in which it has invested billions over the past 17 years, say analysts.

An email sent to the company went unanswered and efforts to reach senior management proved futile.

Resource security

JSW’s 10 million tonnes per annum (mtpa) steel plant at the historic Vijayanagar town lies at the heart of the high-grade iron ore belt in the Bellary-Hospet region. It was set up there for its proximity to the resource.

A file photo of the company’s steel plant in Karnataka. Photo by Bloomberg.

It only has a 10% iron ore security from its holding in Vijayanagar Minerals Pvt. Ltd, its joint venture with the Karnataka government-run Mysore Minerals Ltd. It has no local coking coal mines either; the fuel is used in furnaces to melt iron ore into steel.

“They really have no option but to depend on NMDC and the other suppliers," said Rakesh Arora, managing director and head of research at Macquarie Capital Securities (India) Pvt. Ltd.

The Supreme Court has allowed state-run NMDC Ltd to continue mining in the region so local steel makers can keep their plants running, though the Lokayukta has named India’s largest iron ore producer as well in its report, accusing it of under-invoicing high-grade iron-ore exports.

“Given the location of their (JSW’s) plant, which isn’t close to any port, they don’t have the option of buying an overseas mine and importing the ore back in here," Arora added. Vijayanagar’s closest ports are located 400km away in Goa.

The worries reflect in the stock’s performance. JSW shares have lost nearly half their value this year. On Monday, the shares inched up 0.72% to 725.80 while the benchmark Sensex on the Bombay Stock Exchange lost 0.64%.

The importance of having one’s own raw material assets needs to be seen in the context of iron ore prices. The price of spot iron ore in China has risen to $237 (Rs 10, 878) a tonne from $74 in June 2006, when the data was first available on Bloomberg.

The worst is possibly yet to come. Australian miner Rio Tinto, the world’s second largest iron ore producer, estimates steel makers will need an additional 800 million tonnes (mt) of iron ore in the next eight years to meet demand, which would need a doubling of production.

India doesn’t lack deposits to feed its hungry steel industry. The country has about 25 billion tonnes of quality reserves, the sixth largest in the world, and is the fourth largest producer of the commodity, according to an Ernst and Young report.

But available mining leases are taken up by miners or some of the older steel makers while new investors like South Korea’s Posco and ArcelorMittal have been waiting for years for allotments. Stricter environmental and land acquisition laws also delay mine allotments.

Steel makers like JSW that don’t have secure sources leave themselves exposed to the vagaries of volatility in international prices. To be fair to the company, in the first decade of the Vijayanagar plant’s operation, iron ore prices were much lower, and while mining concessions were available, there wasn’t a compelling argument to secure backward linkages, say analysts in the company’s defence.

But JSW was slow to wake up to the reality of China’s mammoth steel making machine.

“Initially, iron ore wasn’t a high-priced commodity so no one was worried too much about availability in that area, which is why JSW Steel lost out on the opportunity in buying their own mines," Arora said.

“Secondly, mining and environment legislation has become stricter, so obviously that is taking a toll on production. Given all these conditions, which were not anticipated earlier on and by the time they woke up to the reality of iron ore prices, nothing was available," he added.

JSW’s loss, China’s gain

The spurt in ore prices has a lot to do with the emergence of China as the pre-eminent steel maker in the world. As the Asian giant’s hunger for steel grew, so did its need for iron ore. Steel production more than quadrupled to 626.65 mt in 2010 from 151.63 mt in 2001, and iron ore imports rose from 92 mt to 628 mt, show data from the World Steel Association and Metalytics.

Cashing in on the opportunity, miners in places like Bellary began exporting to China. Export mining contracts gained pre-eminence and local steel makers like JSW were caught off-guard.

Prices rose so sharply that negotiations for long-term contracts for the supply of iron ore, which were done annually the past four decades, are being done every quarter since 2010.

Integrated steel makers like Steel Authority of India Ltd and Tata Steel Ltd, by virtue of having been around much longer, are better placed as they secured their own mines when the country was still expanding at the Hindu rate of growth—a term coined by economist Raj Krishna referring to the Hindu philosophy of fatalism and contentedness as India’s socialist economy grew at 3.5% annually in the pre-liberalization years from the 1950s to the 1980s.

Having its own iron ore sources in Jharkhand and Orissa hasn’t stopped Tata Steel from looking for raw materials in Australia, Mozambique, Ivory Coast and Oman to feed its European furnaces. Essar Steel Ltd and Jindal Steel and Power Ltd (JSPL), peers of the the same vintage, too began their quest to control inputs.

In fact, Sajjan Jindal needn’t look far for a successful strategy on backward integration. JSPL, headed by younger sibling Naveen Jindal, is clear that its growth can only be based on the security of its resource pool. JSPL has 200 mt of secure iron ore reserves in Tensa, Jiraldaburu and Bailadila on the country’s east. Naveen Jindal has also acquired an iron ore mine in faraway Bolivia with reserves of 20 billion tonnes. Many of these were done when mining concessions were available cheaply locally.

The older Jindal admitted to Forbes magazine in an October 2009 cover story on Naveen Jindal that his own focus on building new capacity than on securing mining concessions proved to be a mistake. “I missed out," he had said. “Now, we’re buying more resources."

JSW got into the game only in 2008, when it acquired a 70% interest in Chile’s Santa Fe Mining, which started iron ore mining at Bella Vista in April 2011. It expects an output of 1 mt this fiscal, which will be sold in the global market. Plans are on to increase output to 3 mt in three years.

Some analysts say a lack of backward integration doesn’t necessarily mean steel makers got their models wrong.

“Structurally, the industry has become more volatile and that’s where producers realize that if I backward integrate, then my price is also protected," said Hiran Bhadra, partner, management consulting, at KPMG. “There are companies like Tata Steel, who for legacy reasons have got iron ore mines, are suddenly waking up today to find that it’s providing a price advantage particularly against very high volatility. But that’s not necessarily the model everyone needs to follow."

Missed chances

Sajjan Jindal missed an opportunity to secure an iron ore source when Japan’s Mitsui and Co. put Indian miner Sesa Goa Ltd on the block in 2007, losing the bid to Vedanta Resources Plc.

With captive mines in Goa and Karnataka, Sesa Goa could have fit JSW’s strategy. Sesa Goa too is named in the Lokayukta’s report.

In 2010, JSW acquired coking coal blocks in West Virginia, US with estimated reserves of 161 mt, of which one is operational. In 2006, it acquired a coal block in Mozambique with estimated reserves of 200 mt. But after initial exploration and drilling, it was discovered that the block had thermal and not coking coal. Subsequent plans to transfer the resource to sister company JSW Energy Ltd are in cold storage, according to media reports.

In another deal gone wrong for the group, eight months after JSW Energy signed a agreement with Toronto-listed resources company CIC Energy Corp., the $439 million acquisition was called off in June after twice extending the deadline. JSW Energy also called off a plan to expand power production capacity at a plant in Ratnagiri to 3,200MW from 1,200MW earlier this year due to its dependence on imported coal.

“A deal being called off shouldn’t necessarily be seen in negative light as there are a number of challenges in resource deals, the biggest being local legislation, which could be a constraint," said Kameswara Rao, partner at consultancy PricewaterhouseCoopers.

These issues are perhaps symptomatic of the group’s troubles with backward integration, though it has focused on adding capacity and improving efficiencies, making it one of the lowest-cost steel producers globally.

In December, JSW Steel acquired a 41.29% stake in debt-ridden Ispat Industries Ltd for 2,157 crore, making it among India’s largest producers of the metal by capacity.

Future needs

JSW Steel aims to produce 34 mtpa of the metal by 2020, up from its present capacity of 14.3 mtpa, which will require about 55 mt of iron ore a year.

“They need to stop expansion just for the sake of adding capacity unless they’re able to secure raw material. Otherwise they should go for port-based plants so it gives them an option for bringing in raw materials from outside India," said Arora.

Not all of the proposed expansion will be at JSW’s Vijayanagar plant. The company has signed pacts with the governments of Jharkhand and West Bengal to set up 10 mtpa plants. In West Bengal, the company has assurance of coal supply from the government; in Jharkhand, it has a prospecting licence for an iron ore deposit in Ankua, apart from a joint venture for a coal block.

Group chief financial officer and joint managing director Seshagiri Rao told Mint in an interview in June that JSW Steel had formed a seven-member team to acquire iron ore and coal mines as it aims to gain iron ore security in five years.

But with global mining giants controlling most of the available assets overseas and delays associated with procuring local mines, JSW Steel may be in for a tough hunt.