The Ukrainian steel and aluminium industries are entering a period of heightened uncertainty, with tenuous growth revealing inherent structural weaknesses – namely a lack of integration – while predatory Russian investors are aggressively pursuing controversial acquisitions.

In the first five months of 2010, Ukrainian crude steel output grew 24.8% year-on-year (y-o-y) to 14.11mn tonnes, in line with the expectations. Ukrainian crude steel output stabilised at around 2.8- 3.0mn tonnes per month in Q210, while rolled output was around 2.7mn tonnes with little movement in terms of month-on-month (m-o-m) growth.

Growth comes from a very low base, with output at least 75% below the industry's full potential. Growth appears to being spurred more by domestic consumption than exports, with flat products leading the way. Tubes are also providing a boost to output. In the first five months of the year, Ukrainian tubes production was up 9% y-o-y to 639,000 tonnes with tube plants increasing output by 6.7% to 542,400 tonnes and steel works by 26.5% to 97,000 tonnes. The recovery of the automotive industry, which collapsed in 2009, is shoring up flats growth, but a full recovery would require an increase in demand from the construction industry, which is currently in stagnation.

Based on the trends observed in H110 in both crude output data and within steel-consuming industries, we forecast 12.9% growth in crude steel output to 33.6mn tonnes in 2010 and 13.2% growth in hotrolled output to 27.4mn tonnes. However, domestic output will struggle to keep up with market trends in 2010, with industry sources expecting a 16% growth in domestic hot rolled steel consumption. Structural constraints within the industry, coupled with policy flux and uncertainties regarding future sector consolidation, will militate against the domestic industry to the benefit of imports. The decline in the value of the euro and a fluctuation in steel prices are contributing to increasing uncertainty in the industry and holding back output.

Notable problems include a lack of access to high quality iron ore and coking coal at a competitive price. In addition, merger and acquisition activity by secretive front companies associated with Russian oligarchs is causing alarm and controversy within the industry. The Ukrainian steel industry is in critical need of consolidation and looks set to follow the global trend in which steelmakers are seeking integration with raw material suppliers to cut costs and bolster profitability. The choice for the industry is largely between being controlled by Ukrainian or Russian oligarchs. Russian oligarchs have snapped up control of the Industrial Union of Donbass (ISD), the Alchevsk Metallurgical Plant and other downstream mills, while System Capital Management, the holding company of Ukraine's richest man, Rinat Akhmetov, which owns Ukraine's Metinvest, is seeking to consolidate its hold on the Ukrainian steel industry.

Although the election of Viktor Yanokovych as president marks a turn towards a more pro-Russia foreign policy, it is still unclear to what extent the new president will tolerate Russian acquisitions in the Ukrainian steel industry. Prime Minister Mykola Azarov reportedly indicated in June 2010 that the government would seek to protect Ilyich Iron and Steel Works from a take-over by a Russian group of investors. Yanokovych also called for an investigation after a group of unnamed Russian investors registered in Cyprus claimed that it had actually acquired Ilyich by buying a 90.41% stake, despite the company's board chairman Volodymyr Boyko protesting that the acquisition was illegal. He has called for Illyich to be merged with Akhmetov's Metinvest, as he is politically allied with Yanokovych. The merger would create one of the world's top 20 steelmakers by volume and makes commercial sense: more than 70% of Ilyich's ore supplies and a quarter of its coke are already supplied by Metinvest.

Consolidation also makes sense amid a national financial crisis. The Zaporizhstal steel plant has also been a target for acquisition by another group of unknown Russian businessmen financially backed by the Russian government's Vnesheconombank. Its bid appears to have muscled out a take-over move by Akhmetov, who was seeking a partnership with South Korea's POSCO. The Ukrainska Pravda news agency said in May 2010 that the deal amounted to US$1.7bn but gave no further details.

Meanwhile, although we expect a full recovery in aluminium by 2014, it is dependent on RusAl maintaining operations in Ukraine. RusAl indicated even before the financial crisis that it may close the 130,000 tonnes per annum (tpa) Zalk smelter as it was unprofitable to keep it running. With output falling 56% y-o-y to 50,000 tonnes in 2010 – the worst performance in the RusAl group – and the debtridden company already facing severe financial problems, it may consider a permanent closure and sale.

If RusAl can find a way to improve efficiency, we believe the smelter can be returned to full capacity after the recession, assisted by a recovery in supplies to the automotive industry. However, until RusAl announces that it will close Zalk, wewill forecast a return to full capacity within five years.