Corporates. FY16 Outlook: Non-ferrous Metals. Physical Premiums to Cushion Margins Against Uncertain Global Recovery and US Rate Hike STABLE

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1 Non Ferrous Physical Premiums to Cushion Margins Against Uncertain Global Recovery and US Rate Hike Outlook Report Sector Outlook STABLE (214: STABLE TO NEGATIVE) AL and Zn Prices May Creep Upward Recovery in Domestic Demand during 2HFY16 Steady Physical Premiums Steady TCRC Margins Amid Surplus Cu Concentrates Rating Outlook STABLE Key Rating Drivers Stable Outlook: India Ratings and Research (Ind-Ra) has revised the Outlook on the nonferrous metals and mining sector to Stable for FY16 from Stable to Negative. Also, it has maintained a Stable rating Outlook on sector companies for FY16. Physical premiums to broad market prices such as London Metal Exchange (LME) may remain substantial due to the oligopolistic nature of the non-ferrous metals market in India. However, physical premiums may fall somewhat from the levels observed in 214. Thus, despite a fall in global commodity prices, the agency expects industry players to sustain realisations and operating profits. MMRD (Amendment) Ordinance 215 has also cleared the air on the renewal of existing concessions, royalty sharing and allocation of new concessions. Non-Integrated players will benefit from auctions being made the sole method of allocation of concessions with removal of state discretion. Aluminium to Stabilise: The agency does not expect the low aluminium price levels of sub USD1,689/ton observed in 214 to be revisited in FY16. On the other hand, the price levels above USD1,9/ton may not be sustained for long, given global oversupply and high inventory levels. The agency expects LME prices to increase at a moderate pace in FY16. Ind-Ra expects the global aluminium demand to stabilise, around current level, with a positive bias. (214: STABLE) Related Research Other Outlooks Other Research 214 Outlook: Steel Producers Analysts Mahaveer Jain S mahaveer.shankarlal@indiaratings.co.in Deep N Mukherjee deep.mukherjee@indiaratings.co.in Regional physical premiums are likely to remain stable in FY16. The demand-supply situation of the physical metal outside China is fairly tight. Domestically, metal price realisation may improve in 2HFY16, buoyed by a pick-up in volumes for industries such as automobiles, packaging, power and construction. However, 1HFY16 may exhibit some pressure on physical premium. Aluminium Margins to Remain Stable: Ind-Ra expects the operating profitability of domestic aluminium players to remain stable in FY16. The agency expects the rupee-dollar exchange rate to marginally weaken and hover around INR63/USD, helping export sales realisation. The on-going coal blocks auctions would substantially determine the direction of profitability, given as major players have captive power plants. Stable Copper Realisations: Ind-Ra expects concentrates oversupply risk to magnify in the near term. Reduced demand growth from China and high levels of inventory tied to financing deals will keep the metal prices under check in FY16. Hence domestically, the positive impact of the concentrated nature of the market and likely pick-up in demand will be countered by weak LME prices. The agency expects realisations and operating profitability to remain stable. Robust TCRC Income: Indian copper metal and mining companies may see robust treatment and refining charges (TCRC) in FY16 resulting from a surplus in concentrates in the international market. Non-integrated players could benefit from strong TCRC led by increases in supplies from both green and brownfield expansions globally. Assuming limited volatility in rupee-dollar exchange rates, higher operating levels would compensate the likely pressure from cost inflation coming from power costs, as was seen in FY April 215

2 Zinc in Deficit: Integrated zinc producers will take advantage of the likelihood of a deficit in the international market as some large mines progress on their planned closure. Ind-Ra expects domestic producers to generate better realisations on back of a robust outlook on LME prices, while physical premiums are expected to remain stable. Domestic metal demand growth is likely to be buoyed by growth in steel production. The agency expects the demand growth for steel to be 5.5%-6.% in FY16 compared with 1.3% yoy in 8MFY15. As expected by the agency, zinc prices remained strong in 214 with a favourable demand-supply situation. Outlook Sensitivities Chinese Economic Activity: A further economic slowdown in China will cause a sustained long-term correction in metal prices and will lead to a negative sector outlook. A further economic slowdown in China will cause a sustained long-term correction in metal prices. Metal prices depend substantially on Chinese economic activity. China accounts for 4%-5% of the global consumption of aluminium, copper and zinc metals. Latest leading economic indicators are not encouraging with a weak output and low order growth rates. Rupee Volatility: If the currency levels were to strengthen to INR6/USD or below, it could negatively impact the operating profitability of sector companies and result in a stable-tonegative sector outlook. Delay in Domestic Recovery: In the event of delays or a lower-than-expected recovery in core sectors such as power, infrastructure, construction, capital goods and auto, the physical premium of the metals may fall substantially below the 214 levels, which may affect the operating margins of sector companies. April 215 2

3 Physical premium is an amount paid over LME price for the physical delivery of a metal. This is mostly attributable to the costs incurred due to the cost of storage, transportation and insurance. Aluminium Global Scenario Fitch Ratings projects the primary aluminium price to continue to trend upwards in 215 and 216. Spot LME aluminium prices are expected to improve to USD1,9/ton in 215 and 216. The global deluge of low-cost liquidity has significantly distorted the relationship between the actual physical demand of the underlying metal and the directional trend of its traded price in exchange such as LME. Thus, a significant amount of physical inventory remains with exchange warehouses, since these are tied to financial transactions. This to an extent limits supply to industrial consumers, giving rise to a high physical premium for lot of metals including aluminium. Higher physical premiums continued to support production levels despite a fall in aluminium prices from 211 levels. In absence of such high premiums, a lot more production capacity would have been curtailed. Structural Features More Positive The overcapacity situation prevalent in the industry has been addressed to an extent, since the overcapacity has proportionately moderated over a period. Current per capita aluminium consumption in China is around 13-15kg, 5kg in Brazil and 1-2kg in India, comparing peak levels of around 25kg per capita in Germany and Korea. Peak aluminium consumption typically occurs at a later stage in the industrialisation process than for steel, indicating significant scope for growth in aluminium demand. Long-term consumption trends are quite positive, reflecting rising per capita consumption in emerging economies. However, longer-term price evolution for aluminium will largely be determined by supply-side considerations such as the availability of key raw material inputs such as bauxite and access to low-cost energy. However, the substantial inventory and new capacities in China, India and Middle East will continue to prevent increases in metal prices. In addition, the new efficient capacities being built in China would calibrate downward the cost curve of the industry. Aluminium consumption trend will remain positive with 214 growth at 7.5% yoy. Figure 1 Global Primary Al Production & Consumption (t) 6, 5, 4, 3, 2, 1, Production (LHS) Consumption (LHS) Percentate surplus to consumption (RHS) (%) Unwinding Financial Structure Can Crash Prices Coinciding with the surge of low-cost global liquidity, LME inventory went up significantly post January 29. However, producer inventory, which has higher alignment with actual consumption, has remained around historical levels with some downward bias. April 215 3

4 Figure 2 Primary Aluminium LME & Producer Inventory Continues to be at historical highs (mt) 6, 5, 4, 3, 2, 1, Jan 8 Aug 8 Mar 9 Oct 9 May 1 Dec 1 Jul 11 Jan 12 Aug 12 Apr 13 Oct 13 Jun 14 Dec 14 Source: IAI,LME, Ind-Ra estimates Producer stocks LME stock Exchange inventory, a substantial proportion of which is connected with pure financial investment transactions, may be at least partially liquidated if such financial structures are unwound in the event of a global rise in cost of capital. LME inventory has been winding down since March 214 while producers stocks have shown a marginal uptick. Figure 3 Spread between Three MonthFutures and Spot Bounce back to contango in early 215 (USD/ton) 3, 2,5 2, 1,5 1, 5-6 Feb 1 Aug 1 Feb 11 Aug 11 Feb 12 Aug 12 Feb 13 Aug 13 Feb 14 Aug 14 Feb 15 Spot (LHS) Spread (3M futures-spot) (RHS) (USD) The risk of significant unwinding of exchange inventory positions in response to the change in global liquidity and cost of funds remains. Under such a scenario, the aluminium spot price may fall below USD1,65/ton for a brief period. However, the agency believes that the downside risk to the price is limited as the ruling price is close to all-in-cost of at least 3%-4% of the global production. Ind-Ra acknowledges that in a liquidity flush, world forward price is not often a great indicator of future prices. However, according to the most recent futures-spot spread, which is in a moderate contango, a wild swing in prices is not expected in the immediate future. Domestic Scenario Demand Recovery The agency expects domestic demand growth to moderately improve in 2HFY16. The key sectors driving aluminium growth, such as automobiles, packaging, power and construction, are likely to witness a moderate improvement in the later part of FY16. Export sales posted strong growth of 22%, while domestic consumption declined by an estimated 13% yoy. The domestic sales declined due to weak demand from core sectors. The demand of aluminium is likely to exhibit a minor recovery in FY16 if there is an increase in government spending in infrastructure and a revival of activities in the mining and power sectors. April 215 4

5 Solid Physical Premiums In India, aluminium metal is an oligopolistic market with Hindalco Industries Ltd. (Hindalco), Sesa Sterlite Ltd. (SSL) and National Aluminium Company Ltd. (Nalco)) being the major players and having strong pricing power. Physical premium surged to record highs of USD35/t-USD45/t in 214 from about USD25/t-USD35/t in 213. In 1HFY16 however, the physical premium are likely to moderate to 213 levels, driven by weak demand as well as pressure from imports. The premium is likely to improve in 2HFY16. Figure 4 Aluminium Price Trend-LME & India Indexed LME price (LHS) (Index) USD INR exchange rate (RHS) Indexed indian prices (LHS) (INR/USD) Jan 11 May 11 Oct 11 Mar 12 Aug 12 Dec 12 May 13 Oct 13 Mar 14 Aug 14 Dec 14, LME, Ind-Ra estimates Sufficient Supplies Hindalco has attained 5% utilisation at its new 36,tpa smelting capacity at Mahan Aluminium. Also, production at Utkal Alumina increased to about 64% in 2QFY15. Similarly, SSL also started producing from its new 325,tpa smelting capacity at Korba II in 1HFY15. Both the new capacities put together account to 3%-35% of the increase in the current levels of India s aluminium production. Moreover, SSL has total capacity addition plans of about 4mtpa at its Lanjigarh location. Most of the new capacity production would be sold in export markets. Overall operating rates remain dependant on the de-bottlenecking of coal supply chain. During the trailing twelve months (TTM) October 214, the combined production of Hindalco, SSL and Nalco improved substantially by an estimated 9% yoy. Bauxite Imports Trends Up Of the three major aluminium producers, Hindalco and Nalco are fully integrated with bauxite/alumina linkages. However, SSL largely depends on the outside purchase of inputs and is thus subject to the price volatility of key raw materials. Bauxite and alumina prices inched up during 1HFY15. Bauxite imports increased substantially during the same period, led by a higher smelter available capacity and operating rates. Any increase in the alumina capacity utilisation would weigh on alumina prices. Figure 5 Figure 6 India Al Metal and Alumina Price Trends Indexed Al metal Alumina 1 Jan 1 Jan 11 Jan 12 Jan 13 Jan 14 Dec 14, WBMS, 24-25=1 India Bauxite and Anumina Import Trends (tons) 25,1 2,1 15,1 1,1 5,1 Import Bauxite Imports Alumina 1 Jan 1 Dec 1 Dec 11 Nov 12 Nov 13 Nov 14 April 215 5

6 1QFY13 2QFY13 3QFY13 4QFY13 1QFY14 2QFY14 3QFY14 4QFY14 1QFY15 2QFY15 2QFY13 3QFY13 4QFY13 1QFY14 2QFY14 3QFY14 4QFY14 1QFY15 2QFY15 Corporates Stable Operating Profits Ind-Ra expects FY16 realisations to be sustained in view of a recovery in demand and stable to marginally upward LME metal prices under the assumption of continued availability of low-cost global liquidity. The agency expects the rupee/dollar rate to trend up to INR63/USD in FY16. While this is positive for integrated producers, the benefit would be offset for non-integrated players by the increased cost of imported inputs. The impact of an increase in realisation on operating margins is likely to be countered by higher energy costs, as was in FY15. Realisations and operating profits improved in 9M14 despite higher energy costs. All of the three largest players have captive power plants; however, the availability of domestic coal was constrained and use of imported coal led to the increase in energy costs. The on-going coal auctions would substantially determine the direction of profitability as the major players have captive power plants. Figure 7 Figure 8 Quarterly Sales of Top Producers (INRm) Hindalco Nalco Sterlite 4, Quarterly Operating Profit per ton (INR) Hindalco Sterlite 16, 3, 2, 1, 12, 8, 4, Source: Company results Source: Company results, Ind-Ra estimates - Indicative blended profitability per ton - Hindalco EBIT/ton & Sterlite EBITDA/ton Copper Global Scenario LME copper prices continued to fall to an average of USD6,84/ton in 214 from USD7,335/ton in 213. The falling price reflects continued subdued import demand growth in China, which accounts for 4% of the global consumption. On the supply side, the ramping-up of copper supplies from new mines weighs on the prices despite a decline in the inventories. Fears of Oversupply Overall, the copper market is likely to be in a physical surplus for the coming two to three years. Fitch Ratings see a downside risk to copper prices. While the demand-supply situation till 214 was more evenly balanced for copper than for aluminium, there is an expectation of oversupply. Ind-Ra expects the prices to remain under pressure as the new mine supply will exceed the rate of copper consumption by about 1.5% per annum. Majority of the new mine supply is expected to come from Peru, Chile, Zambia, Panama and Mongolia. Also, copper demand seems to trend down to a modest annual average growth rate of 5%-6% in three to five years. International Copper Study Group expects the overall refined metal supply to grow at a rate of 4.3% yoy as opposed to the consumption growth rate of 1.1% yoy in 215. April 215 6

7 Figure 9 Cu Metal Production & Consumption (mt) 25, 2, 15, 1, 5, Production (LHS) Consumption (LHS) Percentate surplus to consumption (RHS) (%) Unwinding Financial Positions As expected by the agency in the previous outlook, LME prices languished below the 213 average prices due to high inventory levels and surplus production. This could result in unwinding of the inventory tied to financial deals. The LME inventory has reduced significantly since October 213. However, the downside risk to prices remains in the event of a sharp reduction in copper-based financial structures in response to a reduction in global liquidity. Figure 1 Cu Inventory and LME Price Trend Off from the peak (mt) 1,6 1,2 8 4 Stock exchange inventory (LHS) Average monthly LME prices (RHS) Producers and other inventory (LHS) (USD/mt) 1, 8, 6, 4, 2, Jan 8 Oct 8 Jun 9 Feb 1 Nov 1 Jul 11 Mar 12 Nov 12 Aug 13 Apr 14 Dec 14 Figure 11 Spot Trend 3M LME Futures-Spot Contango market in early 215 Robust support for prices (USD/mt) 12, 1, 8, 6, 4, 2, Jul 1 Jan 11 Jul 11 Jan 12 Jul 12 Jan 13 Jul 13 Jan 14 Jul 14 Jan 15 Last price (LHS) Spread 3M futures-spot (RHS) (USD) The signals from futures market suggest a moderately strong contango with higher price risk. April 215 7

8 Domestic Scenario Demand Growth Ind-Ra expects domestic metal demand growth for FY16. The key sectors driving demand growth, such as electricals, power and construction, are likely to see a modest recovery in investments given a moderate infrastructure push in the most recent national budget. Domestic copper production and usage increased by an estimated 26% yoy and 5% yoy, respectively, for TTM October 214. Metal exports to China continued to support high domestic production growth. The agency expects exports to China to more or less remain flat in the absence of a recovery in the real-estate construction sector. In the medium term, the agency expects India and China to persistently overwhelm global copper production. Figure 12 India Metal Exports to China (USD ) Metal import by China/India value total 35, 3, 25, 2, 15, 1, 5, Oct 8 Jun 9 Jan 1 Aug 1 Apr 11 Nov 11 Jun 12 Feb 13 Sep 13 Apr 14 Nov 14, WBMS, Customs China Robust TCRC In FY16, the agency expects TCRC margins to remain robust at the current levels due to continued supplies from new mines in the international market. The expected surplus in global copper concentrates along with additional mining capacity favours TCRC. Figure13 shows the agency s observation that copper ore prices did not move up in tandem with metal prices in 1HFY15. However, it did catch-up with metal prices by October 214. India is among the top 1 countries by smelting capacity. Smelters generally pass through increases in copper prices and earn TCRC margin. Figure 13 India Cu Metal and Cu ore Price Trends Indexed 21 WS copper price index (LHS) Copper ore WS price index (RHS) Oct 8 Jun 9 Jan 1 Sep 1 Apr 11 Nov 11 Jul 12 Feb 13 Oct 13 May 14 Dec 14, WBMS, 24-25:1 April 215 8

9 Figure 14 Copper Price Trend-LME & India (Index) 16 Indexed LME price Indexed indian prices USD INR exchange rate Jan 1 Jul 1 Dec 1 Jun 11 Dec 11 Jun 12 Dec 12 Jun 13 Dec 13 Jun 14 Dec 14, LME, Ind-Ra estimates Figure 15 Operating Profits Likely To Improve The operating profitability of local players is likely to benefit from their improving operating levels and realisations. However, the positive impact of a recovery in key by-products, such as sulphuric acid and precious metals, on the operating margins would partly be offset by higher power charges. India depends on imported ore/concentrates to a large extent and is a net exporter of the primary metal. Hindustan Copper Ltd. is the only integrated producer in India, SSL and Hindalco primarily are custom smelters. India s export trade recovered from the lows of FY14 and posted strong volume growth of 1% yoy in TTM October 214. A weak rupee is generally favourable for both integrated and non-integrated copper miners. However, integrated producers are in a better position to sustain their operating margins in the event of volatility in input prices and/or forex rates. Figure 16 Figure 17 Quarterly Revenue Trend with Top Producers (INRm) 8, Hindalco Sesa Sterlite Hindustan Copper 6, 4, 2, Sep 12 Dec 12 Mar 13 Jun 13 Sep 13 Dec 13 Mar 14 Jun 14 Sep 14 Source: Company results Figure 18 Quarterly Profitability Trend with Top Producers (Index, 212=1) Hindalco Sesa Sterlite Dec 12 Mar 13 Jun 13 Sep 13 Dec 13 Mar 14 Jun 14 Sep 14 Source: Company results April 215 9

10 Zinc Global Scenario The global zinc market continued to be in deficit in 214, despite China s net imports of the metal falling about 3% in TTM October 214. Globally, the zinc market posted production and consumption growth of 6% and 5%, respectively in TTM October 214. The metal consumption in January-November 214 grew 5% yoy while the production grew 4.2% yoy. Zinc prices averaged to USD2,17/ton, up from USD1,943/ton in 213. Fitch Ratings expects the average refined metal price to be at about USD1,95/ton in Inventory levels remain high; however, a portion of them is tied to financial transactions. Physical supply may be tighter than that implied by the stock level. Long-term price would depend on the timing of the planned mine closure and ramping-up of new supplies. Large mines including Vedanta s Lisheen mine and MMG Ltd s Century Mine are likely to be closed in the next few years due to ore depletion. However, the expected price levels may not be remunerative enough to encourage the development of greenfield supplies. To that extent, the supply deficit is likely to continue. In addition, funding and/or country risk issues could lead to the continued deferment of some planned projects. In this backdrop, Fitch Ratings has its long-term price assumption at USD2,5/ton. Figure 19 Zn Metal Slab Production & Consumption Strong consumption growth 15, 12, 9, 6, 3, Production (LHS) Consumption (LHS) Percentate surplus to consumption (RHS) (%) Figure 2 Zinc Inventory & Price Movement LME inventory off the peak (mt) 1,4, 1,2, 1,, 8, 6, 4, 2, LME inventory (LHS) LME price (RHS) (USD/mt) Jan 8 Oct 8 Jun 9 Mar 1 Nov 1 Aug 11 Apr 12 Jan 13 Sep 13 Jun 14 Feb 15 /London Metal Exchange 3, 2,5 2, 1,5 1, 5 April 215 1

11 Figure 21 Spread between Three Month Futures and Spot Low contango contrary to demand-supply gap (USD/mt) 3, 2,5 2, 1,5 1, 5-6 Jun 1 Nov 1 May 11 Nov 11 Apr 12 Oct 12 Apr 13 Sep 13 Mar 14 Sep 14 Feb 15 Last price (LHS) Spread (futures 3M-spot) (RHS) (USD/mt) Domestic Scenario Deficit to Support Premiums Ind-Ra expects the zinc industry players to benefit from improved fundamentals. Domestic realisations and operating profitability in FY16 are likely to improve due to an increase in metal demand amid a global supply deficit on back of growth in steel production. Galvanisation of steel is the key end-industry, consuming an estimated three-fourths of the domestic production. The agency expects the demand growth for steel to be 5.5%-6.% in FY16 compared with 1.3% in 8MFY15. India s zinc industry is marked by a duopoly with Hindustan Zinc Ltd (HZL) and Binani Zinc Ltd. being the only two meaningful metal producers. HZL is among the top three integrated players globally (in terms of metal capacity) with cash cost in the lower quadrant. Robust Exports Outlook The agency expects the domestic supply situation to remain comfortable in the medium term. HZL plans to increase its mining capacity to 1.2mtpa (metal) by end- FY15. The company s metal production volume declined by 7% yoy in TTM December 214 due on-going mine development. India s annual consumption is estimated to be at about.7mt in FY15 while the proportion of exports to production to be about 25/3% of the production. Robust Operating Profits Outlook The global deficit situation is likely to underpin steady physical premiums and operating profits in FY16, as in FY15. Ind-Ra expects the strong LME price to fully percolate into domestic realisations in FY16. HZL s average realisations increased 14% yoy in TTM December 214 on back of strong LME Prices. However, is operating profitability improved only marginally due to the higher cost of production and lower by-product realisation. The cost of production at HZL increased due to a decline in production volume because of prestripping works developing a mineral block for higher mining capacity. The decline in silver prices, a key by-product, also impacted operating profits. Average silver prices declined about 14% yoy to about USD18/oz. The agency expects the silver prices to range between USD17/oz -USD19/oz. April

12 Figure 22 Zinc Price Trend-LME & India Robust exports realisations due to strong LME & weak rupee (Index) 16 Indexed LME price Indexed indian prices USD INR exchange rate Jan 1 May 1 Oct 1 Mar 11 Aug 11 Jan 12 Jun 12 Nov 12 Apr 13 Sep 13 Jan 14 Jun 14 Nov 14, LME, Ind-Ra estimates, 21=1 Figure 23 Hindustan Zinc's per ton Realisation and EBITDA Trend (INR) 2, Realisation per ton (LHS) EBITDA per ton (RHS) (INR) 1, 17, 8, 14, 6, 11, 4, 8, 2, 5, Jun 12 Sep 12 Dec 12 Mar 13 Jun 13 Sep 13 Dec 13 Mar 14 Jun 14 Sep 14 Dec 14 Source: Company results, Blended realisation & EBITDA (Zinc, Lead & Silver) April

13 Appendix Figure 24 Issuer Ratings Issuer Rating/Outlook/RW (Current) Rating/Outlook/RW (End-214) Sesa Sterlite Ltd. IND AA+/Stable/IND A1+ IND AA+/Stable/IND A1+ Century Aluminium Manufacturing IND BB (suspended) IND BB/Stable/IND A4+ Co. Limited Gravita India Ltd IND BBB+/Stable/IND A2 IND BBB+/Stable/IND A2 Source: Ind-Ra April

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