28 Sep 2020

ChelPipe CEO Boris Kovalenkov: I'm absolutely convinced Darwin’s theory of evolution, that the strongest survive, is right

The drop oil prices and the coronavirus pandemic have meant double trouble for the pipe industry, both in Russia and abroad. The Russian Pipe Industry Development Foundation reckons demand for steel pipes in the country will fall nearly 8% this year. Boris Kovalenkov, CEO of the ChelPipe Group, tells Interfax in an interview how the industry might emerge from the crisis with minimal losses, what support the industry might receive and whether it can expect new orders from Gazprom.

Question: The pipe industry faces particular challenges today. How do you assess the Russian pipe market situation?

Answer: It's very turbulent, untypical and challenging in all respects, the situation has had a very marked effect on the sector as a whole and on our company in particular. We’ve seen a drop in consumption both in Russia and in countries that import pipes. Nearly all export markets have been shut off due to coronavirus-related restrictions. Even so, there is potential for growth in the industry segment through the localization of automobile manufacturing and infrastructure projects such as the program to modernize Russian oil refineries.

Q.: The pipe industry faces particular challenges today. How do you assess the Russian pipe market situation?

A.: It's very turbulent, untypical and challenging in all respects, the situation has had a very marked effect on the sector as a whole and on our company in particular. We’ve seen a drop in consumption both in Russia and in countries that import pipes. Nearly all export markets have been shut off due to coronavirus-related restrictions. Even so, there is potential for growth in the industry segment through the localization of automobile manufacturing and infrastructure projects such as the program to modernize Russian oil refineries.

Q.: How seriously will demand in Russia slump this year?

A.: We forecast pipe consumption this year will be level with 2009 at around 9 million tonnes. This year has set us back 10 years. The market will shrink by around a million tonnes compared with 2019.

Q.: When will it be possible to talk about a recovery?

A.: Many experts are forecasting that the economy and demand will start to recover in H2 2020, but we don’t yet see the figures to back that up.

We have a lot of export-related projects that have to be carried out in H2 2020, and we have been busy preparing for them. But the first half of the year, when we could not even travel to reach our clients on the one hand and buyers were not in a position to carry out new projects on the other hand, delivered a major blow to our plans and forecasts for the current year.

Borders are gradually reopening but our main export markets remain closed. For example North America is almost at a complete standstill due to both the oil crisis and the fact that the borders are closed due to the pandemic raging there. The situation is better in the MENA countries and in Africa but this is unfortunately nothing like those plans we set for ourselves at the end of last year and start of this year. The key projects for the near future are the North-South gas pipeline in Pakistan, and TAPI in Turkmenistan.

I don’t think we’ll see a real improvement before the second half of 2021. Our sector is fairly conservative. This crisis came upon us gradually, and we’ll be emerging from it just as gradually.

Q.: The company last year started to develop exports actively in the absence of major new orders from Gazprom and as the ruble fell in value. Now we are seeing that export projects have been put on hold and that the domestic market situation is also fairly challenging. How might the state support pipe producers, and does the sector need such support?

A.: There are two sides to that question. The objective one is that our various pipelines, built in the 1970s and 1980s, stretch for a huge distance. All that infrastructure needs support with operating the pipelines and repairs related to the consumption of tubular products.

On the other hand, in today’s conditions even the major oil and gas industry players are finding it hard to resolve this issue on their own: we can all see the reports unveiled by the oil and gas companies which posted either losses for H1 2020 or reduced EBITDA and sharply reduced oil pumping.

The state could help the sector with major investment in infrastructure.

These are challenging times for the pipe industry. After all in addition to the obvious drop in demand in the domestic and external markets, we must not forget there is a surplus of pipe capacity in Russia.

Q.: Was Gazprom's tender for pipe contracts worth nearly 100 billion rubles able in any way to support the sector and ChelPipe, which got 15% of the contracts?

A.: The company invited tenders for around 1.2 million tonnes of LDP. Around 1 million tonnes should be delivered prior to March 2021. Nearly all companies must therefore produce and deliver the majority of pipes this year. But orders under this tender have yet to be formalized. We’re hoping that the situation with signed contracts will change in Q4.

Q.: This tender for the first time partially took into consideration the wishes of pipe manufacturers, which were on Gazprom’s still unapproved Standard of Procurement. Are you happy with the results of the tender and format?

A.: We're talking a lot about the necessity of changing the purchasing format to make it more predictable for producers and suppliers of pipe products. From this standpoint, Gazprom has undoubtedly accommodated us. Now the rules of summing up the results of the tender are in line with our requests that companies should be able to secure a certain volume of the order when providing a competitive price.

When we applied to take part we understood our potential in terms of the economics. It is difficult to compete with vertically integrated companies which have their own ore and their own sheet metal. I can say that we received roughly what we were expecting within this tender.

Q.: Are you expecting any new Gazprom tenders before the end of the year?

A.: No, no new tenders - they are on hold for now.

Q.: ChelPipe boosted capex 17% to 3.1 billion rubles in H1 2020. How much investment can be expected in H2?

A.: Capex is one area that is being subjected to very serious analysis from the point of view of the timeliness of investments.

As for the pipe division, we have carried out a major review of the expenditure program: we have put some projects off until better times, but we have increased the program where this concerns increased operating efficiency. Both 2020 and perhaps 2021 will need stringent approaches to budget expenditure.

Q.: What are these projects that are intended to improve operating efficiency?

A.: One of the cost cutting drivers for the group has been the renovation of the Iron Ozone 32 electric steel shop in H1. We got it done before the pandemic and commissioned it in Q2. The renovation raised productivity and reduced the cost of pipe billets. We have also completed two projects to do with our own power generation: both thermal power plants will go fully into service this year at our Pervouralsk and Chelyabinsk pipe plants. They were carried out on the energy service contract principle, but even so they allow us to work on lowering our costs and improving the reliability and quality of power supply.

A few days ago, at the Pervouralsk Pipe Plant’s site, AQA Genesis, a modern water refining system, was launched to provide a “green” water supply circuit for pipe production processes and to significantly reduce the plant’s environmental footprint.

Q.: What’s the capex guidance for this year?

A.: The pipe division’s capex will be lower than the original investment plans, which were quite substantial. The pipe division’s capex will be around 3.8 billion rubles and overall group capex will be around 7 billion rubles.

We continue to finance customer-centric transformation projects and will allocate around 6 billion rubles for them by 2023.

Q.: Which projects has the company put on hold?

A.: We have put the precision tubes project off until better times.

Q.: This summer, ChelPipe said it was boosting capacity to produce pipe billets. When you and I talked two years ago we also discussed this project and the difficulties with scrap metal for the electric smelting furnaces. Has the situation with scrap and prices for it improved at all in that time?

A.: Today I’m convinced as I was then that it makes more economic sense to produce your own billets. When we were building the electric steel complex its nominal capacity was 950,000-990,000 tonnes. Following the renovation, which we completed this year, we’ll be able to produce 1.35 million tonnes of steel, covering almost our entire needs for pipe billets, not counting billets made from special steels. We don’t for example make stainless steel billets, because there’s a different technology involved, different specifications. This is not economically feasible for us. We produce all the rest ourselves, which is more economical than buying them from third parties.

Billets are a commodity that practically entirely replicates both the market situation and the currency situation. So in the ruble zone, despite price changes, we are seeing good results even when the ruble devalues.

As for scrap, domestic market prices for this have been climbing for five straight months and have already reached the all-time high that there was two years ago. The reason is limited scrap metal supply due to the pandemic and the ban on importing it from Kazakhstan.

Russia is the only one of the five EAEU countries that has no major restrictions on scrap exports. Deputy Prime Minister Yury Borisov has asked ministries to draft proposals on this issue, and further analysis of the situation will be made.

Q.: You mentioned stainless steel tubes. ChelPipe and TMK are the only producers in Russia. The latter said at the end of summer that it was getting ready to deliver a project to produce stainless steel feedstock for welded pipes. ChelPipe specializes in seamless stainless pipes. But still, have you not discussed possible involvement in this project with TMK, are you thinking about branching out into welded stainless steel pipes?

A.: Many have diversified, and built more than 70 pipe mills of various kinds, which has collapsed the market for welded steel pipes, where the profit margin struggles to reach 1%. This is not our way.

We’re not in talks with TMK. TMK is expecting to carry out a project with flat roll for welded stainless pipes, while we specialize in seamless stainless pipes.

ChelPipe has many years of stainless steel pipe production under its belt. In Soviet times, Pervouralsk was the main producer of such pipes for all sorts of industries. It used all sorts of methods to roll and treat pipes, and it is able to draw on its own wealth of expertise to perform an objective assessment of new technological solutions on offer to clients. Our share of this market today is around 20%, and we want to increase it, expanding the range of our products, because we see demand for stainless pipes growing in the world market.

Q.: Not so long ago ChelPipe approved its dividend policy. Shareholders voted to accept final dividends for 2019 in keeping with the board’s recommendation, despite the fact there were already obvious problems due to the coronavirus. Might this “new reality” be a reason to adjust or review dividend policy? Dividends have not been announced for the first half of this year, but might they be paid for the year?

A.: We want to be of interest to investors, and we'll try and do all we can to put our dividend policy into practice. It states that dividends are paid at least twice per year. Decisions on the amount depend on the company's financial results, on leverage, FCF and net profit. These are absolutely clear indicators. Let's get through Q3 and Q4 and see how demand recovers.

Q.: As far as I can gather, the dividend policy was adopted in preparation for an IPO, which has had to be shelved due to the poor market situation. Is this now off the agenda?

A.: The company has to develop, and it is the management's job to offer shareholders the best solutions to finance that development. We are generating steady cash flow, which enables us to implement our planned projects in keeping with the adopted strategy.

We're looking at various options to finance accelerated growth in promising areas of business, and they include a public share offering. I think this would be an interesting, good and effective means of financing our development.

Q.: ChelPipe and Zagorsk Pipe Plant or ZTZ said in the summer that they intended to create an industrial group. What was behind the decision to combine assets with ZTZ? Was the coronavirus the catalyst that sped up the decision?

A.: I'm absolutely convinced Darwin’s theory of evolution, that the strongest survive, is right. The more effective you are from various points of view – costs, opportunities to work with clients, suppliers, and the stronger you are in the market, the more likely it is that you will survive this turbulence, and meet all challenges.

From this point of view yes, the coronavirus has kick-started these processes.

The market is clearly stagnating as there's a surplus of capacity and a lot of competition, so one way of easing the pressure on manufacturers might be to form alliances of pipe producers. We are working on such an option with ZTZ. We see in this decision a lot of opportunities and prospects for both companies: we could align our capacity utilization, combining our scientific potential to develop consumer specifications and have a more balanced investment program.

Q.: Has the form of the alliance been decided?

A.: A working group that the companies set up is discussing the form in which this will take place - a JV, industrial alliance or something else. Crucially, the alliance would strengthen our market footing. It's hard to do that on your own, you need to use all possible opportunities that make you strong.

Q.: ChelPipe tapped the Eurobond market in the autumn of 2019. The company said at the time that the bulk of the proceeds went towards paying off ruble loans. This year you have placed ruble bonds. Are you looking to the debt market again?

A.: We placed both the ruble bonds and the Eurobonds with the aim of restructuring outstanding debt. The company’s strategy calls for consistently lowering the debt load, and we plan to pursue that policy going forward.

Today we have reduced the share of bank loans to 50%. That’s a far more sustainable figure from the point of view of balancing debt. We have enough liquidity to cover upcoming payments on outstanding loans over a two-year horizon.

Q.: What’s the company’s leverage guidance for end-2020? This increased somewhat in H1 2020, to 2.3х from 2.1х...

A.: Net debt/EBITDA will depend very much on how we get through the second half-year. Much will also depend on the contract with Gazprom, on exports, in particular to America, and on a number of other factors. I’m confident we will not breach any covenants.

Q.: What’s the guidance for your pipe shipments this year?

A.: Right now it’s hard to operate with any absolute figures. Today we are looking more at that share of the market that we occupy in various segments. We performed very well in the first half of the year, we did not reduce our share anywhere, in fact we even increased it in places. Right now it is crucial that we focus on not losing our market positions. Partly with that in mind we are focusing on high value-added production.

Operating efficiency is also important to the company. For this year we have the “5+” program where we are looking to lower costs by 5 billion rubles or more compared with 2019.

Absolute volumes are the second or even third derivative for me today. If we do not lose our market shares we’ll ship as much as the market allows us to.

Q.: How seriously will demand in Russia slump this year?

A.: We forecast pipe consumption this year will be level with 2009 at around 9 million tonnes. This year has set us back 10 years. The market will shrink by around a million tonnes compared with 2019.

Q.: When will it be possible to talk about a recovery?

A.: Many experts are forecasting that the economy and demand will start to recover in H2 2020, but we don’t yet see the figures to back that up.

We have a lot of export-related projects that have to be carried out in H2 2020, and we have been busy preparing for them. But the first half of the year, when we could not even travel to reach our clients on the one hand and buyers were not in a position to carry out new projects on the other hand, delivered a major blow to our plans and forecasts for the current year.

Borders are gradually reopening but our main export markets remain closed. For example North America is almost at a complete standstill due to both the oil crisis and the fact that the borders are closed due to the pandemic raging there. The situation is better in the MENA countries and in Africa but this is unfortunately nothing like those plans we set for ourselves at the end of last year and start of this year. The key projects for the near future are the North-South gas pipeline in Pakistan, and TAPI in Turkmenistan.

I don’t think we’ll see a real improvement before the second half of 2021. Our sector is fairly conservative. This crisis came upon us gradually, and we’ll be emerging from it just as gradually.

Q.: The company last year started to develop exports actively in the absence of major new orders from Gazprom and as the ruble fell in value. Now we are seeing that export projects have been put on hold and that the domestic market situation is also fairly challenging. How might the state support pipe producers, and does the sector need such support?

A.: There are two sides to that question. The objective one is that our various pipelines, built in the 1970s and 1980s, stretch for a huge distance. All that infrastructure needs support with operating the pipelines and repairs related to the consumption of tubular products.

On the other hand, in today’s conditions even the major oil and gas industry players are finding it hard to resolve this issue on their own: we can all see the reports unveiled by the oil and gas companies which posted either losses for H1 2020 or reduced EBITDA and sharply reduced oil pumping.

The state could help the sector with major investment in infrastructure.

These are challenging times for the pipe industry. After all in addition to the obvious drop in demand in the domestic and external markets, we must not forget there is a surplus of pipe capacity in Russia.

Q.: Was Gazprom's tender for pipe contracts worth nearly 100 billion rubles able in any way to support the sector and ChelPipe, which got 15% of the contracts?

A.: The company invited tenders for around 1.2 million tonnes of LDP. Around 1 million tonnes should be delivered prior to March 2021. Nearly all companies must therefore produce and deliver the majority of pipes this year. But orders under this tender have yet to be formalized. We’re hoping that the situation with signed contracts will change in Q4.

Q.: This tender for the first time partially took into consideration the wishes of pipe manufacturers, which were on Gazprom’s still unapproved Standard of Procurement. Are you happy with the results of the tender and format?

A.: We're talking a lot about the necessity of changing the purchasing format to make it more predictable for producers and suppliers of pipe products. From this standpoint, Gazprom has undoubtedly accommodated us. Now the rules of summing up the results of the tender are in line with our requests that companies should be able to secure a certain volume of the order when providing a competitive price.

When we applied to take part we understood our potential in terms of the economics. It is difficult to compete with vertically integrated companies which have their own ore and their own sheet metal. I can say that we received roughly what we were expecting within this tender.

Q.: Are you expecting any new Gazprom tenders before the end of the year?

A.: No, no new tenders - they are on hold for now.

Q.: ChelPipe boosted capex 17% to 3.1 billion rubles in H1 2020. How much investment can be expected in H2?

A.: Capex is one area that is being subjected to very serious analysis from the point of view of the timeliness of investments.

As for the pipe division, we have carried out a major review of the expenditure program: we have put some projects off until better times, but we have increased the program where this concerns increased operating efficiency. Both 2020 and perhaps 2021 will need stringent approaches to budget expenditure.

Q.: What are these projects that are intended to improve operating efficiency?

A.: One of the cost cutting drivers for the group has been the renovation of the Iron Ozone 32 electric steel shop in H1. We got it done before the pandemic and commissioned it in Q2. The renovation raised productivity and reduced the cost of pipe billets. We have also completed two projects to do with our own power generation: both thermal power plants will go fully into service this year at our Pervouralsk and Chelyabinsk pipe plants.  They were carried out on the energy service contract principle, but even so they allow us to work on lowering our costs and improving the reliability and quality of power supply.

A few days ago, at the Pervouralsk Pipe Plant’s site, AQA Genesis, a modern water refining system, was launched to provide a “green” water supply circuit for pipe production processes and to significantly reduce the plant’s environmental footprint.

Q.: What’s the capex guidance for this year?

A.: The pipe division’s capex will be lower than the original investment plans, which were quite substantial. The pipe division’s capex will be around 3.8 billion rubles and overall group capex will be around 7 billion rubles.

We continue to finance customer-centric transformation projects and will allocate around 6 billion rubles for them by 2023.

Q.: Which projects has the company put on hold?

A.: We have put the precision tubes project off until better times.

Q.: This summer, ChelPipe said it was boosting capacity to produce pipe billets. When you and I talked two years ago we also discussed this project and the difficulties with scrap metal for the electric smelting furnaces. Has the situation with scrap and prices for it improved at all in that time?

A.: Today I’m convinced as I was then that it makes more economic sense to produce your own billets. When we were building the electric steel complex its nominal capacity was 950,000-990,000 tonnes. Following the renovation, which we completed this year, we’ll be able to produce 1.35 million tonnes of steel, covering almost our entire needs for pipe billets, not counting billets made from special steels. We don’t for example make stainless steel billets, because there’s a different technology involved, different specifications. This is not economically feasible for us. We produce all the rest ourselves, which is more economical than buying them from third parties.

Billets are a commodity that practically entirely replicates both the market situation and the currency situation. So in the ruble zone, despite price changes, we are seeing good results even when the ruble devalues.

As for scrap, domestic market prices for this have been climbing for five straight months and have already reached the all-time high that there was two years ago. The reason is limited scrap metal supply due to the pandemic and the ban on importing it from Kazakhstan.

Russia is the only one of the five EAEU countries that has no major restrictions on scrap exports. Deputy Prime Minister Yury Borisov has asked ministries to draft proposals on this issue, and further analysis of the situation will be made.

Q.: You mentioned stainless steel tubes. ChelPipe and TMK are the only producers in Russia. The latter said at the end of summer that it was getting ready to deliver a project to produce stainless steel feedstock for welded pipes. ChelPipe specializes in seamless stainless pipes. But still, have you not discussed possible involvement in this project with TMK, are you thinking about branching out into welded stainless steel pipes?

A.: Many have diversified, and built more than 70 pipe mills of various kinds, which has collapsed the market for welded steel pipes, where the profit margin struggles to reach 1%. This is not our way.

We’re not in talks with TMK. TMK is expecting to carry out a project with flat roll for welded stainless pipes, while we specialize in seamless stainless pipes.

ChelPipe has many years of stainless steel pipe production under its belt. In Soviet times, Pervouralsk was the main producer of such pipes for all sorts of industries. It used all sorts of methods to roll and treat pipes, and it is able to draw on its own wealth of expertise to perform an objective assessment of new technological solutions on offer to clients. Our share of this market today is around 20%, and we want to increase it, expanding the range of our products, because we see demand for stainless pipes growing in the world market.

Q.: Not so long ago ChelPipe approved its dividend policy. Shareholders voted to accept final dividends for 2019 in keeping with the board’s recommendation, despite the fact there were already obvious problems due to the coronavirus. Might this “new reality” be a reason to adjust or review dividend policy? Dividends have not been announced for the first half of this year, but might they be paid for the year?

A.: We want to be of interest to investors, and we'll try and do all we can to put our dividend policy into practice. It states that dividends are paid at least twice per year. Decisions on the amount depend on the company's financial results, on leverage, FCF and net profit. These are absolutely clear indicators. Let's get through Q3 and Q4 and see how demand recovers.

Q.: As far as I can gather, the dividend policy was adopted in preparation for an IPO, which has had to be shelved due to the poor market situation. Is this now off the agenda?

A.: The company has to develop, and it is the management's job to offer shareholders the best solutions to finance that development. We are generating steady cash flow, which enables us to implement our planned projects in keeping with the adopted strategy.

We're looking at various options to finance accelerated growth in promising areas of business, and they include a public share offering. I think this would be an interesting, good and effective means of financing our development.

Q.: ChelPipe and Zagorsk Pipe Plant or ZTZ said in the summer that they intended to create an industrial group. What was behind the decision to combine assets with ZTZ? Was the coronavirus the catalyst that sped up the decision?

A.: I'm absolutely convinced Darwin’s theory of evolution, that the strongest survive, is right. The more effective you are from various points of view – costs, opportunities to work with clients, suppliers, and the stronger you are in the market, the more likely it is that you will survive this turbulence, and meet all challenges.

From this point of view yes, the coronavirus has kick-started these processes.

The market is clearly stagnating as there's a surplus of capacity and a lot of competition, so one way of easing the pressure on manufacturers might be to form alliances of pipe producers. We are working on such an option with ZTZ. We see in this decision a lot of opportunities and prospects for both companies: we could align our capacity utilization, combining our scientific potential to develop consumer specifications and have a more balanced investment program.

Q.: Has the form of the alliance been decided?

A.: A working group that the companies set up is discussing the form in which this will take place - a JV, industrial alliance or something else. Crucially, the alliance would strengthen our market footing. It's hard to do that on your own, you need to use all possible opportunities that make you strong.

Q.: ChelPipe tapped the Eurobond market in the autumn of 2019. The company said at the time that the bulk of the proceeds went towards paying off ruble loans. This year you have placed ruble bonds. Are you looking to the debt market again?

A.: We placed both the ruble bonds and the Eurobonds with the aim of restructuring outstanding debt. The company’s strategy calls for consistently lowering the debt load, and we plan to pursue that policy going forward.

Today we have reduced the share of bank loans to 50%. That’s a far more sustainable figure from the point of view of balancing debt. We have enough liquidity to cover upcoming payments on outstanding loans over a two-year horizon.

Q.: What’s the company’s leverage guidance for end-2020? This increased somewhat in H1 2020, to 2.3х from 2.1х...

A.: Net debt/EBITDA will depend very much on how we get through the second half-year. Much will also depend on the contract with Gazprom, on exports, in particular to America, and on a number of other factors. I’m confident we will not breach any covenants.

Q.: What’s the guidance for your pipe shipments this year?

A.: Right now it’s hard to operate with any absolute figures. Today we are looking more at that share of the market that we occupy in various segments. We performed very well in the first half of the year, we did not reduce our share anywhere, in fact we even increased it in places. Right now it is crucial that we focus on not losing our market positions. Partly with that in mind we are focusing on high value-added production.

Operating efficiency is also important to the company. For this year we have the “5+” program where we are looking to lower costs by 5 billion rubles or more compared with 2019.

Absolute volumes are the second or even third derivative for me today. If we do not lose our market shares we’ll ship as much as the market allows us to.