Annual Report 2013

Industry risks

Dependence on the oil and gas industry

The oil and gas industry is the principal consumer of steel pipe products worldwide and accounts for most of our sales, in particular sales of OCTG, line pipe and large-diameter welded pipe. In 2013, sales volumes of pipe used in oil and gas industry accounted for approximately 76% of our tubular products. The oil and gas industry has historically been volatile and downturns in the oil and gas markets can adversely affect demand for our products, which largely depends on the number of oil and gas wells being drilled, completed and reworked, the depth and drilling conditions of wells and the construction of oil and gas pipelines. The level of such industry specific activities in turn depends on the level of capital spending by major oil and gas companies. The level of investment activities of oil and gas companies, which is largely driven by prevailing prices for oil and natural gas and their stability, significantly affects the level of consumption of our products. In case of significant and/or sustained decline in oil and natural gas prices energy companies could reduce their levels of expenditures. As a result, the demand for oil and gas pipe can substantially decrease, leading to the tightening of competition and a possible decrease of market prices for tubular products. Thus, the decline in oil and gas exploration, drilling and production activities and prices for energy commodities could.

Increases in the cost of raw materials

We require substantial quantities of raw materials to produce steel pipe. The principal raw materials used in production processes include scrap and ferroalloys for use in steelmaking operations, steel billets used for the production of seamless pipe and steel coils and plates for the production of welded pipe. The demand for the principal raw materials we utilise is generally correlated with macroeconomic fluctuations, which are in turn affected by global economic conditions.

In 2013, the costs of raw materials and consumables accounted for 65% of total cost of production. Prices for raw materials and supplies are one of the main factors affecting our results of operations. They are influenced by many factors, including oil and gas prices, worldwide production capacity, capacity utilisation rates, inflation, exchange rates, trade barriers and improvements in steelmaking processes. Costs of the principal types of raw materials that we require decreased in 2013 as compared to 2012. In 2013, in the Russian division, the average purchase costs of coils and metal scrap decreased 8% and 7%, respectively, the average purchase cost of steel plates decreased 10% as compared to 2012. In the American division, the average purchase costs of metal scrap and coils used in production decreased 7% and 9%, respectively, as compared to 2012. The average purchase costs of metal scrap in the European division were lower by 7% in 2013 than those in 2012. As the result of higher sales volumes, our costs of raw materials and consumables increased from 3,352 mln USD in 2012 to 3,384 mln USD in 2013.The share of raw materials’ and consumables’ costs in the total cost of production decreased from 66% in 2012 to 65% in 2013.

Raw materials prices continue to have a key influence on our production costs. The increase in prices for scrap, coils and other raw materials, if not passed on to customers in a timely fashion, can adversely affect our profit margins and results of operations.

Our plants also consume significant quantities of energy, particularly electricity and gas. In 2013, the share of energy costs and utilities remained almost flat and amounted to 8% of the total cost of production. Nevertheless, price increases for energy resources will increase our costs of production and could have an adverse effect on results of operations and financial results.

Dependence on a small group of customers

As we focus on supplying primarily the oil and gas industry, our largest customers are oil and gas companies. In 2013, our five largest customers were Rosneft (including TNK BP), Gazprom (excluding Gazprom Neft), Surgutneftegas, Bourland and Leverich and Lukoil which together accounted for 30% of our total sales volumes. The increased dependence of pipe sales on a single large customer bears the risk of an adverse effect on results of operations in the event that our relationship with any of these major customers deteriorated.

Our large-diameter welded pipe business is largely dependent on one of our largest customers, Gazprom, and is subject to increasing competitive pressure. In 2013, 43% of our large-diameter welded pipe were sold for Gazprom projects. Gazprom is one of our largest customers for 1,420 mm diameter welded pipe used for construction of gas trunk pipelines. Increased competition in the supply of large-diameter pipe or a change in relationships with Gazprom could negatively affect our competitive position in the 1,420 mm diameter pipe market, resulting in decreased revenues from sales of these products and adversely affecting our business, financial position and results of operations. Additionally, large-diameter welded pipe business depends significantly upon the level of construction of new oil and gas pipelines in Russia and the CIS. The delay, cancellation or other changes in the scale or scope of significant pipeline projects, or the selection by the sponsors of such projects of other suppliers could have an adverse effect on our sales of large-diameter welded pipe, and thus on the results of operations and financial position. We mitigate this risk by developing cooperation with new customers from CIS countries.

Competition

The global market for steel pipe products, particularly in the oil and gas sector, is highly competitive and primarily based on compliance with technical requirements, price, quality and related services. In the Russian and CIS markets, we face competition primarily from ChTPZ, which produces both welded and seamless pipe, OMK, which produces welded pipe, and the Ukrainian and Chinese pipe producers.

Accession of Russia to the WTO and subsequent reduction of import duties for steel pipe to the level of 5%-13.8%, as well as usage of unfair methods of competition by some importers, led to growth of steel pipe import to Russia and to the Customs Union from China, Ukraine and European Union. Implemented in 2013, antidumping duties of 18.9%-19.9% on imports of Interpipe’s (Ukraine) pipe production, antidumping duties of 19.15% on imports of cold-drawn stainless pipe originated from China as well as imposed earlier and currently active import quota for stainless pipe allowed to restrain the total supply of pipe to Russia in 2013 at the level of 2012.

Nevertheless, if the definitive measures imposed to defend the Custom Union from unfair import are insufficient in the future, this could have an adverse impact on TMK market position.

Outside Russia and the CIS, we compete against a limited number of premium-quality pipe products producers, including Tenaris, Vallourec, Sumitomo, Voestalpine and a limited number of Chinese producers, including Baosteel and TPCO.

In the United States, TMK IPSCO faces competition primarily from Boomerang, Tenaris, U.S. Steel and V&M Star, a subsidiary of Vallourec, as well as from imported OCTG and line pipe products, principally from Asia.

In 2013, the majority of the U.S. steel pipe producers, including TMK IPSCO, submitted a request to the U.S. Department of Commerce to initiate antidumping duty investigations of certain oil country tubular goods from India, South Korea, the Philippines, Saudi Arabia, Taiwan, Thailand, Turkey, Ukraine and Vietnam. In February 2014, the Department of Commerce announced its preliminary determination in the investigation of imports of OCTG from Korea with 0% dumping margin and affirmative preliminary determinations in the investigations of imports from other countries involved with dumping margins from 2.65% to 118.32%.

We are expecting that final determinations in the investigations will be affirmative in relation to South Korean imports as well as imports from other mentioned countries. However, any unfavorable decision could have negative effect on the price environment in OCTG segment.

In addition, several large producers declared their plans to construct new facilities in the U.S. Commissioning of new capacities may lead to toughening of competition, which could have an adverse effect on our business.