China Steel Industry Perspectives

WORKING DRAFT Last Modified /7/7 :53 AM China Standard Time Printed /7/7 5: PM China Standard Time China Steel Industry Perspectives November 7 Yuanpeng Li

CHINA FINISHED STEEL DEMAND China s finished steel demand has already peaked out at 779mtpa in 3, then declined gradually to 79mtpa in 6 China CAGR, Percent apparent finished steel demand by sector 6-6 Million metric tonne 6-3 3-6 386 7 5 7 3 3 3 8 5 7 55 66 6 85 78.5% p.a. 57 58 79 3 37 73 6 9 6 3 8 67 7 8 3 7 9 8 5 9 8 75 8 5 57 9 55 67 95 6 8 8 5 58 5 5 696 3 77 5 3 779 5 7 7 -.% p.a. 757 6 69 5 78 7 7 5 79 5 8.3.5.7 9.6 5. 9. 8.5 7.3 -.3 -..9 3.3. -.6 -.5.9 Machinery Consumable durables Transportation Metal goods Oil & gas Others Urban residential construction Comm./ind./inf. construction 3 6 7 8 9 3 5 6 Mainland China Unclassified construction, stock change, and others 3 Commercial, industrial, infrastructure, and rural residential construction SOURCE: CISA; McKinsey BMI China Steel Demand Model 7Q3 McKinsey & Company 3

CHINA STEEL SUPPLY China s crude steel capacity has increased to ~ bn tonne since 3; production slowdown results in ~8mt capacity idling Chinese crude steel capacity and production evolution Million tons,3,36,5 97 99 85 8 83 8 88 763 7 73 677 7 59 639 577 53 9 5 6 7 8 9 3 5 6 8% 83% 76% 8% 8% 8% 75% 8% 79% Production 77% 8% Capacity CAGR 6-6 6.7% 6.6% Capacity Utilization Aggressive and intensive capacity expansion China s stimulus package effect Slow-down of China demand Nameplate capacity, with corresponding utilization rate referred here Excluding IF capacity and production SOURCE: McKinsey Crude Steel Capacity Database, CEIC McKinsey & Company

CHINA STEEL SUPPLY Several approaches being adopted to remove outdated and inefficient capacity Bankruptcy Forced closures Environmental Compliance Sep 5 Songting steel, private steel mill in Hebei Province, officially bankrupted Mar 6 - Shandong Huayuan Steel Co. bankrupted and auctioned its asset Local government announced targeted 5mt steel capacity reduction by Leveraging rigid environmental and legal compliances, government shut down ~mt IF capacity by the end of June 7 8 cities in North China (e.g. Hebei, Shandong, provinces) are requested to cut steel operations by 5% during Nov 5, 7 Mar 5, 8 To actively and steadily promote the survival of the fittest, we will clear the market through mergers and acquisitions, bankruptcy and liquidation. XI Jinping, president of China, Dec 5 Reduction of outdated and inefficient steel capacity is the prerequisite of industry restructuring and normalizing. The State Council, May 7 Capacity elimination in tandem with tightening environment regulations, help to facilitate restructuring of local steel industry. CISA,July 7 Funds for reeducation Laid-off employees will be re-educated and re-deployed Central Govt set up Industrial Enterprises Structure Adjustment Special Funds (~Rmb bn) for young, who have learning ability and are trainable, they could learn new technics and skills, and transfer to service industry, eg. express delivery. Ministry of Finance, Mar 6 SOURCE: Press search; McKinsey McKinsey & Company 5

CHINA STEEL SUPPLY Elimination volume in 6 out-performed government target 6 elimination target, mt 6 real elimination, mt Hebei Liaoning 3 Fujian Hubei Jiangsu Yunnan Tianjin Shanghai Anhui Helongjiang Shandong 3 Henan Guizhou Sichuan Zhejiang Guangxi Guangdong Gansu Xinjiang Jilin Hunan Jiangxi Shanxi Inner Mongolia Total 5 3 3 3 6 7 79 Elimination volume in 6 out-performed the government target Government plans to shut down ~5mtpy outdated steel capacity in 7 By the end of Sep 7, capacity reduction reached to ~35mtpy capacity BOF+EAF capacity SOURCE: Local government announcement McKinsey & Company 6

CHINA STEEL SUPPLY Complete elimination of mtpy IF capacity has been creating substantial impact on the industry climate 6 IF capacity in China, mt Sichuan () Hebei () Shandong () Others (8) Jiangsu () June 7 Jan 7 Dec 6 Dec 6 Nov 6 ~mt IF capacity was eliminated NDRC announced on CISA meeting that the crack-down of IF capacity to be completed by the end of June 7 MIIT and NDRC released Notice of Controlling Steel Capacity Addition and Crack-down of IF Supply to Restore Industry Behavior IF regulation stormed over provinces in Jiangsu, Sichuan, Shandong, and Hebei MIIT announced 3 th Five Plan for Steel and put shut-down of IF capacity into schedule Capacity: ~mt Production: ~7mt Aug 6 Urged by Central govt., Jiangsu province started to investigate illegal IF supply SOURCE: Mysteel; press search; team analysis McKinsey & Company 7

CHINA STEEL SUPPLY Due to IF closures, 7 production of CISA member mills has grown faster than small private mills YoY,% day CS production Mt 8 6 8 6 Total steel production grow by only 5.8% YoY in YTD 7, SMEs growth rate is -3% day CS production YoY growth % J F M A M J J A S O N D J F M A M J J A S O N D J F M A M J J A 5 5-5 - -5 % 5 6 7 YTD growth, % -.%.7% 7.% CISA member mills SOURCE: Mysteel; NBS McKinsey & Company 8

CHINA STEEL PRICE Rebar prices have closed the gap with international prices due to IF closures creating tightness in the market US China India Chinese price vs. global prices (USD/tonne, local VAT excluded) EU HRC Rebar 8 75 75 7 7 65 65 6 6 55 55 5 5 5 5 35 35 3 3 5 5 5 5 5 5 J M M J S N J M M J S N J M M J S N J M M J J M M J Japan S N J M M J S N J M M J S N J M M J 5 6 7 5 6 7 SOURCE: MEPS McKinsey & Company

CHINA STEEL PROFITABILITY Profitability improved significantly in 7 as net margin increased from.% in 6 to 5.5% in July 7 Net profit margin Revenue Net profit margin % 8 6 - - -6-8 3 5 6 7 Revenue Billion RMB 35 3 5 5 5 Profit data for 77 large & medium CISA member steel mills SOURCE: Mysteel; CISA McKinsey & Company

We expect the industry to be a bit balanced but with continues structural changes for upgrading A B C Supply reform will continue, yet market tightness being offset by demand slowdown Industry consolidation likely to improve for more cross region M&A EAF could go at higher growth due to scrap availability D Export unlikely to grow but outbound investment could grow McKinsey & Company

CHINA FINISHED STEEL DEMAND A Going forward, China steel demand is expected to decline to 7mt in and 63mt in 5 China apparent finished steel demand by sector -5 -.6% p.a. CAGR, Percent -.% p.a. 75 739 6- -5 79 7 7 5 6 3 63 -.5 -.6 Machinery 99 Consumable 86 -. -.3 7 86 durables 85 8 5 5 3..7 Transportation 5 5 5 9 8 5 -.8 -.9 Metal goods 9 8 7 8. -3. Oil & gas 57 6 58 8 3 5 -.6 -. -. -. Others Urban residential construction 5 5 9 7 7 3 -.5 -. Comm./ind./inf. construction 3 6 7 8 9 5 Mainland China Unclassified construction, stock change, and others 3 Commercial, industrial, infrastructure, and rural residential construction SOURCE: McKinsey BMI China Steel Demand Model 7Q3 McKinsey & Company

CHINA FINISHED STEEL DEMAND A Continuous decline in steel consumption is driven by decreasing demand in construction and machinery segments China apparent finished steel demand sources of growth, 6-5 Million metric tonne 6 Urban residential construction Comm./ind/inf. construction Machinery Consumer durables Transportation Metal goods 386 3 8 6 7 Oil & gas 3 Construction: Increasing urbanization Increased steel intensity as buildings get taller Auto production experienced significant growth CAGR of 5% 6 79 5 9 7 BASE CASE Slow-down in urbanization and saturated real estate market Dip in machinery Slowing industrial sector growth Decrease in exports Vehicle growth due to increasing auto penetration Others 3 6 6 79 5 63 Commercial, industrial, infrastructure, and rural residential construction SOURCE: McKinsey BMI China Steel Demand Model 7Q3 McKinsey & Company 3

CHINA STEEL SUPPLY A Chinese government continues to push restructuring and capacity elimination of 5mt in 6- China crude steel capacity, -, Million tons 763 3 Govt. has pushed reduction of ~3mt capacity in th Five 5 ~53% of additions from SOE,5 5 5 6 35 Capacity replacement Small private mills Local governments plan to shut down 5mtpy crude steel capacity in 3 th Five All BOF based integrated route ~9% of additions from SOE Capacity replacement Small private mills EAF investment 995 Closure Addition Capacity 5 creep Closure Addition Capacity creep e Excluding IF capacity Other small mill: crude steel production < 3.mt SOURCE: Press search; McKinsey McKinsey & Company

CHINA STEEL SUPPLY A Capacity elimination will be highly concentrated on Eastern and Coastal regions, especially Hebei province China steel production by province, 5 - Mt -5 Mt >5 Mt Xinjiang Tibet SOURCE: McKinsey Crude Steel Capacity Database; CISA; McKinsey Province Shandong Shanxi Xinjiang Inner Mongolia Sichuan Capacity, 5, mt Guangdong 9 Jiangxi 6 Tianjin 6 Shanghai Hunan Guangxi 3 Zhejiang Private SOE Eliminations will concentrate on Eastern and Coastal regions Fujian Hebei province accounts for ~33% of the shutdown Heilongjiang 3 Small and private mills are the key regulation targets, e.g. Gansu Qingquan Steel, Zongheng Steel in Heibei While elimination from SOE mills is driven by replacement, e.g. Guizhou 6 Shandong Steel, Baowu Steel Qinghai 3 BOF+EAF capacity Liaoning Inner Beijing Mongolia Tianjin Hebei Ningxia Shanxi Shandong Qinghai Gansu Henan Shaanxi Jiangsu Anhui Shanghai Hubei Sichuan Chongqing Zhejiang Jiangxi Hunan Guizhou Fujian Yunnan Guangdong Taiwan Guangxi Hong Kong Macau Hainan Heilongjiang Jilin Hebei Jiangsu Liaoning Henan Hubei Anhui Yunnan Jilin 76 6 3 33 33 3 3 3 6 73 57 Total 75,5 Over supply 5, mt 5 3 8 5 8 5 8 6 6 3 7 69 Shutdown plan, in 6-, mt 3 9 8 5 6 NA 6 6 NA 3 9 5 5 3 3 McKinsey & Company 5 5

CHINA STEEL SUPPLY A Overcapacity is likely to hang over China steel industry due to continuous decline in steel demand China demand/capacity Million metric ton, crude steel,, 8 6 Strong capacity increase Nominal capacity Capacity growth slow down Production @ 85% capacity utilization Capacity reduction Demand BASE CASE 5 6 7 8 9 3 5 6 7e 8e 9e e SOURCE: CISA; McKinsey BMI China Steel Demand Model Q3 7 McKinsey & Company 6

CHINA STEEL CONSOLIDATION B To meet central government expectation on 6% of consolidation, strong support from local government on M&A is needed Government plan for top concentration China Top crude steel player share % EU level @ ~75% 9 3 35 6 7 5 5 6 Recent M&A activities 6 5 5 3 Strongly supported by central govt., Baosteel merged with WISCO by the end of 7 Liugang spinned off from WISCO, the separation was mainly due to management and interests conflicts between two parties Approved by MOFCOM, Angang acquired Guangzhou LISCO Under the support of Jiangxi government, Fangda group acquired Pingxiang Steel Government postponed the concentration target by five years Local govt. interference is the key barrier for cross regional M&A Actual Target th Five New target 3 th Five Angang failed with consolidating Benxi Steel after years of efforts, Angang belongs to central government while Benxi Steel belongs to provincial govt. SOURCE: McKinsey Crude Steel Capacity Database; Mysteel; SBB; th and 3 th Five-Year Plan McKinsey & Company 7

CHINA STEEL CONSOLIDATION B The prevailance of regional and cross-regional consolidation can be expected in the medium to long term Government consolidation plan for 5 To foster 3- steel groups with capacity of ~8mtpy and 6-8 steel group with capacity of mtpy 3-steps approach will be adopted to realize the 5 plan, : Step (6-8): Shutdown obsolete steel capacity and develop model example for consolidation (Baosteel WISCO) Step (8-): Optimize consolidation policy and compliances Step 3 (-5): Facilitate consolidation progress to a grander level Regional consolidation to # of companies: Shanxi province to foster 5 steel hubs with capacity mtpy by Regional consolidation to reduce # of companies: Hebei province by to foster large national steel groups (Hebei Steel and Shougang), 3 provincial steel groups (based in Qian an, Fengnan, Wu an Cities) and local steel companies Cross-regional consolidation led by large steel groups Baosteel WISCO (~8mtpy) Baosteel announced to expand scale to ~mtpy by further M&A in the future Central government guideline for consolidation and disposal of mothballed capacity SOURCE: China central government McKinsey & Company 8

CHINA SCRAP C China scrap will grow stably over next decade, driven by strong generation in obsolete scrap China scrap availability mmt 5 3 Obsolete Prompt Obsolete share, Percent ~5 Home x ~8 China scrap supply 7% recycling mmt 5 3 65 35 8 More details on next pages +% p.a. 5 85 3 5 5 5 3 5 5 5 3 for the future 7% of available obsolete scrap is assumed to be recycled, For home and prompt scrap a % recycling efficiency is assumed SOURCE: Worldsteel; McKinsey Analysis McKinsey & Company 9

CHINA SCRAP C Surplus of scrap in China is likely to occur as scrap supply will exceed the demand even while assuming high usage rates in EAF and BOF China scrap supply demand balance 5E base case assumptions mmt Scrap supply Crude production (as a result of steel demand and net trades) to decline by ~7 mmt in next years Typical life cycles and collection rates for different end use sectors of steel Obsolete scrap recycling efficiency of ~7% 85 Supply 75 75-5 Demand @ new scrap intensity 7 Demand @ current scrap intensity ROUNDED NUMBERS Scrap demand Steel demand to decline by ~8 mmt in next years Net exports to decline to ~7mmt in 5 from ~mmt in 5 Maximized EAF crude steel production ~7 mmt (capacity ~75 mmt in 6) EAF: kg BOF: kg EAF: 6 kg BOF: 5 kg SOURCE: Worldsteel; McKinsey Analysis McKinsey & Company

CHINA SCRAP C Different scenarios could be considered by which China s future scrap supply demand mismatch gets balanced NOT EXHAUSTIVE China scrap supply demand balance 5E mmt - + 75-5 - 85 3 Will there be as much obsolete scrap available and enough incentives in China to collect and recycle the scrap? How will scrap recycling industry evolve and what prices are needed to make the industry profitable? Will current BOF and EAF players be able to use more scrap up to the standards typically observed in developed regions or above by applying new technologies? To what extend is the country ready to allow the steel industry to make the switch from BOF to EAF and hence closing more BF-BOF capacity while investing in new EAF facilities? Demand Supply If not all collected scrap can be consumed locally, what measures will be put in place to support or discourage the exports of scrap from China? Will it distort global trade of scrap, and iron ore market? SOURCE: Worldsteel; McKinsey Analysis McKinsey & Company

CHINA SCRAP C3 Beyond the current capacity closure plans a significant switch from BOF to EAF is needed to accumulate the scrap ROUNDED NUMBERS China crude steel capacity assessment mmt Current estimates 99 97 33 9 Capacity decrease based on 3 th Five Year elimination plan Capacity additions covering announced (replacement) projects 888 83 3 BOF 9 EAF Additional needs Rethink capex plans when blast furnaces are up for reline Install new EAFs with latest technology to allow flexible RM input 865 7 EAF share, Percent 75 75 65 6 Closures Addition 5E 5E 8 9 SOURCE: McKinsey Analysis McKinsey & Company

CHINA SCRAP C Increasing surplus due to lacking the ability to absorb collected scrap could distort global scrap trade and iron ore market Global share of metallics 5 Percent 6% Blast furnace pig iron Alternative primary iron % Scrap 3% Total scrap consumption mmt ~65 ~565 ~85 Local Trade 3% China scrap supply surplus based on base case assumptions mmt 5 75 5 3 5 5 75 5 5 SOURCE: McKinsey Analysis McKinsey & Company 3

CHINA STEEL EXPORT D Export of Rod & bar products reduced significantly in 7 due to IF elimination, Asia markets still the biggest destination for China steels Chinese steel products export Million tons Rod & Bar Angle, Shape, Section Sheet & Plate 9 9 9 9 9 9 9 9 8 8 8 8 8 8 7 Tube & Pipe Railway Use Other 8 7 7 6 6 7 Export by destination % % = 5 6 3 7 3 ASEAN DA Other Asia Europe NA Russia Others J F M A M J J A S O N D J F M A M J J A S O N D J F M A M J J 5 7 Jan-Aug 5 6 7 Developed Asia North America SOURCE: Mysteel; NBS McKinsey & Company

CHINA STEEL EXPORT D Strong exports are not expected to be sustainable over the long term China finished steel export, - Million metric tons 3 9 56 6 9 8 76 8 8 8 China steel exports are facing with increasing pressure of protections such as anti-dumping, regarding current huge export volume and slowdown of global demand, the export growth potential will be limited in the future - Mysteel Government doesn t encourage steel exports, the export volume is mainly decided by global demand. China steel exports will remain ~ 8-9mtpy in the long term - Steel Home 3 5 6 7e 8e 9e e SOURCE: CEIC McKinsey & Company 5

CHINA STEEL EXPORT EVOLUTION OF INDUSTRY STRUCTURE D Government s long-term policy goal to restrict the export of low value-added steel products China steel products export tariff, 5-7 Percentage 5 5 5-5 - -5 Jan 5 3 Jan 7 5 6 8 7 Jan 9 9 Jan Jan 3 Jan 5 3 Jan 7 Semi Rebar/Bar/Wire HR wide strip and plate HR narrow strip CR narrow strip Section Boron steel Seamless pipe Welded pipe CR wide strip May 5: cut tax rebate from 3 - % for rolled steel and to % for semi-steel September 6: cut tax rebate from - 8% for rolled steel 3 November 6: imposed % export tax for semi- steel April 7: cut tax rebate from 8-5% for 73 high-end rolled steel products (i.e., stainless); for the remaining 83 rolled steel products, tax rebate was removed 5 June 7: further added 5 - % export tax for most rolled steel products and increased semi-steel export tax to 5% 6 January 8: increased semi-steel export tax to 5%, most long products and narrow strip to 5%, wide flat and seamless pipe remain 5%; some high-value-added cold rolled flat products (i.e., coated) still enjoy 5% tax rebate 7 December 8: temporary export duty removed for categories of finished steel products from Dec 8 to Dec 9 8 April 9: VAT rebate for high-value-added products (i.e., CR wide strip, stainless, electronic sheets, alloyed steel, stainless seamless pipe) increased from 5-3% 9 June 9: VAT rebate was raised again for steel products (i.e. HR strip, plate, part of seamless pipe and welded pipe) January : VAT rebate was raised for welded pipe to 9% July : VAT rebate was canceled for 8 steel products, mostly plate and strip (i.e. HR wide / narrow strip, CR narrow strip) January 5: VAT rebate of boron containing steel was canceled 3 January 6: Export tax for semi reduced from 5% to % SOURCE: China Customs; McKinsey McKinsey & Company 6

CHINA STEEL INVESTMENT D Increasing global investments from Chinese top steel players as they expand market footprints, seek new growth, and acquire technology More and more Chinese steel mills explore oversea markets to achieve new growth and acquire technology. For some companies such as WISCO and Baosteel, the acquisition is shifting from resource driven to technology driven YiCai Financial, Jun 5 Steel companies could invest production hubs of steelmaking and distribution in ASEAN and Africa countries to extend value chain and expand sales, and take advantage of local raw material resources ideally Hebei Government, Nov Chinese steel players Investment details Value creation levers Apr 3 WISCO Announcement for JV with TBEA for silicon steel distribution center ( ktpy) in India Jun 3 WISCO Acquired laser welding dept. of ThyssenKrupp Sep 3 Baosteel New Five-Year plan: Develop distribution networks and JV in ASEAN markets for CR and coating products May May Maanshan Steel Kunming Steel Applied to French govt. for acquisition of wheel producer Sasvaldunes Commissioned JV in Vietnam for. mtpy integrated steel mill Sep Hebei Steel Started investment in South Africa for 5. mpty integrated steel mill Sep 5 Hebei Steel Acquired European steel trader Duferco (annual trading volume ~ mt) Jul 5 Delong Steel Commission of JV in Thailand for.6 mtpy steel sheet distribution center Apr 6 Hebei Steel Acquired Zelezara Steel (~. mtpy) in Serbia New growth market Extend value chain Acquire technology New growth market Acquire technology Extend footprints New growth market New growth market Extend footprints Avoid anti-dumping New growth market Extend footprints Chinese top steel players have been increasing investment for globalization, ~. bn USD in 3-6 They target ASEAN countries and South Africa for new growth engine via JV of integrated steel mill and distribution centers While investments in European market mainly to acquire technology as well as extend value chain and market footprints SOURCE: Press search; McKinsey McKinsey & Company 8

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