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 pipe. In 2015, sales volumes of pipes used in oil and gas industry accounted for approximately 78% 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 2014 and 2015, oil and natural gas prices decreased significantly by more than 50%. As a consequence, we faced pricing pressure on our products, particularly in the United States, and are likely to continue to face similar pressure in 2016.
Thus, the decline in oil and gas exploration, drilling and production activities, prices for energy commodities and other economic factors beyond our control could adversely affect our results of operations.
62%the share of raw materials’ and consumables’ costs in the total cost of production in 201539%of our total sales volumes were shipped to five largest customers (Rosneft, Gazprom, Surgutneftegas, Gazprom Neft and Lukoil)66%of our LDP were sold for Gazprom projects
We require substantial quantities of raw materials to produce steel pipes. 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 utilize is generally correlated with macroeconomic fluctuations, which in turn are affected by global economic conditions.
Prices for raw materials and supplies have a key influence on our production costs and are one of the main factors affecting our results of operations. There are many factors which influence raw materials prices, including oil and gas prices, worldwide production capacity, capacity utilization rates, inflation, exchange rates, trade barriers and developments in steelmaking processes. In 2015, the cost of scrap metal in Russia in rouble-terms increased on average by 6%, and the cost of coils increased by 30%. At the same time, we are negotiating new contract terms with our major clients based on pricing formulas, which secure us against growing raw materials prices. The share of raw materials’ and consumables’ costs in the total cost of production in 2015 was 62%. The increase in prices for scrap, coils and other raw materials, if not passed to customers can adversely affect our profit margins and results of operations.
Our plants also consume significant quantities of energy, particularly electricity and gas. In 2015, energy and utility costs comprised approximately 8% of our total cost of production. The prices for electricity for our plants increased by 1% in rouble-terms compared to 2014, while the average prices for domestic natural gas for our plants increased by 3% in rouble-terms. If we are required to pay higher prices for gas and electricity in the future, our costs will rise and this could have a material adverse effect on our business, financial condition, operational results and prospects.
As we focus on supplying primarily the oil and gas industry, our largest customers are oil and gas companies. In 2015, our five largest customers were Rosneft, Gazprom, Surgutneftegas, Gazprom Neft and Lukoil, which together accounted for 39% 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 deteriorates.
Our LDP business is largely dependent on one of our largest customers, Gazprom. In 2015, 66% of our LDP were sold to Gazprom projects. Increased competition in the supply of LDP or a change in relationship with Gazprom could negatively affect our competitive position in the large-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 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 LDP, and thus on the results of operations and financial position.
The global market for steel pipe products, particularly in the oil and gas sector, is highly competitive. In the Russian and CIS markets, we face competition primarily from ChTPZ, OMK, and the Ukrainian and Chinese pipe producers.
After accession to the WTO, Russia had adjusted its national legislation in full accordance with WTO rules and regulations, which allowed Russia along with the EEU (Eurasian Economic Union) to use WTO trade defense mechanism for the national market protection to the full extent. To date, the following antidumping measures were imposed: antidumping duties 18.9%-19.9% on imports of Interpipe (Ukraine) pipe production, antidumping duties of 19.15% on imports of cold-drawn stainless steel pipe from China, antidumping duties 12.23%–31% in respect to OGTG originated from China.
In 2015, the EEC initiated anti-dumping investigations against imports into the EEU: an investigation in respect to seamless stainless steel pipes and an expiry review in respect to certain tubes and pipes. Both products were originated from Ukraine. Final decisions are expected in 2016.
Outside Russia and the CIS, we compete against a limited number of premium-quality pipe products producers, including Tenaris, Vallourec, Sumitomo, Voestalpine and Chinese producers.
In the United States according to the DOC’s findings in August 2014 antidumping duties were imposed at the following levels in respect to Oil Country Tubular Goods: India 2.05%–9.91%; Turkey 35.86%; South Korea 9.89%-15.75%, Taiwan 2.34%, Vietnam 25.18%–111.47%, the countervailing duties were 5.67%–19.57% for India and 2.53%–15.89% for Turkey.
In October 2015, after the results of the investigations in respect to welded API line pipe from South Korea and Turkey were released the final antidumping and countervailing duties were set at the following level: 6.66%-22.95% for Turkey, 2.53%–6.19% for Korea, the final countervailing duties for Turkey were set at level of 1.31%–152.20%, for Korea 0.28%–0.44% (less than de minimis level and wouldn’t be applied).
Decisions and determinations subsequent to results of the investigations mentioned above are expected to ensure the alignment of competitive conditions of the competition in the market of pipe products in Russia and America in 2015 and contribute to the improvement of market positions of Russian and American plants.
Nevertheless, if the measures taken by the EEU or International Trade Commission have appeared to be insufficient for the protection from the unfair import in the future, this could have an adverse impact on TMK market position.
As of December 31, 2015, our total debt decreased to $2,801 million as compared to $3,223 million at the end of 2014, partially due to the rouble depreciation against the U.S. dollar. Net repayment amounted to $193 million. As of December 31, 2015, our Net-Debt-to-EBITDA ratio was 3.92x.
In 2015, we duly satisfied and discharged obligations under loan agreements and refinanced a certain part of our loan portfolio In February, 2015 we redeemed our 5.25% Convertible Bonds due 2015 convertible into GDRs, each representing four ordinary shares of TMK. To redeem the bonds TMK used cash accumulated from operating and financial activities, including four-year USD denominated credit facility from one of the leading Russian commercial banks.
In October-November 2015, we redeemed $91.78 million of $500 million 7.75% loan participation notes due 2018. Following settlement of the transaction outstanding amount of the Eurobonds is $408.82 million.
Improving liquidity profile remains one of our priorities, and we continue to carry out measures to maintain sufficient liquidity and improve loan portfolio structure. During 2015, to assure effective access to financial resources, we concluded short-term and medium-term credit line agreements with major Russian banks for the total amount of 30.1 billion Roubles. As of 31 December 2015, we committed credit lines in Russian, European and American banks with the available limit of $527.9 million.
Nevertheless, there can be no assurance that our efforts to improve liquidity profile and reduce leverage will prove successful. The negative debt market reaction on deteriorating global political and financial situation, US and EU sanctions, economic situation in Russia, hike of the key rate by the Bank of Russia may have an adverse impact on our ability to borrow in banks or capital markets, and may put pressure on our liquidity, significantly increase borrowing costs, temporary reduce the availability of credit lines or lead to and possibility to incur financing on acceptable terms.
Certain amount of our loan agreements and public debt securities currently include financial covenants. Some covenants impose financial ratios that must be maintained, others impose restrictions in respect of certain transactions, including restrictions in respect of indebtedness, pledging of assets and material asset disposals. A breach of financial or other covenants in existing debt facilities, if not resolved by means such as obtaining a waiver from the relevant lender and/or making amendments to debt facilities, could trigger a default under our obligations.
As of 31 December 2015, we were in compliance with lenders’ requirements under covenants.
Nevertheless, in case financial markets or economic situation on the markets, where we operate, deteriorate in the future, we may not comply with relevant covenants. In case of possible breach we will obtain all necessary waivers or standstill letters. We do not expect the occurrence of such events in the near future.
Substantial part of our loan portfolio is represented by loans with fixed interest rate. However, some loan agreements contain a right of creditors at its sole discretion to change interest rates including in case of change of credit indicators by the Central Bank of Russia and in some other cases. After significant growth of the key rate in the end of 2014, interest rates for some of our borrowings have increased.
Interest expenses are the prevailing part of our finance costs. In 2015, our finance costs increased as compared to 2014. As of December 31, 2015 our weighted average nominal interest rate amounted to 9.06% compared to 7.26% as of December 31, 2014.
Additionally, certain part of our loan portfolio is represented by loans with floating interest rates. As of December 31, 2015, loans with floating interest rates represented $261 million. The underlying rates in current loans with floating interest rates are LIBOR and EURIBOR. Variable rate loans accounted for 8% of the total loan portfolio at the end of 2015, after taking into account the effect of interest rate swaps.
Should floating interest rates increase in the future or Central Bank of Russia changes the key rate, interest expenses on relevant loans will grow.
USD 261 mloans with floating interest rates as of December 31, 2015
Our products’ prices as well as our costs are nominated both in roubles and in other currencies (generally, in U.S. dollars and EUR). We hedge our net investment in operations located in the United States and Oman against foreign currency risks using U.S. dollar denominated liabilities. Gains or losses on the hedging instruments relating to the effective portion of the hedge are recognised as other comprehensive income while any gains or losses relating to the ineffective portion are recognised in the income statement. In 2015, we incurred foreign exchange losses from spot rate changes in the total amount of $371 million, including $141 million recognised in the income statement and $230 million (before income tax) recognised in the statement of comprehensive income.
As of December 31, 2015, 63% of our loans were denominated in U.S. dollar. In this regards, as well as taking into consideration continuing volatility of the rouble against U.S. dollars, the risk of losses owing to the rouble devaluation remains sufficiently high. Nevertheless, depreciation of the rouble against the U.S. dollar could adversely affect our net profit as coherent losses will be reflected in our consolidated income statements.
A significant amount of our production activities are located in Russia, and a majority of direct costs are incurred in roubles. We tend to experience inflation-driven increases in certain costs, such as raw material costs, transportation costs, energy costs and salaries that are linked to the general price level in Russia. In 2015, inflation in Russia reached 12.9% as compared to 11.4% in 2014. In spite of the measures of the Russian government to contain inflation, growth of inflation rates may be significant in the short-term outlook. We may not be able to increase the prices sufficiently in order to preserve existing operating margins.
63%of our loans were denominated in U.S. dollar as of December 31, 2015
Inflation rates in the United States, with respect to our American division operations, are historically much lower than in Russia. In 2015, inflation in the United States decreased to 0.73% in comparison with 0.76% in 2014.
High rates of inflation, especially in Russia, could increase our costs, decrease our operating margins and adversely affect our business and financial position.
Our subsidiaries make significant tax and non-budgetary funds payments, in particular, profit tax, VAT, property tax and payments to social security funds. Changes in tax legislation could lead to an increase in tax payments and, consequently, to a lowering of financial results. As significant part of the operations is located in Russia, the main risks relate to changes in the legislation of the Russian tax system. The Russian Government continually reviews the Russian tax legislation. The new laws generally reduce the number of taxes and the overall tax burden on business while simplifying tax legislation. Nevertheless, should the Russian taxation system undergo any changes related to an increase tax rates, this could adversely affect our business.
Moreover, the Russian oil industry is subject to substantial taxes, including significant resources production taxes and significant export customs duties. Changes to the tax regime and customs duties rates may adversely affect the level of oil and gas exploration and development in Russia, which can adversely affect the demand for our products in Russia.
We meet the requirements of national environmental laws the locations of our industrial facilities the directives and regulations of Russian, the United States, the European Union, Romanian, Kazakhstan and Omani legislation.
The main environmental-and-economical risks of our Russian plants are related to changes and tightening of the Russian environmental protection laws. Environmental legislation in Russia is constantly developing. The imposition of a new law and regulation system may require further expenditures to install new technological and waste disposal equipment, pollution and wastewater control equipment, and will lead to growth of the rate of payments for negative impact on the environment. It is expected that compliance with the regulations will be accompanied by stricter control by state monitoring authorities.
We estimate that the environmental legislation of the European Union and the United States, Romania, Kazakhstan and Oman will not undergo any material changes in the near future. Nevertheless, if such changes arise, the cost of compliance with new requirements could have a material adverse effect on our business.
Our production capacities are subject to the risk of equipment failures due to unanticipated events, such as fires, explosions and adverse weather conditions. Manufacturing processes depend on critical pieces of steelmaking and pipe-making equipment. Such equipment may, on occasion, be out of service as a result of unanticipated failures could require us to close part of the relevant production facility or cause to reduce production on one or more of production lines. Any interruption in production capability may require us to make significant and unanticipated capital expenditures to affect relevant repairs, which could have a negative effect on our profitability and cash flows.
We have limited and, potentially, an insufficient level of insurance coverage for expenses and losses that may arise in connection with the quality of our products, property damage, work-related accidents and occupational illnesses, natural disasters and environmental contamination. We have no insurance coverage for loss of profits or other losses caused by the death or incapacitation of our senior management and we have no business interruption insurance. Losses or liabilities arising from these or other such events could increase our costs and could have a material adverse effect on our business, financial condition, results of operations and prospects.
Our Russian subsidiaries are often the largest employers in the cities in which they operate, such as Volzhsky, Taganrog, Kamensk-Uralsky and Polevskoy. While we do not have any specific legal social obligations or responsibilities with respect to these regions, the ability to reduce the number of our employees may nevertheless be subject to political and social considerations. Any inability to make planned reductions in the number of employees or other changes to operations in such regions could have an adverse effect on the operational results and prospects.
Competition for skilled labor in the steel pipe industry remains relatively intense, and labor costs continue to increase moderately, particularly in the CIS, Eastern Europe and the United States. We expect the demand and, hence, costs for skilled engineers and operators will continue to increase, reflecting the significant demand from other metallurgical companies and other industries. Continual high demand for skilled labor and continued increases in labor costs could have a material adverse effect on our business, financial position and results of operations.