OREANDA-NEWS. The sharp increase in coking coal prices since August 2016 could squeeze Indian steelmakers' profitability and threaten their deleveraging, Fitch Ratings says.

The risk will increase if high coking coal prices persist and domestic steel demand growth remains weak. Leverage for producers such as Tata Steel Limited (BB/Rating Watch Evolving) and JSW Steel Ltd (BB/Negative) jumped in the financial year ending March 2016 (FY16), mainly due to poor profitability, and sustained pressure on margins would hamper the deleveraging process.

Prices for hard coking coal for export by Australia as of 30 September 2016 were 125% (USD100/tonne) higher than the average in the quarter ended June 2016 (1QFY17), according to data from The Steel Index. Prices rallied following China's decision to limit coal mines' operating days to 276 a year, from 330 before, to restructure the industry and improve its profitability. Others issues such as flooding in China's Shanxi province, which reduced supply, and a number of unplanned mine outages in Australia also supported the price rise.

The increase in raw material costs for Indian steel producers could shrink margins, if the cost rise is not passed on to consumers. For example, we estimate that a USD50/tonne increase in Tata Steel's coking coal cost in 1QFY17 would have reduced consolidated EBITDA by around 35%, if all else stayed the same. Similarly, JSW Steel's 1QFY17 consolidated EBITDA would have fallen by around 25%. The impact of higher coal costs would be offset if we assume price realisations for the two companies were 5%-10% higher.

However, the ability of steelmakers in India to raise prices to counter any sustained cost increase is likely to be constrained if weak domestic demand growth persists amid increased capacity. Domestic consumption in April-September 2016 rose by just 2.5% yoy, compared with 5.9% in FY16. Meanwhile, producers, including Tata Steel and JSW Steel, aim to increase sales volume after recent capacity expansions.

The full impact of the recent jump in coking coal prices on steelmakers will be felt from the later part of 3QFY17, as volumes are mostly traded on a contractual basis and priced using monthly or quarterly averages, and companies generally keep two to three months' worth of inventories. JSW Steel relies solely on imported coking coal and is therefore exposed to the cost rises. Tata Steel's Indian operations are less susceptible to the rise in coking coal prices as its own production caters to roughly 45% of its requirements, but its overseas units are at higher risk as they rely on imports.

While short-term supply disruptions are being resolved, it is yet unclear how China's policy on coal will evolve. Steel makers in China have recently requested the government to allow higher coal output to alleviate cost pressures. However, coking coal prices could remain high in the absence of a relaxation in operating guidelines for mines. Fitch raised its mid-cycle price assumption for hard coking coal by around 10% to USD110/tonne for the long term in August 2016.