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 2011, sales volumes of pipes used in oil and gas industry (mainly OCTG, line pipe and large-diameter pipe) accounted for approximately 74% 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 pipes 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 have a negative impact on our results of operations and financial position.

Increases in the cost of raw materials

We require substantial quantities of raw materials to produce steel pipes. The principal raw materials used in production processes include scrap, pig iron, ferroalloys and refractories for use in steelmaking operations, steel billets used for the production of seamless pipes and steel coils and plates for the production of welded pipes. 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 2011, the costs of raw materials and consumables accounted for 69% 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. Raw material prices increased in 2011 as compared to 2010. However in the fourth quarter of 2011, prices began to fall. Prices for certain types of raw materials and supplies varied depending on the region. In 2011, in the Russian division, the average purchase cost of metal scrap increased 25%, the average price for coils increased 17% and the average purchase price for pig iron increased 11% as compared to 2010. The average purchase cost of metal scrap and coils in the American division increased 22% and 19%, respectively, as compared to 2010. Average purchase costs for metal scrap in the European division were higher by 20% in 2011 than those in 2010. As a result of the increase both in prices for raw materials and sales volumes, our costs of raw materials and consumables increased from $2,972 million in 2010 to $3,721 million in 2011.

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 2011, energy costs amounted to 7% of the total cost of production. In January 2011, the liberalisation of the Russian electricity market was finalised, which resulted in an increase in electricity tariffs. Average natural gas tariffs in Russia, although remaining significantly below Western European levels, also increased in 2011. At the same time, natural gas consumption has been decreasing recently as we have replaced most of open hearth furnaces with EAFs. Further 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 2011, our five largest customers were Gazprom (excluding Gazprom Neft), Rosneft, Surgutneftegas, TNK BP and Lukoil, which together accounted for 34% of total revenue. We maintain strong business relationships with key customers and expect this concentration of customers in Russia to continue for the foreseeable future. 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. In the United States, TMK IPSCO cooperates with a wide range of distributors in North America, whose shares in our total sales are not significant.

Our large-diameter welded pipe business is largely dependent on one of our largest customers, Gazprom, and is subject to increasing competitive pressure. Gazprom is one of our largest customers for 1,420 mm diameter welded pipes used for construction of gas trunk pipelines. Increased competition in the supply of large-diameter pipes 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 pipes, and thus on the results of operations and financial position. Thereby in the second half of 2011, Gazprom finished construction of several pipelines, including Gryazovets-Vyborg, Pochinki-Gryazovets, SRTO-Torzhok and the first string of Nord Stream. 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 pipes, OMK, which produces welded pipes, and the Ukrainian pipe producers. Outside Russia and the CIS, we compete against a limited number of producers of premium-quality principally seamless steel pipe products, including Tenaris, Vallourec, Sumitomo 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, Canada and Mexico. In 2011, our several key competitors added new capacities and started their ramp-up, which is expected to increase competition we face on international pipe markets.

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