Financial risks

Liquidity risk

As a result of borrowings undertaken for the acquisition of TMK IPSCO in 2008, as well as a result of continued large-scale capital expenditure program, our leverage remains significant. As of December 31, 2011, our total debt amounted to $3,787 million as compared to $3,872 million at the end of 2010. The decrease of our total debt in 2011 was primarily attributable to the rouble depreciation. Together with the improvement of our operating performance in 2011, our leverage decreased and Net-Debt-to-EBITDA ratio reduced to 3.4 as of December 31, 2011.

In 2011, we continued to concentrate on improving our liquidity profile and optimising financial performance. We negotiated extensions of credit terms and lower interest rates in order to improve our financial position and overall debt maturity profile. The actions relating to the loan portfolio allowed us to further decrease the share of short-term debt in the total credit portfolio, which stood at 16% as of December 31, 2011 as compared to 18% at the end of 2010.

Improving liquidity profile remains one of our priorities, and we continue to carry out measures to maintain sufficient liquidity and improve loan portfolio structure. Thus, in January 2011 we partially repaid Gazprombank loan facilities in the total amount of $1,108 million using the proceeds from the issuance of TMK 7.75% $500 million Eurobonds due in 2018. In October 2011, we refinanced a loan from Gazprombank in the aggregated amount of $208 million using the proceeds from operating cash flow and from a $200 million Nordea Bank loan due 2017 with a lower interest rate. Due to improved liquidity in 2011 our S&P rating was upgraded to B+/ruA, outlook stable and Moody’s rating of B1/A2.ru, outlook stable was confirmed. Nevertheless, there can be no assurance that our efforts to improve liquidity profile and reduce leverage will prove successful. The negative market reaction on deteriorating global financial situation may have an adverse impact on our ability to borrow in banks or capital markets, and may put pressure on our liquidity, increase borrowing costs, temporary reduce the availability of credit lines and lead to unavailability of financing on acceptable terms.

Compliance with covenants

Certain of our loan agreements and public debt securities currently include financial covenants. For example, some covenants are set in relation to leverage, total indebtedness and tangible net worth, and impose financial ratios that must be maintained. Other covenants impose restrictions in respect of certain transactions, including restrictions in respect of indebtedness. A breach of a financial or other covenant in existing debt facilities, if not resolved by means such as obtaining a waiver from the relevant lender, could trigger a default under our obligations.

In January 2011, we undertook a consent solicitation to modify certain covenants contained in the loan agreement relating to the loan participation notes fully repaid in July 2011 issued by TMK Capital S.A. in order to continue our growth strategy and further enhance our flexibility to implement refinancing plan. In relation to other debt facilities covenants were not revised due to our stable financial and economic position and absence of covenants violation.

Nevertheless, in case financial markets or economic environment deteriorate in the future, we may not comply with relevant covenants. Though, historically, we have successfully secured from the relevant lenders all necessary waivers or standstill letters to address possible breaches of financial covenants we may not be able to secure such necessary waivers or standstill letters during future reporting periods if not in compliance with financial covenants. We do not expect the occurrence of such events in the near future.

Interest rate risk

Interest expenses are the prevailing part of our finance costs. In 2011, our finance costs decreased 30% or $128 million and amounted to $303 million as compared to $431 million in 2010. The decrease in a nominal interest expense, net of transaction and issue costs, was achieved primarily as a result of our negotiations to reduce interest rates on most of significant borrowings that took place as a part of the measures to improve the structure of our loan portfolio. Consequently, our weighted average nominal interest rate as of December 31, 2011 decreased by 94 basis points as compared to December 31, 2010. Although we currently benefit from relatively low interest rates, there can be no assurance that rates will stay low in the future. The cost of funding for Russian and international banks may increase in the future, which can increase our interest expense and adversely affect our financial position.

Additionally, certain part of our loan portfolio is represented by loans taken out at floating interest rates. As of December 31, 2011, loans with floating interest rates represented $617 million or 16% of our total credit portfolio. The underlying rates in current loans with floating interest rates are LIBOR and EURIBOR. In 2011, floating interest rates remained close to their historical lows, which kept our interest expense on the relevant loans low. Taking into account current low levels of interest rates, we considered to hedge a part of interest rate risks at the beginning of 2012. Nevertheless, several loans with floating interest rates still exist in our credit portfolio and, should floating interest rates increase in the future, interest expenses on relevant loans will increase.

Currency risk

Our products are typically priced in roubles for Russian sales and in U.S. dollars and euros for CIS, U.S. and other international sales. Our direct costs, including raw materials, labour and transportation costs are largely incurred in roubles and U.S. dollars. Other costs, such as interest expense, are currently incurred largely in U.S. dollars and roubles, and capital expenditures are incurred principally in roubles, euros and U.S. dollars.

We hedge our net investment in operations located in the Unites States 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 2011, we incurred foreign exchange losses from spot rate changes in the total amount of $69 million, including $1 million recognised in the income statement and $68 million recognised in the statement of comprehensive income. Losses in the statement of comprehensive income from foreign exchange difference relating to hedged financial instruments arose from the revaluation of U.S. dollar denominated loans attracted by Russian companies of the Group.

The rouble remains volatile. Our debt is currently largely denominated in U.S. dollars, and the possible devaluation of the rouble against the dollar in the future could result in foreign exchange losses. To mitigate this risk, during 2011 we refinanced certain U.S. dollar denominated loans with a series of loans taken in roubles. As a result, the share of U.S. dollar denominated loans in the loan portfolio as of December 31, 2011 decreased to 48% as compared to 50% at the end of 2010. Since revenue of the Group is nominated in EUR, USD and Russian rouble due to the geographic diversification of sales, this provides a natural hedge for our foreign exchange position. Nevertheless, if the U.S. dollar appreciates against the rouble in the future, this could adversely affect our net profit as coherent losses will be reflected in our consolidated income statements.

Inflation risk

A significant amount of our production activities are located in Russia, and a majority of direct costs are incurred in Russian 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 2011, inflation in Russia reached 6.1% as compared to 8.8% in 2010. In spite of the intention of the Russian government to reduce rates of inflation in the coming years, inflation may increase in the future. We may not be able to increase the prices sufficiently in order to preserve existing operating margins.

Inflation rates in the United States, with respect to TMK IPSCO operations, are historically much lower than in Russia. Nevertheless, in 2011, inflation in the United States increased to 3.0% in comparison to 1.5% in 2010. Accordingly, high rates of inflation, especially in Russia, could increase our costs, decrease our operating margins and materially adversely affect our business and financial position.

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