Management Board Report on the activity of the JSW S.A. for 2012

4.1.1. Factors related to the Company’s business and market environment

Market risk is managed to mitigate the impact of undesirable effect of changes in market risk factors on cash flows and on financial results. The key market risks and risks related to the business operations include:

Global economic situation

Economic growth determines the situation on the markets for coal, coke and steel. Unequal levels of global GDP and a universal economic slowdown, especially in Europe where financial problems of the Euro zone, mainly in Greece, Span and Portugal were an additional hindrance in the crisis fighting process, reduced the production of steel. In 2012, steel production in European Union states declined 4.7% from the preceding year. As a result of that situation, demand for raw materials used to produce steel and coke, i.e. coke and coking coal, respectively, decreased. The year 2012 was very difficult for coke production because of the lower consumption of coke by the blast furnace steel industry. Out of the 74 blast furnaces installed in Europe, 20 were down and only about 75% of the production capacity was utilized.

Excess supply of coal and coke on the European Union market

In the last decade, the growing global coal market and the increasing demand for coal throughout the work drew new investors to the coal industry. Many new mines were created and the existing ones were expanded, thus increasing the global production capacity. The global production of coal grew very dynamically, from 4.6 billion tons in 2000 to 7.8 billion tons in 2011. Moreover, the coal price growth which has taken place from the outset of 2003 has enticed new and existing international coal producers to expand their production capacities.

The coinciding excess supply of coal and coke on global markets and on the domestic market may lead to a considerable decline in coal and coke prices and may exert a material and adverse impact on the Company’s operations, performance and financial position.

During the current economic slowdown, where new selling markets are sought, product prices reduced or coal or coke inventories placed in storage sites, JSW S.A. was quite significantly affected by this risk in 2012. Coal inventories in 2012 rose by 772.8 thousand tons compared to the previous year, despite a 2% increase in coal sales from 2011.

Also, coke sales were affected by the declining steel production in European Union states. The declining demand for coke on the European market was noticeable especially in Q4 2012, where steel production was lower and steel manufacturers suspended their orders, waiting for the market to react to China's expected alignment with World Trade Organization's recommendations on abolishing restrictions in raw materials trading. As a result of this situation, the utilization of production capacity of coking plants dropped and coke inventories increased.

Sales to a relatively small number of major customers from the European Union and a considerable downturn in market conditions in the European economy, decline of coal consumption among the Company’s customers in this region or the inability to obtain payment from them

The considerable downturn in market conditions in the European economy, especially in the steel and coke industries may have a material and adverse impact on the Company’s operations, its results and financial position. Furthermore, if one or more of the Company’s major buyers cuts back on the volume of coal or coke purchased or fails to extend supply contracts, this could have a material and adverse impact on the Company’s operations, results and financial position. Moreover, timely payments hinge upon many factors beyond the Company’s control.

In 2012, the top five buyers accounted for 88.7% of the coking coal sales revenues (89.4% in 2011) and 82.1% of the steam coal sales revenues (80.6% in 2011) produced by the Company.

The top five buyers accounted for 68.1% of the total revenues on sales of coke and hydrocarbons.

Decline or volatility of coal and coke prices

The major driver of domestic and international coal and coke prices and its consumption are the overall supply and demand for these products. Demand for coking coal and coke may be subject to the influences of global economic cycles, political events, force majeure and hinges on the level of demand in the metallurgical and coking industry. Price volatility exerts a direct impact on the Company’s operating and financial results.

In the past the Company has undergone material volatility of coking coal or coke prices and the Company is convinced that there is a probability that such volatility will also occur in the future.

The global economic slowdown was reflected in a drastic decline in benchmark prices for hard coking coal, where the price declined continuously from 330 USD/t in Q2 2011 to 170 USD/t in Q4 2012 (-160 USD/t; -48.5%). The Company, which produces predominantly hard coal, was seriously affected by this drop. As a result, its average coal selling price in 2012 was 15.8% less than in 2011.

The average FCA-based price of coke in 2012 was 19.7% less than in 2011. The market trends and the extent of the drop of prices earned by JSW S.A. were comparable to the quoted prices of coke on the European market (according to the Coke Market Report).

Operational risks that may contribute to lower output or higher costs

The Company’s coal production volume is subject to operational determinants and events beyond its control, which may disrupt its operations and affect the production volumes in the various mines in different periods. The Company’s mining activity is above all subject to the influence exerted by mining determinants, which include among others:

  • difficult geological conditions such as disruptions to the continuity of deposits characterized by volatility and irregularity that may curtail the effectiveness of mining longwall parcels to a greater extent than anticipated;
  • level of natural hazards higher than forecast which may lessen the ability to mine individual longwalls;
  • mine accidents, fires, explosions and methane combustion, coal dust explosions, methane and rock outbursts and rock falls and collapses;
  • failures of machinery and equipment used in mining and processing.

Even though the Company has taken a multitude of measures to enhance safety these risks may grow in particular in conjunction with mining at deeper levels in the Company’s mines.

Moreover, the events and determinants that may affect production volume and in particular cost growth should include changes to the legal regulations concerning the coal industry.

A new geology and mining law is in force as of 1 January 2012. At present, work is in progress on the executive regulations to this law. The regulations governing coal mining in the face of natural hazards are expected to become more stringent. In truth, the Company undertook advance measures to make it possible to achieve the assumed level of output but it will be difficult to assess their impact on the Company’s mines’ production capacities and mining costs until the final wording of the regulations is published.

The quantity and quality of coal mined by the Company may be lower than customers expect

Estimates concerning coal resources inevitably entail a certain amount of uncertainty and to some extent depend on the geological criteria used, coal prices, cost assumptions and statistical data, which may ultimately prove to be imprecise. As a result, estimates concerning coal resources are regularly checked on the basis of the development of current production or other new information; as a result, one should expect that they will change. If the Company’s actual resources prove to be lower than current estimates, this may adversely affect the Company’s operations, operating results and financial position.

Ability to operate existing resources, acquire them and utilize economically attractive coal resources at a competitive cost

Resources may not be available when they are needed or if they are available their extraction at a competitive cost in a given period may not be plausible. The Company may not be able to assess the geological structure of deposits precisely in forward-looking regions, which may adversely affect its profitability and financial position if this assessment proves to be erroneous. Moreover, the investment, acquisition and exploration projects planned by the Company may not provide additional material resources or the operation of these resources may not be profitable.

Company’s inability to execute development projects or delays in their execution

Since the coal resources held by the Company are depleted as they are used, the Company’s ability to achieve the planned level of production in the long-term partially depends on its ability to acquire and operate new coal resources fit for extraction from an economic point of view, and its ability to develop new and expand existing extraction activity. The Company’s ability to acquire additional resources in the future may be curtailed by a host of factors over which the Company exercises no control. The Company’s inability to complete investment projects according to plan may exert a material and adverse impact on the Company’s development, operations, results and financial standing.

Successful integration of newly-acquired companies in the Group

All the acquisitions, joint ventures and investments in minority stakes conducted may involve significant capital investments, a new issue of shares or drawing down considerable obligations. As a consequence, the execution of these projects may lead to an emergence of a number of additional unfavorable circumstances, including problems with effective integration of operations, elevated operating expenses, exposure to unexpected liability and difficulties with attaining the projected levels of efficiency, synergy and cost savings. Each one of the issues discussed above may exert a significant and adverse impact on results and financial position.

Employee relations may adversely affect JSW S.A.’s operations

In the hard coal sector, trade unions have an important role in shaping the salary policy, often using protests to renegotiate the salary policy.

The strong position of trade unions gives rise to a situation in which there exists a risk of increasing salaries under the negotiated salary agreements, which consequently may adversely affect the financial performance of the Company. The Company’s failure to maintain proper employee relations may exert a material and adverse impact on the Company’s operational outlook, results and financial position.

As at the date of this report, there were 38 Trade Union Organizations operating in the Company. The total number of trade union members, as employees may belong to several unions, exceeds the number of employees employed with JSW S.A. and as at 31 December 2012 is 27 068, which means that the trade union membership percentage ratio at JSW S.A. is 119.4%.

The Company aims at negotiating with the trade units a Company Collective Bargaining Agreement for JSW S.A. employees and the Labor Rules and Regulations. During the negotiations on the Collective Bargaining Agreement and consultations about the Labor Rules and Regulations, the trade unions did not accept the proposals included in the draft Collective Bargaining Agreement and draft Labor Rules and Regulations presented by the Management Board. The Company intends to continue the negotiations of the Collective Bargaining Agreement for JSW S.A. employees and consultations on the Labor Rules and Regulations.

The Company is considering the implementation of flexible work time to facilitate the achievement of the mines’ production targets by extending the work week to six days depending on the needs of the particular mines. This requires acceptance of the trade unions and the hiring of additional employees. During negotiations the trade unions did not consent to the solution proposed by the Management Board whereby mines would operate to pursue their production targets six days a week – while employees would have a five day work week.

Collective disputes with employees may disrupt the Company’s operations

In the hard coal mining sector trade unions occupy a significant position symbolized among others by the ability to engage in protests, including collective disputes. The position held by trade unions is particularly strong on account of the headcount in the sector and its strategic influence over the functioning of the economy. In addition, trade unions’ expectations are based on the terms and conditions obtained by employees of other companies undergoing privatization.

Over the most recent financial year there were two collective disputes in the Company that were described in Item 4.6 of this report.

Despite the agreement signed with the Inter-Union Protest and Strike Committee on a 3.4% basic salary rate increase in 2012 and despite the accepted salary growth plan for JSW S.A.'s employees in 2013-2015, collective disputes may still take place in the future. The possible protests or strikes organized by the trade unions operating in the Company may affect the policies or procedures existing in JSW S.A. which in turn may have a material adverse effect on JSW S.A.'s prospects, performance and financial standing.

Ability to retain and acquire experienced and qualified management

The Company’s ability to conduct its operations effectively may deteriorate if the Company loses the current members of the management team and fails to acquire new ones. The Company’s retention of its competitive position and the implementation of its business strategy hinge upon its ability to retain and source experienced and qualified managers. The Company’s managers on average have 10 to 20 years of professional experience in the coal industry. If the Company’s competitors offer more favorable terms and conditions of employment, the Company may lose some managers. If the Company is unable to source, train and retain qualified managers, it may not be able to manage its growth effectively and compete effectively in the European coal industry, which may exert an adverse impact on its operations, results and financial position.

Volatility of PLN and other foreign currencies with respect to the EUR and USD

JSW S.A.’s main products are usually priced in PLN, EUR, USD and CZK while its operating expenses, including employee benefits, the consumption of materials, energy and external services are predominantly incurred in PLN. Other costs and expenditures for investment purchases are incurred in PLN, EUR and USD. Having regard for the structure of JSW S.A.’s sales revenues and expenses, the strengthening of the PLN against the EUR or USD may cause the Company’s revenues to fall and as a result may lead to a lower operating result. According to data published by the National Bank of Poland (NBP), the PLN appreciated against the EUR at the end of 2012 compared to the beginning of the year by about 8.4%, and against the USD by 10.0%. As a result, PLN volatility against the EUR or USD may affect the Company’s operations, its financial position and operating results. The overriding objective of the Company’s FX risk management policy is to curtail the FX risk resulting from the Company’s FX exposure to a minimum as resulting from the threat to future cash flow and financial results as a consequence of movement in the price of the underlying instrument.

The Company is exposed to significant FX volatility risk related to the sale of products on domestic and international markets. To eliminate FX risk, in 2012 JSW S.A. entered into FX forwards. The Company also makes small purchases of materials, services or investment assets in foreign currencies. The Company also makes purchases indexed in foreign currencies. This curtails the FX volatility risk resulting from selling products in a natural way.

The prospective impact exerted by EUR/PLN exchange rate growth and decline has been depicted in Note 3.1 to the financial statements of Jastrzębska Spółka Węglowa S.A. for the financial year ended 31 December 2012. Changes of other foreign exchange rates besides the EUR do not materially affect the Company’s net earnings.

Cash flow volatility risk caused by changes in interest rates

The Company is exposed to the risk of changing cash flows caused by changing interest rates. This risk is associated mainly with a possible decline in income on bank deposits and loans granted, for which interest is calculated at floating interest rates, and an increase in the interest rate on the loan if the available credit facility is used. In 2012, JSW S.A. did not use any external funding, but it had free cash invested in financial assets bearing interest at floating and fixed interest rates. Accordingly, the risk of changing cash flows is related to the change of interest rates on cash held.

The Company does not use derivatives to hedge against interest rate risk. However in 2012, in order to minimize the adverse effect of the declining interest rates on the Company's performance, action was taken to maintain income on term deposits, i.e. before the announced interest rate decrease, term deposits maturing in over 3 months were concluded which may be terminated without waiving any interest.

Issues related to local communities

The Company’s business activity may prompt disputes with local communities concerning the areas where the Company conducts or intends to conduct its operations. These issues may in turn lead to protests in these communities or third party claims. The inability to reach a positive solution to issues related to local communities may exert a material and adverse impact in the future on the Company’s operations, financial position and operating results.