The cement industry switches to coal to recover lost fortunes

Thanks to privatisation and a growing population, the construction industry in Egypt flourished in the years up to 2010 and many of the cement producers doubled their capacity in order to supply the demand. This changed drastically, however, after the January 25 revolution in 2011 partly, but not wholly, because of the revolution itself. Certainly there was a squeeze on feasible construction and infrastructure projects, perhaps best illustrated by work on 204,000 new hotel bedrooms almost grinding to a complete halt.

In addition to the turmoil, shortages of the cheap natural gas that had powered the expansion also dealt another devastating blow to the industry. Finally, the political situation was scarcely conducive to a consistent and cohesive government policy on construction.

Ahmed Hindawy, team head in the research department at Prime Holding, whose activities include asset management, investment banking and investment research, told OBG, “Cement used to be one of the strongest and most thriving industries in the country, especially because of the energy advantage it used to possess.” Times change, as Bruno Carré, the CEO of Suez Cement, pointed out. “Squeezed by a slowdown in construction, the ongoing fuel shortage and rising energy prices, cement factories are operating 30% to 40% below capacity,” he told OBG. He said that since 2010 there had not been any growth in the industry. However, by late 2014 there were signs that the sector was coming back into its own.

“Cement companies, mid to short term, are looking to alternative fuel sources such as coal and better waste management systems in order to stay afloat, but it will take some time for new technology to be implemented to diversify their energy sources,” added Carré. “The shortage in energy, if not addressed quickly, will put a damper on local cement manufacturing and open the gate to costly imported cement products.”

Cheap Gas

The main asset cement producers had was the huge cost savings in production. Around 40% of the total expense of making cement is the energy used to produce clinker in the furnaces. On top of that, another 15% of the final bill goes on electricity.

The energy for the furnaces, natural gas, used to be supplied to cement manufacturers in Egypt at a rate of $2 per million British thermal units (mBtu). Post-revolution prices crept up to, first, $3/mBtu, then $4/mBtu and finally at the beginning of 2013 to $6/mBtu.

Yet another issue with natural gas was the perpetual threat to supply. Some natural gas producers reported a shortfall of 40%, which meant that most parts of the economy suffered alongside the cement industry, not least through frequent power cuts. The bottom line for the cement industry is that, across the board, manufacturers have cut back over the past two to three years to between 50% and 70% of their capacity. “We import most of our gas for local industries, but we cannot import through pipelines as liquefied natural gas (LNG) and in this form the cost would stand at $ 10-COAL: The solution in the search for stability is the decision by the government to allow cement producers to use coal as an alternative to natural gas. The cost is not much different from the current $6/mBtu. Taking into account shipping and other expenses, estimates put the cost of coal at around $5.50/mBtu. There is also the possibility that the government could impose a carbon tax similar to that in other countries, according to Hindawy. That would equalise the prices of gas and coal. Some producers have already made the investment for the changeover to coal, mainly the large companies. “There has been talk of this switch for a long time and some firms began their preparations to change in mid-2013,” Hindawy told OBG. He forecast that Arabian Cement, Suez Cement and Lafarge were all within months of introducing coal-fired cement lines.

“The smaller producers, who between them make up 65% of the market, are the ones that will suffer,” he added. “Given they already do not have very strong cash positions, by the time they implement the changes their costs will be too high and their margins too low and this will put the companies under stress for a long time.” The cost of conversion to coal for a production line is around LE135m ($19.2m) and each line has a capacity of 1.4m-1.5m tonnes per year.

The energy change will not be total, with the government, the producers and the Ministry of Environment all suggesting an energy mix. “The proportion of each kind of energy to that mix has not yet been decided,” said Hindawy. He estimated that it would probably be around 55-60% coal, 25% gas and the remaining 15-20% using direct waste from agriculture. The urgency of finding an alternative to gas was brought home in April 2014 when so much gas was diverted away from cement producers that some plants were temporarily closed and the workers given a holiday. The diversions were caused by falling gas output and the need to supply power stations. Kareem Zahran, cost engineer for Gleeds Construction Consultancy Egypt, told OBG that the higher prices being charged for cement were expected to last for at least another year until coal-fired production lines were brought on-stream.

Cost Of Waste

In May 2014 the South Valley Cement Company (SVCC) announced its own plans for coal-fired options. According to The Daily News, the company said it would be “indifferent” if the government decided not to follow through with the coal plan, as it could rely on mazut, a low-quality fuel oil, and gas to produce cement. SVCC’s spokeswoman Samar Abd Al Gawad said using coal would allow the firm to reach 100% of its production capacity. She confirmed Hindawy’s assessment that agricultural waste could not exceed 15% or 20% of the energy mix, adding that it would cost €2m to introduce its use. “The challenge the company faces in the use of agricultural wastes is that the market is not consistent and the products that are used as wastes, such as the linen seeds and corn cobs, are seasonal,” the paper quoted her as saying.

The expansion plans include two lines and are expected to take 18 months to complete. “The first mill will increase production by 1.5m tonnes,” said Ashraf Salman, SVCC’s consultant and CEO of Cairo Financial Holding.

A New Plant

Another producer with eyes on an expanding future is the armed forces’ Al Arish cement factory, which is building a new production line scheduled for completion at the end of 2015. “This is an attempt to fight the monopoly imposed by foreign cement facilities that sell cement at higher prices than international standards,” Ahmed El Zeiny, head of the construction materials department at the Cairo Chamber of Commerce, told the local press. He put the cost of the expansion at LE700m ($99.4m) to LE800m ($113.6m), adding that it would double annual capacity to 7m tonnes. El Zeiny said cement costs have increased by 50% in past three years, although his figure for the effect on property prices – rises of 10-20% – were higher than those suggested by other analysts.

Inflation

Inflation in the supply of construction materials generally hinges on the proportion of imported materials and the health of the Egyptian pound. Gleeds’ Zahran told OBG, “Unlike, say Britain, there are no inflation rates for the construction industry that are widely available so we have compiled our own based on market activity. Our data starts from 2007 and our projections run to 2016, although they are subject to updates of course.” The inflation forecasts began in 2009 and, Zahran added, have mostly been in line with subsequent events. “Even those projections that were a little wide of the mark were caused by events we could not have foreseen such as the big exchange rate fluctuation with the dollar at the beginning of 2013,” he said. “We do not forecast beyond two years because we don’t really have enough data to do that, and in any case for the moment many things could happen here.”

Real Costs

The overall effect of cement prices on the cost of construction elicits two wholly different answers. According to Zahran, the producers say cement forms only a small percentage of project costs and therefore any price increase has only a marginal effect on the total cost. In fact, Hussein Mansi, CEO of Lafarge Cement Egypt, told a conference in Cairo in October that cement makes up only 3% of the total cost of a building, if the price of land is included, and around 8% if the purchase of the land is left out of the calculations. Cement producers attribute around 60% of a project cost to finishing, said Zahran.

However, he added that contractors hold a totally different view, saying increasing cement prices can have a big difference on their costs. Prices rose from around LE420 ($60) a tonne at the beginning of the fourth quarter of 2011 to about LE550 ($78) by the end of 2012, and then rocketed to a peak of LE800 ($114) by March 2013. Zahran said his figures were based on the cost paid by the construction companies rather than the prices published by the producers. The Gleeds figures take into account transport costs as well as sales tax. “Local producers of cement know their product is preferred to imported cement and they are going to be able to sell it whatever price it reaches,” said Zahran. Even so, the peak price of LE800 ($114) dropped by around 8% the next month because of reduced demand brought on by a labour shortage, according to Gleeds.

Although ready mix is more consistent, more convenient to use and generally of higher quality, it is not often used because it is expensive.

Devaluation

The biggest area where the falling value of the Egyptian currency has been felt is on the finishing works. “In early 2013 I travelled out of Egypt for a short time,” said Zahran. “When I left the exchange rate to the dollar was LE5.50. When I returned it was LE6.50.” Items such as elevators, for example, are priced in dollars or other hard currency, although the cost of installation is paid in Egyptian pounds. Thus a 12% increase in material costs caused by currency exchange differences will have a lesser percentage effect on overall cost because labour is not included. Around half of all finishing materials are imported and thus liable to the same degree of inflationary pressures. Those pressures are worsened by the shortage of hard currency.

Subsidies

The government has started a reform of the subsidies it pays out, including fuel. The first announced change is to raise the price of natural gas to cement producers from $6/mBtu to $7.80/mBtu, a 30% hike. Then a total phase out will begin over three years until gas reaches international prices of around $10-$12/mBtu. By the time the subsidies have been totally removed the otherwise catastrophic effect on cement producers’ profitability will have been largely alleviated by the switch to coal and other energy sources.

“The emphasis at the beginning of subsidy removal is on industry because this is the section of Egypt that is making a profit and can afford to pay higher prices for energy,” said Zahran. “Changes in the price of fuel subsidies will naturally have a big effect on construction – as they will on many things,” he added. Although a very significant factor, energy is not the only determinant in cement pricing. That is also subject to the availability of raw materials and labour, not to mention strikes, said Zahran. Overall the labour market is fragile and inconsistent at best, with some of the supply coming from students at schools and universities who work during their vacation. “Some have developed skills like carpentry and think they can earn more money from construction than from the jobs to which their studies will lead them,” said Zahran. Nationally the minimum wage has risen from LE700 ($99) to LE1200 ($170), but this applies only for public sector employees. In any case, since salaries in the construction industry are based on market forces, the effective minimum wage in the sector is around LE3000 ($426).

Future Demand

After a period of almost unprecedented volatility affecting energy supplies and cement production levels, Hindawy sees the return of calm. “From the supply side, operating costs are expected to improve in the medium term, and therefore supply is expected to improve over the entire industry,” he told OBG. “From another perspective – the demand side – the industry has been facing very unfavourable conditions because of the slowdown and the revolution, so residential projects, infrastructure and other real estate projects have been halted.” That equation produces a decline in both production of and demand for cement. “We expect both increased production and increased demand to absorb the extra cement,” he added.

Before regular and sustained growth is achieved, it will be necessary to absorb the effects of the past three or four years. “Sustained increase for cement in the local market will begin in 2017,” said Hindawy. “There will be sharper increases in demand in 2015 and 2016 with growth rates of 10-15%. This is because of major real estate plans by developers and infrastructure projects by the government. These figures also take account of the fact that 2013 and 2014 experienced very low demand.” Once the parabola is smoothed out, demand is expected to grow by a regular 8% from 2017 onwards.

Part of the reason that current cement prices are inflated is because of reductions in producers’ capacity. If Egyptian cement producers are able to return to 100% of their production capacity, then prices in the country would in theory moderate. Working against this is the projected annual rise in the price of natural gas; in 2015 this will increase the cement producers’ costs by around 12-15%. After that, as more coal is brought into the energy mix, the cost of cement would be rising by around 3-4% a year. “So it is possible to see the price of cement stabilising in the medium term and even perhaps getting a little bit lower,” said Hindawy.

Clinker Imports

Gas shortages convinced some cement manufacturers to import clinker rather than make it. So why not continue importing rather than suffer the cost of conversion to coal-fired furnaces? The straight answer is medium-term mathematics. “As an industry-wide cost burden with conversion to coal, you are talking about LE320 ($45) for a tonne of cement,” said Hindawy. “That translates into $45 to produce one tonne using traditional production methods, i.e. not importing clinker. The alternative – importing clinker – puts the cost at around $55 per tonne.” In any case, quite apart from the extra cost, there would be difficulties in finding the hard currency. Comparing the extra cost of buying imported clinker to the cost of introducing coal means that coal conversion costs would pay for themselves in two to three years. Another consideration that has come to the fore since 2011 is that running production lines at well below capacity produces extra expenses for the manufacturers in terms of high maintenance costs and shorter equipment life. “For this reason, at times it may have been more commercially prudent longer term to import the cement required to service whatever level of construction there was rather than manufacture it,” said Hindawy.

The industry has a capacity of 60m tonnes, according to the American Chamber of Commerce in Egypt. In 2012 and 2013 production reached 46m tonnes.

Shale

A further consideration, of global significance, is the effect on energy prices of the rising gas and oil output from shale in the US and other parts of the world. “Our forecasts for the next five to six years see that current gas prices to cement producers are still very far from the costs of importing LNG,” said Hindawy. “So even though a gradual phase out of subsidies on natural gas will increase costs, it is still nowhere near the cost of importing LNG,” he added. Therefore, even if international prices for LNG fall, this will not overlap with the subsidy phase out plan. “If that were to happen, maybe we would need to adjust our forecast for the last year or two, say 2018, but we do not see that price effect on the immediate horizon,” Hindawy concluded.