CSN: Brazil steelmaker rolls out fresh strategy

Otavio Lazcano is not a typical Latin American finance director. His fluent English is peppered with Wall Street-isms and expressions. He can also reel off the currencies of pre-euro Europe.

His conversational flourishes hint at his background as a fixed-income trader at a local investment bank in the hyper-inflationary 1990s – a time of helter-skelter market performance in Brazil.

Mr Lazcano followed his banking days with a stint in forex derivatives at Aracruz, the Brazilian paper and pulp manufacturer.

The staid world of risk mitigation at CSN, the Brazilian steelmaker, may seem a come-down, but he insists his new job is anything but boring. Even so, one receives the impression that this year’s spike in commodity volatility may not be altogether unwelcome to him.

CSN’s shares have been affected by investor mood swings on commodities and in mid-July it launched a total return swap (the company swaps dividends and capital appreciation in return for a cash flow) on its own shares worth 3.5 per cent of outstanding capital.

“We wanted to reposition our capital structure so as to benefit from the interest in commodities and reduce unnecessary volatility,” says Mr Lazcano. CSN believed at the time that the sum of its parts was worth more than its share price would suggest, he notes.

Until this latest move, CSN had kept its use of derivatives relatively simple – although with total nominal value of contracts in the hundreds of millions of dollars, the portfolio is already sizeable.

The company controls their use, limiting its activities to reducing risk and volatility, says Mr Lazcano. CSN uses primarily forex and interest rate futures and swaps through the local exchange and over the counter markets to hedge exposure stemming from borrowing and currency transactions. The company occasionally uses options, but with specific aims. CSN also hedges exposure to commodities that it uses, such as zinc and aluminium.

Laying off risk has become easier over the years, thanks to deeper Brazilian capital markets, says Mr Lazcano. Investment horizons among Brazilian businesses are much longer than they used to be and the government has been working to build out a liquid government and corporate yield curve to act as a benchmark, he says.

That has promoted the rapid development of capital and derivatives markets and means CSN does not face liquidity or product constraints – a problem common in the rest of Latin America. Indeed, Mr Lazcano sees the Brazilian derivatives market as deep, well-legislated and sophisticated and goes so far as to call it “the mirror image of Wall Street”.

At the same time as the Brazilian derivative markets have been opening wide, CSN has been rapidly expanding and reshaping its business in line with many commodities companies in Latin America. Both these changes will see CSN step up its use of financial markets and derivatives significantly in coming years.

The steelmaker is changing in three key ways. First, it has been in transition from a steel company to a conglomerate with interests in iron ore, logistics, power generation and cement.

This drive to build a vertically integrated business is common in the region. Brazilian mining giant Vale, for example, has been investing in partnerships to build steelworks.

Second, the strong commodities cycle is encouraging rapid expansion. “CSN is bubbling in all sorts of different directions and we need a lot of investment to keep us growing,” says Mr Lazcano. The company will require $15bn-$16bn in the next five or six years to realise its plans, which include development of green- and brownfield sites.

Finally, growth in its iron ore business will also see CSN generate greater revenues from exports. Historically, just 25-30 per cent of sales went overseas, but Mr Lazcano expects 80 per cent of the iron ore produced will be exported and predicts that by 2014 iron ore will be as big as steel in terms of revenues.

“CSN may raise funds in euros, yen and who knows what other currencies. The volumes of our derivatives transactions will have to increase to square with our foreign exchange and interest rate exposures,” says Mr Lazcano.

The firm is exploring other ideas to mitigate risk. On a recent road show in New York, Mr Lazcano heard that Credit Suisse and Deutsche Bank were working on an OTC contract for iron ore and, excited by the idea, he immediately contacted the banks to request a meeting.

For now, negotiations for buying iron ore take place annually with a price set for the year after extensive negotiations. A standardised contract would eliminate this uncertain process.

Mr Lazcano recognizes that the obstacles are manifold and complex. The most significant difficulty is producing a standardised contract, particularly given the range in quality of levels of silica and humidity, for example.

Further, the contracts would need to provide plenty of liquidity and relative simplicity that would allow all participants to benefit.

With all the growth in its hedging needs and an eye on unusual opportunities, CSN’s choice of an insider looks like a shrewd choice.

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