Essar Steel Algoma creates good-paying jobs. For 46 lawyers

Forty-six.

That's the number of lawyers toiling right now over Essar Steel Algoma's Companies' Creditors Arrangement Act proceedings.

Five of them are retained by Essar Steel Algoma to work on Canadian aspects of the case.

Another five are working for Essar on U.S. implications.

Court filings show a haggle of other barristers crowding into the case, representing everyone from Deutsche Bank to Essar employees to retirees to junior and senior noteholders, even Xerox Canada and Ford Motor Co.

The windfall to the legal profession is one of the few bright spots in last week's Essar Steel Algoma collapse into insolvency, with $1.6 billion owing to creditors, including $14 million owing to the City of Sault Ste. Marie and another $24 million owing to about 125 Sault businesses.

It was a stunning reversal for a company that, just three-and-a-half months ago, was the toast of federal and provincial politicians.

"Our government is proud to announce up to $30 million for Essar Steel Algoma Inc. for technological and product innovation at the company," said Sault MP Bryan Hayes at a well-attended news conference on July 24. "As the number one employer in the area, supporting Essar Steel is also an investment in job creation and economic growth in Sault Ste. Marie," Hayes said.

At the same event, Sault MPP David Orazietti promised $30 million in provincial funding.

"I am extremely pleased to announce that after many months of work, we are providing the largest grant in decades from any level of government in the amount of $30 million to strengthen our city's largest employer and support a $240 million capital modernization plan that will create more than 200 new jobs," Orazietti said. "This massive investment will help to ensure Essar Steel Algoma remains competitive for years to come."

Kalyan Ghosh, Essar Steel Algoma's chief executive officer, was also chock full of cheery optimism in July.

"That will ensure we have a long-term future in Sault Ste. Marie, producing advanced steel and maintaining vital jobs that make our community stronger," Ghosh beamed.

Our local steel mill's long-term future, supposedly assured for years to come, lasted just 109 days before Essar Steel Algoma declared itself insolvent and in need of court protection from its creditors.

How much government funding did we get this year?

How much of the $60 million of federal and provincal funding promised in July did the local mill actually get?

"The government funding is structured on a reimbursement basis. To date we have received just under $2 million in total from the federal and provincial agencies," says Brenda Stenta, Essar Steel Algoma's manager of corporate communications.

"Since the project launch in July, the company has invested more than $8 million in the modernization and expansion program," Stenta tells SooToday. "Construction is underway on the No. 2 ladle metallurgy furnace and there have been a number of upgrade initiatives at the direct strip production complex and plate and strip facility."

"Essar cannot stress the importance of these projects to our business and for Northern Ontario - they are a critical part of our turnaround and provide significant economic benefits to the broader community. Essar will continue to work in partnership with both governments to discuss these projects going forward," Stenta said.

So what went wrong?

Why did Essar Steel Algoma go down so quickly?

Some answers and a lot of useful background may be found in a sworn affidavit filed with the court last week by Rajat Marwah, the compay's chief financial officer.

The following are extracts on selected issues, as arranged and adapted by SooToday:

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Affidiavit of Rajat Marwah, sworn November 9, 2015

Essar Steel Algoma Inc. has a significant history in the city of Sault Ste. Marie.

It was founded in 1901 to produce steel for railroad expansion across Canada.

Today, Algoma is an integrated steel producer whose business includes:

the production of certain raw steel inputs;
steelmaking; and
the sale and distribution of steel products to customers in North America.

The steel sheet and steel plate produced by Algoma is used in automotive, fabrication and manufacturing applications, among other things.

Algoma is Sault Ste. Marie’s single largest employer.

Algoma directly employs nearly 3,000 people.

Adding household members and retirees, approximately 54,000 people in Sault Ste. Marie (or 69 percent of the city’s total population of approximately 78,000) directly or indirectly depend on Algoma.

Introduction

On October 5, 2015, the Cleveland Cliffs Iron Company, Cliffs Mining Company and Northshore Mining Company (collectively, "Cliffs") purported to terminate Algoma’s long-term iron ore pellet supply agreement (as amended, the “Cliffs Contract”) and immediately ceased delivering iron ore to Algoma.

Iron ore is the principal input for the manufacture of steel.

Cliffs’ actions have had a number of immediate significant detrimental effects on Algoma and Algoma’s stakeholders, including:

Algoma has been forced to reduce production, resulting in approximately 100 full-time employees being laid off;
The reduced production has resulted in a material decrease in Algoma’s revenues at a time that Algoma could least afford it;
Algoma has been forced to seek supply of iron ore from alternative suppliers at a materially higher price than Algoma was entitled to purchase ore under the Cliffs Contract in order to continue producing at even a reduced level;
Algoma‘s ability to build inventory in advance of winter and the freezing of the Great Lakes (Algoma’s principal method of receiving inventory) has been seriously compromised; and
Algoma has been forced to seek creditor protection on an emergency basis.

In addition to the issues caused by Cliffs’ purported termination of the Cliffs Contract and Cliffs’ refusal to supply iron ore, the applicants face other significant financial issues, including:

Steel prices have continued to decrease to their lowest levels in six years resulting in reduced profit margins;
On October 8, 2015 and October 13, 2015, Standard & Poor’s and Moody’s (respectively) downgraded Algoma’s credit rating;
On October 15, 2015, Algoma breached a borrowing base covenant contained in the term loan. This resulted in an immediate event of default under the term loan and a cross-default under the ABL;
On November 16, 2015, mandatory interest payments on the term loan and the senior secured notes (as defined below) in the aggregate amount of approximately US$25 million come due. Algoma is unable to make these payments;
The public dispute with Cliffs and concerns about Algoma’s credit-worthiness have negatively impacted Algoma’s relationships with customers, suppliers and creditors; and
Algoma faces significant pension and other retiree and employment benefit obligations.

As a result of Cliffs’ actions and the other financial issues that the applicants are facing, the applicants are unable to meet their ongoing payment obligations.

Despite significant efforts to do so, Algoma has been unable to successfully restructure its operations and capital structure outside of formal insolvency proceedings and is now insolvent.

Without the protection of the CCAA and the other relief available thereunder, Algoma will be forced to shut down operations, which would be extremely detrimental to Algoma’s employees, suppliers, lenders and customers.

CCAA protection will allow Algoma to obtain the necessary supply of inventory, stabilize operations, and give the applicants the time required to consult with their stakeholders regarding a restructuring.

Algoma's business and operations

Algoma produces steel and steel products for customers throughout North America.

Algoma is one of the largest integrated steel producers in Canada.

Prior to the decrease in production caused by Cliffs’ termination of supply, Algoma produced an average of 220,000 tons of steel per month, which amounts to approximately 2.5 million tons of steel per year.

Algoma has two general product categories:

Sheet steel products (coils) include a wide variety of widths and gauges of both unprocessed and value-added steel. Algoma supplies steel sheet products to the automotive, hollow structural product, light manufacturing and transportation industries. In the past five years, sheet steel products have represented approximately 85 percent of Algoma’s total steel shipment volumes; and
Plate steel products consist of various high-strength, low-alloy grades of steel. The majority of Algoma’s plate steel products are purchased by members of the fabrication industry, which use these products in the construction and manufacture of railcars, buildings, bridges, off-highway equipment, storage tanks, ships, armored products for military applications, large diameter pipelines and wind energy generation equipment. For the last five years, plate steel products have represented approximately 15 percent of Algoma’s total steel shipment volumes.

In contrast to many other steel manufacturers that convert steel scrap into liquid steel with electricity, Algoma is an integrated steel producer that melts iron ore pellets (with a small proportion of scrap metal) into hot metal using a blast furnace.

Using a blast furnace means that a shutdown of operations, however brief, has a significant negative effect on production.

Algoma experienced a capacity utilization rate of approximately 85 percent during its 2015 fiscal year, as compared to the North American industry average of about 75 percent.

Algoma’s superior capacity utilization is attributable to Algoma’s integrated operations and wide range of production machinery and equipment.

These give Algoma the ability to adjust its product mix between sheet and plate products depending on market conditions, allowing Algoma to optimize its product mix in different markets and based on different customer demands.

Manufacturing steel

Steel production requires a number of different raw material inputs.

The acquisition of these raw material inputs is complicated by Algoma’s location in Sault Ste. Marie, Ontario and by the cold winters experienced there.

Stockpiling sufficient raw materials to maintain operations throughout the winter is one of the most significant operational challenges that Algoma faces.

Algoma takes delivery of the majority of its raw materials from ships sailing on the Great Lakes.

Almost all of these ships are owned and operated by Lower Lakes Towing Limited, which has entered into a long-term contract of

affreightment with Algoma.

These ships arrive and dock at a port.

Winter operations

In the winter, the shipping lanes on the Great Lakes freeze and become unnavigable.

During the winter months, Algoma depends on receiving product by rail (which can be significantly more costly than delivery by ship) and on stockpiles of raw materials that it has accumulated at the facility and the port in the period leading up to winter.

If Algoma is unable to stockpile sufficient raw materials at the facility, it will be forced to idle and eventually shut down its steel-making and other equipment at the facility.

In particular, the coke ovens that Algoma uses to transform coal into coke must be continuously fed with coal in order to maintain their internal temperature.

If the interior of a coke oven falls below its optimal temperature range, the coke oven may suffer damage that could take several

million dollars and several months’ time to repair.

If a sufficient number of Algoma’s coke oven is shut down due to lack of coal, Algoma will have insufficient coke to operate its blast furnace, which must also be shut down.

Shutting down a blast furnace

If the blast furnace is shut down, it will take weeks to reactivate the blast furnace, and Algoma will not be able to restart the blast furnace in the winter.

If the blast furnace undergoes an uncontrolled shut down, molten metal residue inside the furnace will solidify.

This metal residue must be removed before the furnace can be restarted.

The process of cleaning out and restarting the blast furnace could cost several million dollars and two to six months’ time.

Depending on how long it takes to restart the blast furnace, the majority of employees could be laid off.

Iron ore and the Cliffs Contract

Algoma manufactures steel out of iron ore pellets.

Since 2002, all of Algoma’s iron ore has been supplied by Cliffs pursuant to the Cliffs Contract.

Algoma melts these pellets into hot metal in a furnace that is heated by burning coke, natural gas and pure oxygen.

The Cliffs Contract was initially entered into in January 2002 between Cliffs and Algoma Steel Inc. (“Old Algoma”), which is a predecessor company of Algoma.

I understand that Old Algoma entered into the Cliffs Contract at the time of its exit from CCAA creditor protection in 2002.

At the time, Old Algoma had limited negotiating power, was financially vulnerable and owed amounts to Cliffs in respect of previous supply of iron ore pellets.

As a result of this imbalance of power, Cliffs was able to negotiate an exclusive supply contract at a price that was

significantly higher than the then-prevailing market price for pellets.

Amended eight times since 2002

The Cliffs Contract has been amended on eight occasions since 2002.

The most recent amendment was made pursuant to a term sheet dated on or about June 7, 2013 (the “Term Sheet”).

Pursuant to the Cliffs Contract, Algoma agreed to purchase iron ore exclusively from Cliffs until December 31, 2016, and on a non-exclusive basis until 2024.

A key component of the amendments to the Cliffs contract were amendments to the pricing formulas that resulted in a reduction in pricing such that it is based on market prices as compared to the previous formula which was substantially above market prices.

As amended by the Term Sheet, the Cliffs Contract specifies a price for the purchase and sale of iron ore pellets for the 2013 and 2014 calendar years and a formula for fixing the price of iron ore pellets in 2015 and 2016, and a separate formula for calendar years 2017 to 2024.

In essence, all of these formulas provide for a numberof adjustments from the market price for iron ore pellets, which is established in certain g lobal price benchmarks from time to time.

Falling commodity prices

As a result of recent global trends, the price of all commodities, including iron ore pellets has been decreasing over the last few years.

In addition, the top-up relating to the amortization of amounts owing from Old Algoma to Cliffs has been gradually eliminated.

Consequently, the price of iron ore pellets to be supplied under the Cliffs Contract has been decreasing in steps and has now become materially more favourable to Algoma than pricing from other suppliers of iron ore pellets.

The most recent of these stepped decreases in the purchase price under the Cliffs Contract was scheduled to take place within days of Cliffs’ purported termination of the Cliffs Contract.

Algoma believes that Cliffs’ purported termination of the Cliffs Contract was wrongful and ineffective, and considers the Cliffs

Contract to still be valid and binding on the parties thereto.

Algoma intends to seek relief from the court with respect to Cliffs.

As a result of Cliffs’ purported termination of the Cliffs Contract and Cliffs’ failure to supply, Algoma was left with no source of iron ore pellets at a critical juncture.

Algoma is already behind its usual schedule for receiving iron ore.

Algoma must immediately begin stockpiling pellets in order (together with supply by rail during the winter) to have sufficient

inventory to maintain steel production throughout the winter.

Curtailing operations

Without sufficient inventory, Algoma will have to seriously curtail its operations or (in a worst case scenario) shut down its

blast furnace.

Cutting production will have a material adverse effect on Algoma’s employees and could impact Algoma’s ability to regain customers lost during any slowdown or shutdown.

It is estimated a shutdown or material slowdown would cause Algoma to lose all contracted sales, being approximately 50 percent of its total sale volume.

Cliffs has informed Algoma that it is prepared to resume supplying iron ore pellets to Algoma if Algoma pays a price that is significantly more than the existing contract price (which is soon to decrease further)

Algoma is not economically viable if it is required to purchase pellets at the price proposed by Cliffs.

Other iron ore suppliers

In order to mitigate the potentially devastating effect of Cliffs’ purported termination of the Cliffs contract, Algoma approached a number of other pellet suppliers (the “Alternate Suppliers”), including United States Steel International, Inc. (“US Steel”) and The Iron Ore Company of Canada (“IOC”) in order to secure an alternative supply of pellets.

Algoma has entered into agreements with US Steel and IOC to purchase approximately two-thirds of the iron ore pellets that Algoma requires in order to maintain operations through the winter.

Supply pursuant to these contracts has already started arriving at the facility and will continue to be stockpiled.

Notwithstanding this supply, Algoma will require Cliffs to continue supplying.

Coal

Algoma’s blast furnace (which melts iron ore pellets into hot metal) is primarily fueled by coke, which Algoma produces by processing coal.

Each year, Algoma purchases approximately 1.5 million tons of coal, which it converts into approximately 1 million tons of coke.

Algoma purchases the majority of its coal pursuant to year-long contracts with three American coal suppliers and one Canadian coal supplier, and purchases the remainder on the spot market.

An ongoing supply of coal is critical to Algoma’s ongoing operations.

The applicants have recently signed a coal supply agreement (the “Southern Coal Agreement”) with Southern Coal Sales Corporation (“Southern Coal”).

The Southern Coal Agreement terminates on March 31, 2017 and provides for the supply of coal to Algoma on a consignment basis.

Pursuant to the Southern Coal Agreement, Southern Coal will deliver approximately 540,000 tons of coal (±10 percent) to Algoma by rail and vessel in November and December 2015.

This coal will be stockpiled and held in consignment at a segregated area of the Port Algoma will pay Southern

Coal a deposit of 10 percent of the purchase price of each shipment of coal before the coal is loaded for worchshipping.

The arrangement contemplated in the Southern Coal Agreement allows Algoma to stockpile a substantial inventory of coal at the facility before the shipping lanes become unnavigable without incurring the full cost of such coal in advance.

Natural gas

Algoma purchases approximately 50,000 million British Thermal Units (“mmbtu”) of natural gas each day from three suppliers.

Algoma’s principal supplier of natural gas is Shell Energy North America (Canada) Inc. (“Shell”), which supplies Algoma with natural gas pursuant to a five-month contract negotiated each year in the fall.

Pursuant to Algoma’s supply agreement with Shell (the “Shell Agreement”), Algoma purchases approximately 22,500

mmbtu of natural gas each day.

Algoma also purchases approximately 12,500 mmbtu of natural gas per day from Noble Americas Gas & Power Corp. (“Noble”) pursuant to a master agreement dated December 3, 2010 between Noble and Algoma (the “Noble Agreement”).

The balance of Algoma’s natural gas purchases are made at spot pricing from Noble or DTE Energy Co.

(“DTE”).

Algoma has contracts with Active Energy Inc. (“Active”) for capacity on natural gas pipeline networks.

Pursuant to that contract, Active transports natural gas from Shell, Noble and DTE to Sault Ste. Marie Union Gas’s facility in Sault Ste. Marie, from which the natural gas is transported to the Facility.

The supply of natural gas is critical to Algoma’s ongoing operations, and the applicants are seeking a critical supplier order with respect to Shell and Noble.

Oxygen

Algoma uses oxygen in producing steel.

Algoma purchases oxygen from Praxair, Inc. (“Praxair”), which owns and operates a plant that generates oxygen located at the facility (the “Oxygen Plant”).

The Oxygen Plant was constructed specifically to supply Algoma with oxygen and certain other gases.

Algoma cannot economically purchase oxygen from any other vendor, and enjoys significant cost savings because of the location of the Oxygen Plant.

Moreover, Algoma must pay Praxair certain fixed amounts each month regard less of the volume of gases that Algoma

purchases from Praxair (if any).

Power

Algoma purchases approximately 50 percent of its power supply from Essar Power Canada Ltd. (“EPC”) which operates a power co-generation plant (the “Cogen Plant”) located at the facility and which is essential to Algoma’s operations.

Aside from sharing an ultimate parent with Algoma, EPC is not related to Algoma.

On December 21, 2009 Algoma and EPC entered into a land lease, an energy supply agreement and a shared services agreement.

Pursuant to the terms of the land lease, EPC leased the premises that the Cogen Plant is located on from Algoma for a nominal rent of $1 per year, plus approximately $400,000 per year on account of real property taxes in respect of the leased premises and EPC’s proportionate share of unmetered utilities, shared common area repairs and infrastructure and capital repairs.
Pursuant to the terms of the energy supply agreement, Algoma provides EPC with surplus coke oven gas and blast furnace gas which is generated as a by-product from the steel making process that EPC uses at the plant to generate electricity and processed steam. EPC sells the electricity which is generated to Algoma at the Hourly Ontario Energy Price, a rate which is materially less than the cost of purchasing electricity directly from the Independent Electricity System Operator (IESO). In lieu of payment in respect of the deliveries of the by-product fuel and processed steam, payment is satisfied by the parties’ performance of the obligations under the energy sup ply agreement;
Pursuant to the terms of the shared services agreement, Algoma provides EPC with operating, maintenance and administrative personnel as required by EPC at market prices. The cost of all salary and benefits to personnel provided byAlgoma to EPC are paid by Algoma and fully reimbursed by EPC. EPC also pays Algoma an annual flat fee of up to two percent of the total amount of the reimbursement for non-exclusive use of and access to shared premises and equipment.

Scrap

Algoma uses scrap metal to produce steel. Algoma’s principal scrap metal supplier is Triple M Metal LP (“Triple M”).

Algoma buys scrap metal from Triple M pursuant to a letter agreement dated September 14, 2015 (the “Triple M Letter”) that sets out the types, quantities and pricing for scrap that Triple M will sell to Algoma.

The Triple M Letter expires on August 15, 2016.

Customers

Algoma has a diverse customer base.

In Fiscal Year 2015, approximately 62 percent of Algoma’s sales were made to steel service centres, which act as middle-men in the steel markets.

Service centres typically purchase steel products from a variety of manufacturers and re-sell them to end users, including customers in the automotive, construction and heavy equipment manufacturing

industries.

Sales by service centres are typically done on a “just-in-time” basis, which requires a service centre to have a close functional integration with its end users.

Because of this integration, service centres are critical to Algoma’s ability to reach a majority of its ultimate customers, and Algoma’s relationships with service centres are essential to Algoma’s viability as a going concern.

From my knowledge and experience in the steel industry, if Algoma were to become temporarily unable to fill orders from servi

ce centres, the service centres could readily find alternative sources of product, and it would be very difficult for Algoma to replace these suppliers in the future.

The remainder of Algoma’s production is sold directly to end users, as follows:

Direct sales to automotive customers, including car manufacturers and their tier- one suppliers: Eleven percent of Fiscal Year 2015 sales;
Pipe and tube sector sales: Four percent of Fiscal Year 2015 sales;
Fabrication sector: Eight percent of Fiscal Year 2015 sales; and
Manufacturing sector: Seven percent of Fiscal Year 2015 sales.

In Fiscal Year 2015, 47 percent of Algoma’s sales by volume were to Canadian customers and 48 percent were to customers in the United States, with the balance being sold on the international market.

About half of Algoma’s customers purchase steel products pursuant to one-year contracts, while the remainder purchase steel products on the spot market at market prices.

I understand that customers who purchase steel products from Algoma pursuant to one-year contracts are concerned that Algoma should have the liquidity and financial stability necessary to continue supplying products throughout the term

of the contract.

In particular, although purchasers in the automotive industry (which made up 11 percent of Algoma’s sales in Fiscal year 2015) acquire product pursuant to annual contracts, they are reluctant to switch suppliers for a given model of car and commonly enter into consecutive one-year contracts during the lifespan of a project.

Public perception of Algoma’s viability as a going concern is, therefore, critical to Algoma’s ability to continue in business.

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Earlier SooToday coverage of this story

Sheehan talks to Essar CEO. He's not asked to help

'We expect to come out of this a much stronger company' - Kalyan Ghosh

Mayor already talking to Essar Steel Algoma

Essar Steel Algoma to continue operations during restructuring

Essar Steel Algoma enters creditor protection, says report

Province hasn't given promised money to Essar Steel Algoma. Yet

Local businesses left holding millions in dicey Essar debt