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* China demand to grow by 4 percent in 2013
* 'Zombie mills' worsen the sector's outlook in Europe
* Hedging might be more effective than vertical integration
By Silvia Antonioli
Jan 22 (Reuters) - This year is set to be critical for steel producers as heavy overcapacity will offset demand growth, making it hard for the weakest mills to survive, Ernst & Young's mining and metals consultant said in an interview this week.
The consultancy estimates global steel demand will expand by 3.2 percent and demand in China, the top producer and consumer of the alloy, will grow by about 4 percent in 2013.
Yet the continued growth of capacity in new steelmaking facilities particularly in developing economies means there is likely to be no improvement in the excess capacity situation.
"This might be the last of the bad years as we think 2014 will already be a bit better but for those who are already weak the challenge will be to make it through the end of this period. Some may have a shock to their ability to survive," Ernst & Young's Mike Elliott said.
"We don't see overcapacity getting better in 2013. Despite a continued increase in demand for steel and some shut downs of capacity, there is already too much new capacity committed and under construction, to turn things around in 2013."
Chinese GDP growth, which Ernst & Young forecasts to be above 8 percent this year, will provide a reliable locomotive to steel demand, while the Chinese government's efforts to consolidate the sector will lead to more modern and more cost efficient capacity in the country.
Strong growth in the U.S. automotive sector and a mild recovery in construction should support growth in steel demand in North America also.
Europe though will be the most critical region, with steel production expected to contract and national governments potentially harming the sector by trying to delay plant shutdowns to avoid social and economic repercussions.
"In Europe there are zombie mills, they are dead mills being almost entirely propped up by state assistance through direct subsidies or indirect arrangements," Elliott said.
India, now the fourth largest steel producer, will continue to increase its influence by adding more capacity to meet growing domestic demand, Elliott added.
Ernst & Young carried out a study on the top 30 steelmakers which showed a mildly negative correlation between vertical integration of a producer and its profitability.
Many steelmakers have bought mining assets in the last few years to try and offset increasing price volatility for raw materials such as iron ore and coal.
To manage this risk, mills would often be better off using hedging tools such as iron ore swaps, which have recently become available to this industry, rather than buy mines, Elliott said.
Editing by Keiron Henderson