Alusaf case

The Aluminum Industry in 1994:

Alusaf Hillside Project
At the beginning of 1994, Alusaf was
considering building the world’s largest
greenfield primary aluminum smelter
– 466,000 tons per year (tpy)
– Located at Richard’s Bay, a deep-water
port on the east coast of South Africa
– Very large capital expenditure of
around $1.6 billion.

Would you make this investment?

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 Advising Alusaf: To Do’s
What must we do?
– Assess whether the Hillside smelter is a good investment

How will we construct this assessment?

– Analyze the cost structure of the Hillside project
– Develop an understanding of how demand and supply
determine the price for primary aluminum
– Understand demand
– Understand the supply decisions of the 157 existing smelters –
construct individual and market supply curves for aluminum

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 Questions

Before getting to the investment issue, let us address

some background issues:
• How is the aluminum industry organized?
• Is it an attractive industry? Why or why not?
• Why does (excess) capacity matter?

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 Value Chain for Aluminum
Note: Minimum efficient scale
(MES) is the minimum capacity a
- MES ≈ 0.01 M tpy
plant must be if it is to have - 25% of aluminum ingot
competitive costs of production.
Secondary
production

Bauxite Alumina Primary Semi-

Fabrication
mining refining production fabrication

- MES ≈ 4 - 5 M tpy - MES ≈ 1 M tpy - MES ≈ 0.225 M tpy - MES ≈ 0.250 M tpy - MES is relatively low
- 100 mines worldwide - 157 smelters for integrated - thousands of
worldwide in 1994 hot/cold mill fabricators
- 75% of aluminum - MES ≈ 0.04 M tpy
ingot for mini-mill
- hundreds of mills
worldwide
Alusaf is engaged in
primary production
4
Aluminum Smelting

2 Al203 + 3 C → 4 Al + 3 CO2

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 Questions

• What should be our investment criterion?

• To decide on the Hillside investment project, what
does Alusaf need to know?

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 The Investment Criterion
Alusaf should build the Hillside smelter if the project is NPV positive
∞ t
 1 
∑   ( pt − ct ) qt > $1.6 billion
t =0  1 + r 
where
pt is the price in year t
ct is the unit cost in year t
qt is the quantity in year t (which equals capacity if the plant needs to
be run at full capacity)
r is the interest rate (cost of capital)

Need to know: expected unit cost of the Hillside smelter, Hillside smelter’s
expected production, expected price of aluminum

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 What Does Alusaf Need to Know?
Cost of investment
– What is the investment cost?
– Should the investment be delayed?
– Will it be lower or higher in the future?
Demand: What are the prospects for demand growth?
Cost of production
– What is the projected unit cost of the proposed Hillside smelter?
– How does it compare to the cost of other smelters?
– Is cost declining over time in this industry?
Supply constraints
– How much excess capacity is there in the industry?
– How likely is future entry? future exit?
What about future government policies? trade barriers? environmental
regulations affecting production?

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 Questions: Costs

• What is the cost structure?

• Which costs matter most?
• Which costs are fixed/variable?

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 Costs
As a plausible first approximation, suppose an individual
smelter’s cost is a linear function of its volume of production
cost ($)

variable cost at volume 500 tons per week

fixed
cost fixed cost

0 2,000 tons:
500
capacity
Volume of production of smelter
(tons per week)
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 Classifying Costs: Alcasa in Venezuela

Fixed costs/ton:
Variable costs/ton:
– Labor ($68)
– Alumina ($407)
– Electricity ($197) – Maintenance ($41)
– Freight ($27) – G & A ($42)
– Other raw materials ($184) – Plant power and fuel/ton:
Too insignificant to matter
– Consumables ($111)
either way; I will count it as
Total variable costs/ton: $926. fixed. ($13)
Total fixed cost/ton : $164

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 What is the shape of a smelter’s marginal
cost curve? Alcasa in Venezuela

C and VC curves
C MC curve

Marginal cost
($/ton)
VC
cost ($)

slope =
$926/ton
$926 MC=AVC

Volume of production Capacity of smelter: Volume of production capacity

(tons per week) 2,000 tons (tons per week) of smelter
 Questions: Operating or Not

• Under which price conditions should smelters

operate?
• If they operate, at what capacity should they
operate?

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 Supply Decision of an Individual Price-
Taking Smelter: Alcasa in Venezuela
Suppose the market price
of primary aluminum is ...

P = $2,700/ton
Price ($/ton)

P = $1,500/ton

MC=AVC=$926/ton
P = $700/ton

0 capacity
Volume of production of smelter
(tons per week)
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 Profit-maximizing supply of an individual
smelter is either zero or full capacity

• Profit-maximizing supply is full-capacity output when

the market price exceeds smelter’s MC

• Profit-maximizing supply is zero when the market

price is below smelter’s MC

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Comparison of Average Smelter to Hillside
Average smelter Hillside (Table B)
(Exhibit 6)
Electricity + Alumina $316/ton + $369/ton = 41% of price of
cost $685/ton aluminum= $455/ton
at 1994 price of
$1,100/ton
Other raw materials $125/ton $143/ton

Power plant and fuels $10/ton $17/ton

Consumables $70/ton $32/ton

Maintenance $50/ton $38/ton
Labor $150/ton $68/ton
Freight $45/ton $40/ton
G&A $75/ton $32/ton
TOTAL $1,210/ton $825/ton

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 Hillside costs

Hillside smelter would have

• AVC = $670/ton and
• AFC = $155/ton,
• Giving an all-in average cost of AC = $825/ton

(Note: All-in costs neglect annual capital charges.)

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 Questions: Market Supply

• How can we construct a simple industry supply

curve?
• What will be its main limitations

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 Profit-maximizing supply of an individual
smelter is either zero or full capacity

The industry consists of 157 smelters with different cost

structures. To get market supply curve, we line up
smelters in “merit order”, from lowest MC to highest,
and graph MC against cumulative volume

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 Short-Run Market Supply: Primary Aluminum in 1993
$2,500
$2,400
$2,300
$2,200 Our supply curve predicts 19.4 million S
$2,100 tons for 1993. Actual was 19.8 in a year
$2,000
with falling prices and lots of inventory
$1,900
$1,800
accumulation.
$1,700
$1,600
$ per ton

$1,500
$1,400
$1,300
$1,200
$1,100 P = $1,110/ton
$1,000
$900
$800
$700
$600 Smelters
$500 that produce
$400
at P = $1,110
$300
$200
$100
$-
0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000 19,412 20,000
Cumulative Capacity (thousands of tons per year)
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 Short Run Market Equilibrium and Alusaf’s Enviable
Position
$2,500
$2,400
$2,300 D1 is where demand has to
$2,200
$2,100 shift so as to drive price S
$2,000 down to Alusaf’s all-in costs.
$1,900
$1,800
$1,700
$1,600
$ per ton

$1,500
Hillside’s all-in costs
$1,400
$1,300
$1,200
$1,100
$1,000
$900
$800
$700
$600 Early 1994
$500
Where the Hillside equilibrium
$400
$300 smelter will fit into
$200 industry supply D1
$100 D0
$-
0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000 18,000 20,000 22,000

Cumulative Capacity (thousands of tons per year)

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 Supply: additional issues

Adjustment in CIS capacities: how long will that take

Inventories: What will the LME do?

Exits: Will the least efficient (state owned) producers exit for sure?

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 Questions: Prices

The market for aluminum is close to perfectly

competitive
Alusaf is essentially a price-taker
• What’s happening to aluminum prices?
• What can we predict?

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 Aluminum Prices

?
Why did
What will happen with future prices?
prices fall?
How can future prices be forecast?

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“Quick and Dirty” Forecast of Aluminum Prices

Alusaf would take approximately three years to bring the Hillside

smelter online. At the end of 1993, the price is $1,110/ton. But
what will price be in 1996 (and beyond)?
Aluminum demand is predicted to grow 2.5% per year
With 1993 demand of 19.4 millions tons, this results in predicted
1996 demand of20.9 million tons. Assume the demand curve is
almost vertical
Alusaf’s smelter has planned capacity of 466,000 tons/year, which
is a 3.5% increase in world supply
The 1996 short run industry supply curve is constructed by adding
Alusaf’s 466,000 tons of capacity to the 1993 supply curve
Predicted supply and demand for late 1996 yields an equilibrium
price of $1,580 per ton (see next slide)

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 Predicted Equilibrium Price for Late 1996
$2,500
$2,400
$2,300
$2,200
$2,100
$2,000 Price = $1,580/ton
$1,900 Quantity = 20.9 million tons
$1,800
$1,700
$1,600
$1,500
$1,400 The marginal smelter is
$ per ton

Slatina in Romania.
$1,300
$1,200
$1,100 It is state owned.
$1,000
$900
$800
$700
$600 D1996
$500
$400
$300
Hillside smelter D1993
$200
$100
$-
0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000 18,000 20,000 22,000
Cumulative Capacity (thousands of tons per year)

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 Question

Invest or not?

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 Economic Profitability of Hillside at
Expected Market Price
Calculate the annual economic profit of the
Alusaf plant assuming:
– price rises to $1,580/ton and
remains there for foreseeable Capacity: 466,000 tpy

future Revenue
per ton annual total (millions)
$1,580 $736
– capital expenditure = $1.6 billion Costs
– cost of capital is 8%, which implies Alumina & electricity (41% of price)$639 $298
an annual capital charge of 0.08 × Other raw materials
PP&F
$143
$17
$67
$8
$1.6 billion = $128 million/year Consumables $32 $15
Maintenance $38 $18
Labor $68 $32
Freight $40 $19
Annual economic profit per ton is positive G&A $32 $15
at $296, which amounts to $137 million "All-in" $1,009 $471
per year. This implies that investment in Annual Cash Flow $571 $265
smelter is positive net present value (NPV).
Capital Charge at 8% $275 $128

Outcome: Alusaf did build the Hillside plant Annual Economic Profit $296 $137

and completed it on budget.

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 Opening of the Alusaf Hillside Smelter

Speech of President Nelson Mandela

at the opening of the Alusaf Hillside
Smelter (excerpts) - April 19, 1996

There can be few things as exciting as seeing bold plans of strategic moment
come to fruition. It is therefore a great privilege to share with you in the official
opening of a plant which holds so much potential for our country. Your
achievement has done South Africa proud.
What we see here today awakens great admiration and respect. It is a
remarkable achievement, wrought from courageous decisions, skill and
ingenuity in design and construction; and the creative power of labour. It
inspires confidence in the future of South Africa. It is therefore a great honour
for me to declare the Hillside smelter officially "open".

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 Epilogue
• The Hillside facility was built and completed on time
and budget
• It managed to exceed its original 466 kT/Y capacity to
510 kT/Y
• Idle Western European capacity and closures in the
CIS helped price recover despite de-stocking by LME
• The 1997 Asian crisis led to a fall in prices to
$1,200/T in early 1999

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