Alusaf case

The Aluminum Industry in 1994:

Alusaf Hillside Project
At the beginning of 1994, Alusaf was
considering building the worlds largest
greenfield primary aluminum smelter
466,000 tons per year (tpy)
Located at Richards 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?

Advising Alusaf: To Dos

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

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?

Value Chain for Aluminum

Note: Minimum efficient scale
(MES) is the minimum capacity a
plant must be if it is to have
competitive costs of production.

- MES 0.01 M tpy

- 25% of aluminum ingot
Secondary
production

Bauxite
mining
- MES 4 - 5 M tpy
- 100 mines worldwide

Alumina
refining
- MES 1 M tpy

Primary
production

Semifabrication

- MES 0.225 M tpy

- 157 smelters
worldwide in 1994
- 75% of aluminum
ingot

- MES 0.250 M tpy

for integrated
hot/cold mill
- MES 0.04 M tpy
for mini-mill
- hundreds of mills
worldwide

Fabrication
- MES is relatively low
- thousands of
fabricators

Alusaf is engaged in
primary production
4

Aluminum Smelting

2 Al203 + 3 C 4 Al + 3 CO2

Questions
What should be our investment criterion?
To decide on the Hillside investment project, what
does Alusaf need to know?

The Investment Criterion

Alusaf should build the Hillside smelter if the project is NPV positive

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 smelters
expected production, expected price of aluminum

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?

Questions: Costs
What is the cost structure?
Which costs matter most?
Which costs are fixed/variable?

Costs

cost ($)

As a plausible first approximation, suppose an individual

smelters cost is a linear function of its volume of production

variable cost at volume 500 tons per week

fixed
cost

fixed cost

500
Volume of production
(tons per week)

2,000 tons:
capacity
of smelter
10

Classifying Costs: Alcasa in Venezuela

Variable costs/ton:
Alumina ($407)
Electricity ($197)
Freight ($27)
Other raw materials ($184)
Consumables ($111)
Total variable costs/ton: $926.

Fixed costs/ton:
Labor ($68)
Maintenance ($41)
G & A ($42)
Plant power and fuel/ton:
Too insignificant to matter
either way; I will count it as
fixed. ($13)
Total fixed cost/ton : $164

11

What is the shape of a smelters marginal

cost curve? Alcasa in Venezuela
C and VC curves
MC curve

cost ($)

VC
slope =
$926/ton

Volume of production
(tons per week)

Capacity of smelter:
2,000 tons

Marginal cost
($/ton)

MC=AVC

$926

Volume of production
(tons per week)

capacity
of smelter

Questions: Operating or Not

Under which price conditions should smelters
operate?
If they operate, at what capacity should they
operate?

13

Supply Decision of an Individual PriceTaking Smelter: Alcasa in Venezuela

Suppose the market price
of primary aluminum is ...
Price ($/ton)

P = $2,700/ton

P = $1,500/ton

MC=AVC=$926/ton

P = $700/ton

0
Volume of production
(tons per week)

capacity
of smelter
14

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 smelters MC
Profit-maximizing supply is zero when the market
price is below smelters MC

15

Comparison of Average Smelter to Hillside

Average smelter
(Exhibit 6)

Hillside (Table B)

Electricity + Alumina
cost

$316/ton + $369/ton =
$685/ton

41% of price of
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.)

17

Questions: Market Supply

How can we construct a simple industry supply
curve?
What will be its main limitations

18

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

19

Short-Run Market Supply: Primary Aluminum in 1993

$2,500
$2,400
$2,300

Our supply curve predicts 19.4 million

tons for 1993. Actual was 19.8 in a year
with falling prices and lots of inventory
accumulation.

$2,200
$2,100
$2,000
$1,900
$1,800

$1,700

$ per ton

$1,600
$1,500
$1,400
$1,300
$1,200

P = $1,110/ton

$1,100
$1,000
$900
$800
$700

Smelters
that produce
at P = $1,110

$600
$500
$400
$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)

20

$ per ton

Short Run Market Equilibrium and Alusafs Enviable

Position
$2,500
$2,400
$2,300
$2,200
$2,100
$2,000
$1,900
$1,800
$1,700
$1,600
$1,500
$1,400
$1,300
$1,200
$1,100
$1,000
$900
$800
$700
$600
$500
$400
$300
$200
$100
$-

D1 is where demand has to

shift so as to drive price
down to Alusafs all-in costs.

Hillsides all-in costs

Early 1994
equilibrium

Where the Hillside

smelter will fit into
industry supply
0

2,000

4,000

6,000

D1
8,000

10,000

12,000

D0
14,000

16,000

18,000

20,000

22,000

Cumulative Capacity (thousands of tons per year)

21

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?

22

Questions: Prices
The market for aluminum is close to perfectly
competitive
Alusaf is essentially a price-taker
Whats happening to aluminum prices?
What can we predict?

23

Aluminum Prices

?
What will happen with future prices?
How can future prices be forecast?

Why did
prices fall?
24

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
Alusafs 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
Alusafs 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)

25

$ per ton

Predicted Equilibrium Price for Late 1996

$2,500
$2,400
$2,300
$2,200
$2,100
$2,000
$1,900
$1,800
$1,700
$1,600
$1,500
$1,400
$1,300
$1,200
$1,100
$1,000
$900
$800
$700
$600
$500
$400
$300
$200
$100
$-

Price = $1,580/ton
Quantity = 20.9 million tons

The marginal smelter is

Slatina in Romania.
It is state owned.

D1996
D1993

Hillside smelter

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)

26

Question
Invest or not?

27

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
future
capital expenditure = $1.6 billion
cost of capital is 8%, which implies
an annual capital charge of 0.08
$1.6 billion = $128 million/year
Annual economic profit per ton is positive
at $296, which amounts to $137 million
per year. This implies that investment in
smelter is positive net present value (NPV).
Outcome: Alusaf did build the Hillside plant
and completed it on budget.

Capacity: 466,000 tpy

Revenue

per ton annual total (millions)

$1,580
$736

Costs
Alumina & electricity (41% of price)$639
Other raw materials
$143
PP&F
$17
Consumables
$32
Maintenance
$38
Labor
$68
Freight
$40
G&A
$32
"All-in"
$1,009

$298
$67
$8
$15
$18
$32
$19
$15
$471

Annual Cash Flow

$571

$265

Capital Charge at 8%

$275

$128

Annual Economic Profit

$296

$137

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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".

29

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

30