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Professor Kenneth S. Corts prepared the original versions of this case, “Aluminum Smelting in South Africa: Alusaf’s Hillside Project,” HBS No. 799-130 and “The Aluminum Industry in 1994,” HBS No. 799-129. This version was prepated by Professor John R. Wells. This case was developed from published sources. Funding for the development of this case was provided by Harvard Business School and not by the company. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright © 2003, 2014 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545- 7685, write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.
K E N N E T H S . C O R T S
J O H N R . W E L L S
Alusaf Hillside Project
At the beginning of 1994, Alusaf was considering building the world’s largest greenfield primary aluminum smelter, a 466,000-ton-per-year facility at Richard’s Bay, a deepwater port on the east coast of South Africa’s province of Kwa-Zulu Natal. Alusaf was the sole primary aluminum producer in South Africa, operating 170,000 tpy of capacity at the existing “Bayside” facility at Richard’s Bay. Alusaf’s 1993 revenues were $220.2 million, up 1% from 1992. Income was $8.6 million, up 122% from 1992.
A feasibility study for the proposed “Hillside” smelter had been completed over the past two years. During this time, South Africa’s political regime had undergone a dramatic transformation with the 1993 passing of the Transitional Executive Council (TEC) Bill. This bill removed absolute power from the hands of whites and created a multi-racial body that would share responsibility for organizing and overseeing the general elections to be held in April 1994. Within days, Nelson Mandela, leader of the African National Congress party, addressed the UN Special Committee Against Apartheid in New York, calling on the international community to lift sanctions against South Africa. The European Union, the Organization of African Unity, Canada, China, Sweden, Singapore, India, and the United States all responded quickly with announcements that they would begin the process of restoring normal economic relations with South Africa.
Aluminum prices had fallen dramatically since the feasibility study was begun, as Russian aluminum continued to flood the market. Now, with aluminum prices near their all-time low in real terms in early 1994, Alusaf had to decide whether to embark on this massive project.
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The Aluminum Industry in 19941
Aluminum was a versatile metal, valuable in a wide range of applications for its strength and light weight. In most applications, substituting aluminum for steel reduced weight by 50% with no significant loss of strength. Since becoming widely available in the late 1800s, aluminum had become widely used in packaging, building materials, and automobiles, among other products. (See Exhibit 1.)
In 1994 worldwide primary aluminum production approached 20 million metric tons. (All references to “tons” in this case are to metric tons, each equal to 2,200 pounds.) Growth had been relatively steady, though punctuated by significant wartime production increases, until the 1974 oil crisis and the recession of the early 1980s each took significant tolls on industry output (see Exhibit 2). The industry had recovered and prices had reached all time high in the late 1980s, but the collapse of the Soviet military machine in the early 1990s sent prices plummeting again as Russia and the other former Soviet states flooded world markets. In early 1994, aluminum prices stood at an all-time low in real terms.
In late 1993 and early 1994, representatives of the major aluminum producing countries convened in Brussels to discuss the “crisis” in the aluminum market caused by the surge in supply from the
CIS.2 This ultimately led to the signing in January 1994 of the non-binding “Memorandum of Understanding” (MOU), in which the parties recognized the existence of 1.5 million-2.0 million tpy of excess production. The CIS agreed to voluntary production cuts of a half million tons. Other countries agreed not to pursue unilateral trade sanctions and to work with the CIS producers to improve environmental standards and develop local aluminum demand. At about the same time, a number of Western producers voluntary idled of production capacity totaling 950,000 tons. Prices began to climb steadily, though slowly, in the first quarter of 1994. (See Exhibit 3 and Exhibit 4.)
Aluminum Smelting
Aluminum smelting involved passing a large electric current through a molten mixture of alumina and cryolite to produce pure metal. This process was carried out in large containers known as “pots.” Molten aluminum fell to the bottom of the pot, from which it was transferred to a holding furnace and ultimately cast as ingot. Pot linings lasted three to six years before wearing out and requiring replacement.
The electrolytic pots were connected in banks called potlines, usually consisting of 125 to 250 pots, with each pot typically produced between 1 and 1.5 tons of aluminum per day. A typical smelting facility would have at least two potlines that shared the plant’s infrastructure. An average smelter might have therefore 300 pots producing 125,000 tons of aluminum per year.
Production of a ton of aluminum, on average, required two tons of alumina and 15,000 kilowatt hours of electricity. Differences in the trace impurities and particle characteristics in alumina from different alumina refineries made optimizing a smelter’s production difficult. As a result, many
1 Primary Sources: Annual Reports: Alcoa, Alcan, Reynolds, Pechiney, Alumax, Kaiser, Norsk Hydro, various issues; International Primary Aluminum Institute, http://www.world-aluminum.org/main.html; London Metal Exchange, http://www.lme.co.uk/cgi-bin/main1.cgi; Standard & Poor’s, “Industry Surveys: Metals-nonferrous,” various issues; U.S. Geological Survey, Minerals Yearbook, various issues and U.S. Aluminum Association, Aluminum Statistical Review, various issues.
2 Commonwealth of Independent States formed after the collapse of the Soviet Union.
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smelter operators preferred to use alumina from a single refinery. Smelter operators produced their own alumina in many cases, and purchased it on long-term contracts from third parties. In 1994, approximately half the world’s smelters bought alumina under long-term contracts that tied its price to the price of aluminum.
Technological improvements had brought the energy requirements down from 21,000 kWh in the 1950s, and the newest plants required only 13,500 kWh per ton. Smelters were typically located close to low-cost sources of electricity since electricity represented one of the largest costs of smelting aluminum. The majority of smelters relied on hydropower. While in 1973 electricity generated by oil and gas had powered about a quarter of smelting capacity, by 1994 these sources accounted for less than 5% of smelter capacity. Industry participants provided approximately 20% of their own power, and relied on state-owned or state-regulated utilities for most of the remainder. A number of governments offered favorable power rates, as well as tax breaks, to attract investment. As a result, the price of power varied significantly from one smelter to the next.
In addition to electricity and alumina, major raw materials included the coke and pitch used in making anodes and the bath chemicals used in the pots. Other costs included consumables like purchased anodes and pot relining materials, the power and fuel not related to the potlines, maintenance expenses, and labor. The cost structures of the industry’s 114 primary smelters— totaling 21 million tons of capacity—are given in the accompanying spreadsheet. Exhibit 6 gives the operating cost structure for an average plant. Costs were typically calculated to include the freight to the nearest LME3 warehouse.
Because the smelting process was continuous, it was costly to stop and restart smelters. If production was unexpectedly interrupted for more than four hours, by a power failure for example, the metal in the pots would solidify, requiring rebuilding and relining the pots. While it was not possible to reduce the operating hours or vary the production rate of an individual pot, plant production could be varied relatively quickly by shutting down some fraction of the smelter’s pots. When done properly, this caused no damage or excessive wear to the pots. Operating a reduced number of pots still required the operation of all stages of the production process. As a result, scaling back production resulted in essentially no savings in labor or other nonmaterials costs. Only if an entire potline were shut down could significant numbers of workers be laid off, for example.
An increasing proportion of aluminum ingot came not from the “primary production” process described here, but from “secondary production” from scrap. Secondary metal accounted for about a quarter of world production in 1994, ranging from only 4% of production in Russia and Canada to 99% of production in Japan. While secondary recovery facilities were also known as smelters, they bore little resemblance to primary production smelters. An efficient facility could be as small as 10,000 tpy, required relatively little capital, and consumed about 5% of the energy per ton of a primary smelter.
The market for aluminum was global. Most companies involved in primary production also processed some of their output in-house, but a substantial fraction was typically sold to independent semifabricators and fabricators. These sales took place both through supply contracts and through spot transactions coordinated by the LME. The LME physically coordinated such transactions and maintained a number of warehouses to store their inventories around the world. The average freight cost from a smelter to the nearest LME warehouse was $40 per ton.
3 London Metal Exchange: Aluminum began trading on the London Metal Exchange in 1978. The LME established official spot and forced prices for the metal and also provided a physical market with a global network of warehouses. (See Exhibit 5.)
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The South African Aluminum Industry
The South African aluminum industry’s origins could be traced to investments made by Alcan in the 1940s. As part of its efforts to create demand for its ingot, Alcan built semifabrication capacity in South Africa to serve the local market.
A government-coordinated development effort at the port of Richard’s Bay, together with a desire to reduce dependence on imported ingot, led to construction of South Africa’s first primary production facility nearly 25 years later. The original Bayside plant came on stream in 1972 with capacity of approximately 85,000 tpy. Less than a quarter of Bayside’s production was exported. Ten years later, the Bayside plant was expanded through the relocation to Richard’s Bay of a similarly sized plant in Niigata, Japan, that had been shut down due to escalating energy costs. Over three quarters of the new plant’s production was exported as ingot.
A number of companies besides Alusaf participated in the South African aluminum industry either as scrap recyclers or as fabricators. The production of secondary aluminum had held relatively steady at about 30,000 tpy since 1980. Together with primary production, this brought total domestic production to about 200,000 tpy.
In 1994, South Africa conversion of aluminum into semifabricants produced was focused on domestic demand. South African aluminum exports totaled approximately 100,000 tpy, of which 20,000 tpy were semifabricated products and 80,000 tpy were ingot. Domestic consumption of semifabrication totaled about 130,000 tpy, of which about 30,000 were imported products.
The Hillside Project
Escom, South Africa’s electrical power utility, initiated discussion of the Hillside project with Alusaf in mid-1991. With aluminum prices around $1,300 per ton, Alusaf had suggested to Escom that the Bayside smelter was not economically viable given market conditions and might be shut down. Escom responded with an offer to reduce power rates dramatically if Bayside were kept open and an additional facility at Richard’s Bay constructed.
Escom offered to supply the smelter’s approximately 680 Mw electricity requirements under an unusual long-term contract. About half the world’s smelters operated under contracts guaranteeing discounted electricity for multiple years; often these contracts tied the price of electricity to the price of aluminum and employed complicated formulas that imposed caps and floors on prices. The 25- year Escom/Alusaf contract was unique in its simplicity: Alusaf would pay Escom 16% of the per-ton price of aluminum for every ton of aluminum produced, assuming the plant produced at its designed efficiency. While the contract did contain provisions protecting Escom from inefficient production, it did not protect Escom against fluctuations in the price of aluminum. Escom and Alusaf were also discussing whether Escom might take an equity stake in the facility.
As a result of high growth projections in the 1970s, Escom had built enormous generating capacity of 38,000 Mw, of which 8,000 Mw now stood idle. Rob Barbour, managing director of Alusaf, claimed that the high energy requirements of aluminum production made aluminum essentially “frozen energy” and that therefore Alusaf “will become an exporter of South African energy with high value- added.”4
4 Gooding, Kenneth, “Aluminum producer aims to ‘frighten off’ new competitors,” Financial Times, September 24, 1991, p. 36.
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For provision of all the basic engineering and technology for the plant, Alusaf planned to contract with Pechiney, the French firm whose technology had been used in over three quarters of all recent smelter projects. Lacking bauxite and alumina operations, Alusaf intended to import the full 900,000 tpy alumina requirement of the new smelter and had negotiated a tentative alumina supply agreement with Alcoa of Australia and Billiton (a subsidiary of Royal Dutch Shell). This contract tied the price of alumina to the price of aluminum, a common contracting practice employed by about half the world’s smelters. For the Hillside plant, this contract ensured that per-ton alumina and power costs would always amount to 41% of the price of aluminum. Estimates for other operating costs at Hillside are given in Table A. Capital costs were estimated to total $2 billion.
Table A Hillside's Projected Operating Costs
($ per ton)
Other raw materials $143 Plant power and fuel 17 Consumables 32 Maintenance 38 Labor 68 Freight 40 General and administrative 32
Before the feasibility study was complete, Barbour announced that he believed there was a “high probability” the smelter would be approved. “In the meantime we hope to deter others from thinking about aluminum smelter projects,” he added. “We want to frighten them off by convincing them that this one is unstoppable.”5
The Decision
In early 1994, tentative contracts for power, alumina, and the smelting technology were all in place, and willing investors had been lined up.
Three new smelters using the Pechiney technology had been completed in recent months. Now, Hillside was the only planned smelter project, and a number of other proposed projects had been cancelled. Equipment suppliers were quoting Alusaf prices 20% to 30% below those supplied for the feasibility study, and the capital cost of the new plant was now projected to total only $1.6 billion.
At the beginning of 1994, aluminum prices stood at $1,110. Aluminum-producing countries had scheduled meetings in the coming months to address the world glut of aluminum, but it was unclear whether prices would recover anytime soon. Barbour wondered whether he should commit to this enormous and ambitious project in the face of these uncertain industry conditions.
5 Gooding, Kenneth, “Aluminum producer aims to ‘frighten off’ new competitors,” Financial Ttimes, September 24, 1991, p. 36.
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Exhibit 1 U.S. Consumption by Sector
Western World 1993 Aluminum Consumption (millions of metric tons)
Consumption % of Total 10-Year CAGR
Building 4.34 21.3% 2.4%
Transportation 5.09 25.0% 5.1%
Packaging 4.28 21.0% 3.9%
Consumer durables 1.49 7.3% 2.8%
Electrical 1.88 9.2% 1.1%
Machinery and equipment 1.78 8.7% 4.2%
Other 1.53 7.15% 1.4%
Total 20.39 100.0% 3.3%
Source: Alcan
Note: Consumption totals include all countries that were not Communist in the mid-1980s, except for a few smaller Asian economies that did not report detailed consumption data.
World Aluminum Consumption
0.0
1.0
2.0
3.0
4.0
5.0
6.0
1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993
m il
li o
n s
o f
m e
tr ic
t o
n s
Building
Transportation
Packaging
Consumer durables
Electrical
Machinery
Other
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Exhibit 2 World Aluminum Production
Exhibit Primary Aluminum Production
Source: Bureau of Mines, U.S. Department of Interior
World Primary Aluminum Production
0
2,000
4,000
6,000
8,000
10,000
12,000
14,000
16,000
18,000
20,000
22,000
1930 1933 1936 1939 1942 1945 1948 1951 1954 1957 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993
th o
u s
a n
d s
o f
m e
tr ic
t o
n s
Primary Aluminum Production
0
1,000
2,000
3,000
4,000
5,000
6,000
7,000
1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993
th o
u s
a n
d s
o f
m e
tr ic
t o
n s
North America
South America
E.U.
Other Europe
Africa
Asia
Oceania
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Exhibit 3 Aluminum Prices
Source: IMF, London Metal Exchange
Aluminum Prices, 1960 - 1993
0
500
1000
1500
2000
2500
3000
3500
1 9
6 0
1 9
6 2
1 9
6 4
1 9
6 6
1 9
6 8
1 9
7 0
1 9
7 2
1 9
7 4
1 9
7 6
1 9
7 8
1 9
8 0
1 9
8 2
1 9
8 4
1 9
8 6
1 9
8 8
1 9
9 0
1 9
9 2
$ /t
o n Nominal
Real
Aluminum prices, Jan 89 - Dec 93
$0.00
$500.00
$1,000.00
$1,500.00
$2,000.00
$2,500.00
$3,000.00
3 /1
/8 9
1 /3
/8 9
2 /5
/8 9
2 9
/0 6
/8 9
2 5
/0 8
/8 9
2 4
/1 0
/8 9
2 0
/1 2
/8 9
2 0
/0 2
/9 0
2 0
/0 4
/9 0
2 0
/0 6
/9 0
1 6
/0 8
/9 0
1 5
/1 0
/9 0
1 1
/1 2
/9 0
1 3
/0 2
/9 1
1 5
/0 4
/9 1
1 3
/0 6
/9 1
9 /8
/9 1
8 /1
0 /9
1
4 /1
2 /9
1
5 /2
/9 2
2 /4
/9 2
4 /6
/9 2
3 1
/0 7
/9 2
2 9
/0 9
/9 2
2 5
/1 1
/9 2
2 6
/0 1
/9 3
2 4
/0 3
/9 3
2 5
/0 5
/9 3
2 2
/0 7
/9 3
2 0
/0 9
/9 3
1 6
/1 1
/9 3
$ /t
o n
Nominal
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Exhibit 4 World Consumption and Production, 1993 (millions of metric tons)
5-Year CAGR
10-Year CAGR
1993
1988
1983
Primary production 1.4% 3.6% 19.8 18.5 13.9
Secondary production 3.7% 3.4% 6.0 5.0 4.3
Total production 25.8 23.5 18.2
Consumption:
Western worlda 2.0% 3.3% 20.4 18.5 14.8
All other countries -3.5% 0.2% 4.1 4.9 4.0
Total consumption 24.5 23.4 18.8
Changes in inventories 1.3 0.1 -0.6
(excess of production over consumption)
Source: Alcan; U.S. Bureau of Mines; U.S. Aluminum Association; casewriter estimates.
a Western world consumption includes all countries that were not Communist in the mid-1980s, except for some smaller Asian countries that did not report detailed consumption data.
Exhibit 5 London Metal Exchange Inventories
Source: London Metal Exchange
LME Inventories
0
500,000
1,000,000
1,500,000
2,000,000
2,500,000
3,000,000
1 2
/2 9
/7 8
1 2
/2 9
/7 9
1 2
/2 9
/8 0
1 2
/2 9
/8 1
1 2
/2 9
/8 2
1 2
/2 9
/8 3
1 2
/2 9
/8 4
1 2
/2 9
/8 5
1 2
/2 9
/8 6
1 2
/2 9
/8 7
1 2
/2 9
/8 8
1 2
/2 9
/8 9
1 2
/2 9
/9 0
1 2
/2 9
/9 1
1 2
/2 9
/9 2
1 2
/2 9
/9 3
m e
tr ic
t o
n s
Primary Aluminum
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Exhibit 6 Cost Structure for Average Smelter
Average 1993 Operating Cost Structure ($/metric ton except where noted)
Electricity usage (kWh/t) 15,800
Electricity price ($/kWh) 0.02
Total electricity cost 316
Alumina usage (t/t Al) 1.94
Alumina price ($/t alumina) 190
Total alumina cost 369
Other raw materials 125
Plant power and fuel 10
Consumables 70
Maintenance 50
Labor 150
Freight 45
General and administrative 75
Total operating costs 1,210
Source: CRU International
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Exhibit 7 Financials for Leading Aluminum Companies
1993 1992 1991 1990 1989
ALCOA (millions of US dollars)
Sales $ 9,056 $ 9,492 $ 9,884 $ 10,170 $ 10,910
Net income 5 (1,139) 64 295 945
Total assets 11,597 11,023 11,178 11,413 11,541
Alcan (millions of US dollars)
Sales $ 7,232 $ 7,596 $ 7,748 $ 8,757 $ 8,839
Net income (104) (112) (36) 533 835
Total assets 9,810 10,146 10,816 10,649 9,508
Reynolds (millions of US dollars)
Sales $ 5,269 $ 5,593 $ 5,730 $ 6,022 $ 8,143
Net income (322) (749) 154 297 533
Total assets 6,709 6,897 6,685 6,527 6,527
Pechiney (millions of French francs)
Sales 63,925 65,374 74,425 76,869 88,472
Net income (890) 203 820 4,913 3,337
Total assets 71,769 70,570 - - -
Alumax (millions of US dollars)
Sales $ 2,347 $ 2,431 $ 2,302 $ 2,452 $ 2,551
Net income (138) (64) 42 177 289
Total assets 2,959 2,871 2,739 2,379 2,155
Kaiser (millions of US dollars)
Sales $ 1,719 $ 1,909 $ 2,001 $ 2,095 $ 2,193
Net income (652) 27 108 214 202
Total assets 2,528 2,773 2,134 2,119 2,131
Norsk Hydro (millions of Norwegian
krones)
Sales 60,350 58,062 60,608 60,377 63,329
Net income 2,996 (195) (498) 2,901 2,687
Total assets 88,015 85,750
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