Aluminium Industry
by Andrea Galeotti.
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Summary. We briefly describe inputs for the production of aluminium, the key elements of the production process of aluminium, and the main sectors that demand aluminium. We then provide
a short description of the evolution of the market
price of aluminium, and how production of this
metal is shared across the globe. In the second part
of session 2, you will be asked to work in groups and
reflect on a series of questions. We will then discuss the answers during the session. The aim is to
develop your skills in implementing a market analysis of a fairly competitive industry.
Market analysis
Suppose, in the next round of interviews, you meet a
major player in the aluminium industry or in a similar
market. You are asked to assess a potential investment:
the creation of a new smelter. These are investments
of at least $2 billion, and they can easily reach $7 billion.
When you assess the profitability of this investment you
better understand:
• Existing and future demand for aluminium.
• Existing and future supply for aluminium.
• What determines your costs of production.
Figure 1. Aluminium smelter: pot lines
Aluminium production. Aluminium is a versatile
metal that is valuable in a wide range of applications.
Aluminium production has several stages: bauxite
mining, alumina refining, smelting, semi-fabrication,
and fabrication. Here we focus on the smelting: the
electrolytic reduction of a molten mixture of alumina
and cryolite to produce pure metal. This is done by
passing a low voltage, high amperage electric current
between a carbon anode and the lining of large containers known as pots. Pots are connected in lines of
125–150 pots. A facility might have two pot lines and
produce 125, 000 tons of aluminium per year.
Production of a ton of aluminium requires:
• Around two tons of alumina. Smelters tend to have
long term contracts with alumina producers to avoid
the risk induced by spikes in the spot price. Smelters
in geographical zones where alumina production is
limited, relative to demand, will need to rely more
on spot prices, making the cost of this input more
volatile.
• What determines the price movement in the next few • Around 14, 000KWh of electricity. Often smelters have
years.
In what follows, I summarise some information on the
aluminium industry: inputs for aluminium production,
the main sectors that demand aluminium, and political
aspects around the aluminium industry. I also provide
a brief overview of the dynamics of the aluminium industry in the last 30 years.
You will then be asked to develop a market analysis.
tailored contracts with electricity providers, but the
price of electricity varies enormously with geographical
location. Furthermore, shut down of electricity can induce large costs to a smelter as pots will be unusable
after four hours and, therefore, reliability of electricity
providers is essential.
• Other raw materials are used in the pots. Other costs
include consumables (like pot relining materials), the
power and fuel not related to pot-liners, maintenance
expenses, and labour.
Figure 2. Click here for reference
If production unexpectedly stops for more than four
hours, the metal in the pots can solidify, requiring rebuilding of the pots. While it is not possible to reduce
the operating hours or vary the production rate of an
individual pot, production can be varied relatively easily by shutting down a fraction of the smelter’s pots.
If done properly, this does not cause damage to the
pots.
Unfortunately, scaling back production results in no
significant savings in labour or other non-material
costs, as most tasks still need to be performed.
Only if the entire smelter is shut down (that is, if it is
mothballed) can a significant numbers of workers be
laid off. However, once a plant is nearly de-staffed, it becomes extremely expensive to restart.
Demand of aluminium. Aluminium ingots are transformed in intermediate and finished products. Properties of aluminium such as durable, light, resistant and
excellent conduct of electricity contributed to the appeal of this metal for a variety of end uses. The main
markets that demand aluminium are: transportation,
construction, packaging, electrical, consumer durables
and machinery/equipment. Figure 2 provides an illustration of how those markets contribute to total aluminium demand.
As the demand of final goods and services like packaging, transportation and alike are pro-cyclical with economic growth, the demand for aluminium tends to be
strong in periods of global expansion and tends to be
weak in periods of global recession.
Politics and incentives. The presence of a smelter, the
shutting down of a smelter or potential new investments and expansion in a smelter have large effects on
the local community and it may have large effects for
a country as a whole. Hence, governments tend to be
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Figure 3. Prices are period averages
in nominal U.S. dollars per metric ton.
Monthly frequency and not seasonally
adjusted. The same trends occurred if
prices were adjusted for inflation.
involved and to influence those decisions. The assessment of the profitability of such investments cannot ignore political lobbying and negotiations.
Price. Figure 3 summarises price dynamics of aluminium from 1980 to 2015. The price of aluminium has
been very volatile in the last 35 years. Some key events
are important to note:
• In the first part of 1980, we had a major recession with
dramatic reduction on disposable income and GDP.
This was followed by strong economic growth in the
second half of 1980.
• Between 1990-1993 we had a recession and the collapse of Soviet Union. An estimated 80 − 90% of Soviet Union’s approximately 3.5 tons of smelting capacity had been used in military applications, and much of
this metal flooded the market.
• In late 1993, major aluminium producing countries
convened to discuss the crisis caused by the surge
in supply from the Commonwealth of Independent
States. The CIS agreed to voluntary production cuts.
Western producers voluntary idled off substantial production capacity. The price recovered.
• In 1999, the Asian financial crisis affected substantial
the price of aluminium.
• Strong emerging economies in China and India since
the mid-1990s and in the first decade of 2000.
• 2008 financial crisis.
Evolution of the industry. Since the mid 1990s, the
aluminium industry has changed dramatically and followed similar trends of other commodity industries. On
the one hand, the demand for aluminium surged as a
consequence of strong growth in emerging economies
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Variable
Electricity
Alumina
Other raw materials
Plant power and fuel
Consumables
Maintenance
Labour
Freight
General and administration
Figure 4. Production of primary aluminium across geographical regions.
like China and India. At the same time, the need to
increase efficiency in production, by reducing costs,
shifted production from North American and Europe to
the Middle East, China and Africa. In this phase, China
and Asia started to make large investments in the aluminium industry, announcing projects worth billions
of dollar. Given the long lead time from planned investment and actual realisation, actual supply of aluminium from these investments only went on stream
from 2000. Figure 4 plots aluminium production over
time across geographical regions.
Questions and Answers
The first question was to apply the cost taxonomy that
we developed for the production of aluminium. This is
summarised in the above table. Scaling up production
requires a change in electricity, alumina and other raw
materials, and so these are variable costs. The costs of
the power needed to run other aspects of the plant are,
to a great extent, fixed costs. The same is for maintenance costs. One may think that by scaling up or down
production labour would change and so this is also a
variable cost. While this may hold in some industries, in
the case of aluminium, if the manager decides to suspend operation, most of the tasks related to pot-lines
will need to be executed. Hence, labour is also a fixed
cost.
Using this taxonomy, and using the data available, we
can simulate what production choices we will make as
a manager of an aluminium company.
We first take the job of a manager of Rockdale A, a
smelter plant of Alcoa and located in Texas. Rockdale
has a production capacity of 160K tons per year. The
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Yes
Yes
Yes
Yes?
Yes?
Yes
Yes
Yes
Yes
Rockdale A, Texas, US.
Variable
Electricity
Alumina
Other raw materials
Plant power and fuel
Consumables
Maintenance
Labour
Freight
General and administration
422.53
353.61
109.31
Total per ton
954.30
Fixed over 160k tons per year
Fixed
Fixed
11.09
28.68
97.94
191.19
40.17
57.99
358.21
57.313.600
costs per ton for aluminium of the different inputs are
reported in the table below. So, the marginal cost of
production for a ton of aluminium is around 950 and
the average cost of production is around 1300. Hence,
the optimal short-run production choice of Rockdale
was to produce at full capacity whenever the market
price was above 950 and to suspend operation otherwise.
If the manager of Rockdale expected that the price of
aluminium would permanently be below 1300 and that
there was no available option to decrease the costs of
primary inputs, like electricity or alumina by negotiating better contracts with suppliers, then the best thing
would be to propose a shut-down of the plant.
We were then promoted to Alcoa’s manager. Alcoa had
different plants in USA, see Figure 5. Due to the different geographical locations, the costs of inputs, like electricity or labour, may vary greatly across plants, thereby
creating more and less efficient plants. Figure 6 illustrates, for each Alcoa plant, the capacity and the marginal cost of production. Plants are ordered from the
most efficient to the least efficient, based on their marginal cost. At a market price of 900, Alcoa’s manager will
suspend operation of plant Baldin B and all the other
plants that are less efficient than Baldin B, whereas all
other plants will produce at full capacity. Summing
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Figure 5. Alcoa plants in USA
Figure 7. Alcoa plants sorted from most
to least efficient, based on marginal cost
of production
Figure 6. Alcoa plants sorted from most
to least efficient based on marginal cost
of production
up capacity of all plants on stream, Alcoa will supply
around 1200 tons of aluminium.
We can then determine the supply function of Alcoa by
determining Alcoa’s optimal supply for each potential
market price, see Figure 7. This function is step-wise
increasing until we reach full capacity at around 1800
tons. It reflects a production technology that has constant marginal cost within a plant, and so, across the
multi-plant company Alcoa, the production technology
exhibits increasing marginal costs of production.
The industry supply of aluminium will just aggregate
all supply curves of individual multi-plants company.
Since the production of aluminium is rather standardised, each of this company will have a similar supply
curve, and so the supply curve of the whole industry will
also share very similar characteristics. Figure 8 depicts
the industry supply that we have constructed with the
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Figure 8. Industry agreggate supply
1993.
data. As we can see, the supply curve is rather flat (the
price elasticity of supply is large) until we reach total industry capacity, around 19000 tons. At that point, the
supply curves because extremely price inelastic. Since,
in such an industry, there is a large lag between investment in production and the time in which the metal
goes on stream, demand movements are the ones that
are the most responsible in the short and medium run
of price movements. What a manager needs to know,
to understand whether aluminium price will be highly
volatile or not, is whether the industry operates close to
capacity or not.
The collapse of the Soviet Union in 1991 created a strong
excess of supply, with the result of a collapse in the
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market price of the metal. In late 1993, after the collapse of the Soviet Union, major aluminium producing countries convened to discuss the crisis caused by
the surge in supply from the Commonwealth of Independent States. This overproduction had to be tackled and the CIS agreed to voluntary production cuts.
Western producers voluntary idled off substantial production capacity. Such practice can be potentially challenged as collusive behaviour. In that particular circumstance, governments of western countries anticipated
the critical phase of this industry and decided to allow such practice. Furthermore, in 1994, most of aluminium production was coming from Western producers, who shared similar technologies, costs and incentives.
This agreement was effective and the strong demand
from emerging markets like China and India from the
mid 1990s led to a strong increase in demand of aluminium and a surge in price. In this phase, China
and Asia started to make large investments in the aluminium industry announcing projects worth billions of
dollar. Actual supply of aluminium from these investments only went on stream starting from 2000. In 2008,
the financial crisis led to a global recession, with a sharp
decrease in the demand for aluminium and a drop in
price of 50%. Millions of tonnes of aluminium accumulated in storage facilities worldwide. There were closures of smelters belonging to virtually all Western aluminium companies. Producers in China and the Middle East moved in the opposite direction: they kept expanding capacity.
Practitioners compared the 2008 aluminium oversupply crisis to the 1993 aluminium crisis induced by the Soviet Union’s collapse. Practitioners also discussed possible solutions, like a new CIS agreement. If you are interested you can check two articles by click here and
here.
However, such an agreement was not implemented.
Despite the period 2008 and 1991 sharing the characteristic that the market for aluminium was flooded with
metals, the geopolitical conditions and the production
of the main players in the market was very different.
In 1991, all major players were Western producers with
similar incentives and similar efficiency in terms of production technology. These are conditions that are important in order to be able to sustain an agreement like
the CIS agreement. Each of those players faced a similar trade-off and understood the mutual benefits of the
agreement, a prerogative to implement it.
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In 2008, production of aluminium was very different,
with Western producers struggling to keep up with the
most cost-effective producers in China and the Middle
East. The latter, now contributing to a substantial share
of global production, had no incentive to "collude". On
the contrary, their incentive was to expand production,
thereby creating a threat to Western producers that
even more supply would go on stream in the future.
The dip during the financial crises was substantial but
demand for aluminium is fundamentally strong, so it
recovered fast and kept recovering.
Business to business demand. Alumina is one of the
most important input for Aluminium production. To
produce a ton of aluminium you need around 2 tons of
alumina. Hence, you should expect that the demand
for Alumina is generated, to a great extent, by the Aluminium industry. You may be interested to know about
the shape of the demand of Alumina for many reasonsL
you want to invest in Alumina and you know that price
movements depend on shape of demand; you want to
enter an industry in which the Alumina price has impact on its profitability, etc.
To derive this demand you have to determine the willingness to pay of each aluminium producer for each
ton of alumina. A maximizing profit aluminium producer will trade off the marginal revenue of producing
an extra ton of aluminium, which (in a low friction marketplace) is the market price of aluminium, with the
marginal cost of producing a unit of aluminium. The
willingness to pay for a unit of alumina is therefore the
price of alumina so that the marginal cost of production
of one unit of aluminium equals its market price.
For example, consider an aluminium plant with capacity 160 unit of aluminium and where all marginal cost
per unit of production excluded the alumina costs are
959. Suppose the aluminium price is expected to be
stable around 1100 per unit and that the production
process in the plant requires 1.94 units of alumina to
produce each unit of aluminium. If the price of alumina
is P then the total marginal cost to produce a unit of
aluminium is 959 + 1.94 × P . Hence, the manger will
buy alumina to produce aluminium in the plan only if
and the manager buys alumina to run production, the
profit per unit of aluminium are
959 + 1.94 × P ≤ 1100
the same as
P ≤ 72.6
So, here, 72.6 is the willingness to pay of the manager
for the alumina in this specific plant. The demand of
the manager is to buy all alumina needed to produce
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at full capacity if the market price of alumina is below
72.6; otherwise the manager will not demand alumina
and suspend operation. Moving from a single plant to
the demand of alumina of Alcoa is just a question of
aggregating all these informations as we did during the
Session.
Note that this hypothetical manager is not any different (conceptually) than any of the consumer of Product
X in our experiment. If you were a buyer in the experiment I assigned you a card with a number. That was
your willingness to pay (the analogous of 72.6). Most of
you behaved according to this framework: you traded if
you found a seller willing to offer you a price less than
your willingness to pay, otherwise you did not.
An important take away from the analysis was that the
B2B demand depends very much on the heterogeneity
in the production costs of firms on the demand side. If
in that marketplace firms have similar production costs
(i.e., as an extreme case they are equally efficient in production and they all access the same markets for inputs), then their demand of the inputs used for their
production will be quite flat. Eventually, understanding well the nature of the costs of firms operating in a
marketplace, and how heterogeneous these costs may
be across market participants, is a first order element
to infer the shape of supply and demand in that market.
Excel analysis and screencast
The following Excel file provides an exhaustive analysis of the 1993 data. .
The following screencast illustrates the analysis developed in the above Excel file..
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