Project: South African Aluminum Essay

At the beginning of 1994, Alusaf was considering building the world’s largest greenfield primary aluminum smelter, a 466,000-ton-per-year smelter 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 â€Å"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 â€Å"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. 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 onstream in 1972 with ________________________________________________________________________________________________________________ Professor Kenneth S. Corts prepared this case as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Copyright  © 2002 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 http://www. hbsp. harvard. edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School. This document is authorized for use only in PGDM 1st Year – 1007 by Rakhi Singh at IILM Institute for Business and Management, Gurgaon (IILM-IBM, Gurgaon) from October 2013 to April 2014. 799-130 Aluminum Smelting in South Africa: Alusaf’s Hillside Project 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. In 1989, South African mining and metals giant Gencor acquired a controlling interest in Alusaf. The other primary shareholders were Swiss aluminum producer Alusuisse and South Africa’s quasigovernmental Industrial Development Corporation (IDC). Gencor was founded in 1980 by the merger of two major mining companies, each founded in the late nineteenth century. Since that merger, Gencor had been a diversified financial, mining and industrial conglomerate. In May 1993, Gencor announced it was spinning off its financial and industrial interests in order to refocus on its mining, metals, and minerals businesses. In addition to Alusaf, the companies retained in the â€Å"unbundled† Gencor included the world’s third-largest gold producer, the world’s second-largest platinum producer, the world’s largest producer of ferroalloys, and the world’s largest supplier of titanium dioxide feedstock. Basic financial results for Gencor are given in Table A. Table Aduction 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 (see Exhibit 1). In 1994, semifabrication in South Africa remained primarily 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 totaled about 130,000 tpy, of which about 30,000 was imported products (see Exhibit 2). 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 2 This document is authorized for use only in PGDM 1st Year – 1007 by Rakhi Singh at IILM Institute for Business and Management, Gurgaon (IILM-IBM, Gurgaon) from October 2013 to April 2014. Aluminum Smelting in South Africa: Alusaf’s Hillside Project 799-130 of aluminum and employed complicated formulas that imposed caps and floors on prices. The 25year 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 â€Å"frozen energy† and that therefore Alusaf â€Å"will become an exporter of South African energy with i high value-added. † 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 B. Capital costs were estimated to total $2 billion. Table B Hillside’s Projected Operating Costs ($ per ton) Other raw materials $143 Plant power and fuel 17 Consumables 32 Maintenance Labor Freight 38 68 40 General and administrative 32 Before the feasibility study was complete, Barbour announced that he believed there was a â€Å"high probability† the smelter would be approved. â€Å"In the meantime we hope to deter others from thinking about aluminum smelter projects,† he added. â€Å"We want to frighten them off by convincing ii them that this one is unstoppable. † 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. The financing plan called for $1. 9 billion of new capital to be raised, about $830 million of it in equity. Gencor was to contribute $340 million in 3 This document is authorized for use only in PGDM 1st Year – 1007 by Rakhi Singh at IILM Institute for Business and Management, Gurgaon (IILM-IBM, Gurgaon) from October 2013 to April 2014. 799-130 Aluminum Smelting in South Africa: Alusaf’s Hillside Project equity, the IDC $270 million in equity, other local institutions $140 million in equity, and Escom $80 million in convertible debt. 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. 4 This document is authorized for use only in PGDM 1st Year – 1007 by Rakhi Singh at IILM Institute for Business and Management, Gurgaon (IILM-IBM, Gurgaon) from October 2013 to April 2014.