Friday, March 26, 2010

The benefits of aluminium smelters and Eskom's risky contracts

By Galen Sher

The context
At Creamer Media's Engineering News, Matthew Hill has discussed a 2008 Econometrix report, which says the South Africa enjoys "enormous" benefits from its controversial aluminium smelters.

The report was commissioned in 2008 by BHP Billiton. Southern Africa has three aluminium smelters, two in Richards Bay and one in Maputo, all drawing their power from Eskom. They are part of Eskom's controversial undisclosed deals, obtaining power at much-reduced rates. The smelters have been criticised because:

  1. They use large amounts of electricity - as much as 5% of South Africa's total electricity consumption.

  2. They obtain their electricity at low cost, which is seen as inequitable.

  3. They are a capital (machinery)-intensive use of resources, rather than a labour-intensive use of resources, and hence they do not meet South Africa's employment generation objectives.

Risky contracts
None of this is new. However, the article makes a striking observation:

Under the terms of its contract with Eskom, BHP Billiton pays less for power when the aluminium price falls and more when it climbs. For Eskom, the economic crisis of 2007 and 2008, which led to precipitous declines in commodity prices, including the price of aluminium, blew in the perfect storm, with large chunks of power reportedly supplied to the smelters at below cost. [emphasis added]
Any actuary would immediately spot these contract terms as being extremely risky for Eskom. The cost to Eskom of providing electricity has virtually no relationship to the aluminium price. Therefore, these contract terms effectively place Eskom in a position where it has taken an outright bet on the aluminium price. Specifically, when the contracts were signed Eskom effectively took a wager that the aluminium price would continue to rise at least as fast as inflation.

The aluminium price graph below (Source: London Metals Exchange) shows the aluminium price hovering between $2500/t and $3000/t until late 2008 when the financial crisis broke in earnest, after which the price drops to some $1300/t in March 2009. Today the price has recovered only to some $2200/t. Therefore, from March 2009 to today Eskom has been forced to provide the smelters with low-cost electricity at a time when the utility could least afford it. This situation has arisen through Eskom's own folly in entering into such risky contracts and failing to provide adequately for the risk.

The benefits of smelters
Notwithstanding the costs incurred through providing them with cheap electricity, Southern Africa's smelters have given the region substantial economic benefits, according to the unreleased Econometrix report:

  1. The smelters employed more than 3 200 employees and 2 800 contractors when the report was written

  2. contributing R1,3-billion in corporate tax to the South African and Mozambique governments

  3. it was estimated that about 100 000 South African citizens depended on the Bayside and Hillside smelters for their livelihoods

  4. Foreign currency earned from exports... [were] more than R21-billion. [Net of imports, the smelters earned the region R12 billion in foreign exchange.]

  5. The facilities comprised around 1% of gross regional product.

The report goes on to argue that South African investment in aluminium smelters should be increased, not reduced, at the time of writing. If only Engineering News, BHP Billiton or Parliament would release the full report to the public.