Rio Tinto, the majority owner of the Tiwai Pt aluminium smelter, announced last Thursday, 9^th July, that it has terminated its electricity contract with Meridian Energy and that it will close the smelter by August 2021.  The announcement is short on details, and many questions remain unanswered.

By Greg Sise, 13^th July 2020

There will be many who view the closure of the Tiwai Pt smelter, which consumes about 13% of New Zealand’s electricity, in a positive light, with the prospect of lower electricity prices from 2021, the year in which the smelter will wind down its operations and then close. 

But unfortunately, closure will lead directly to an overall reduction in economic activity; in electricity production, for the 2,500+ people whose livelihoods rely directly on the smelter at present, and for the thousands more whose livelihoods depend indirectly on the smelter, right when the country, and Southland in particular, least needs to shed jobs.

The decision has come as a shock because the smelter has operated profitably for several years, as shown below.  The underlying profit, which is calculated without fair value adjustments on the large hedge contracts with Meridian Energy, did fall last year to a loss of $46 million, a fall of $68 million relative to 2018.  What’s surprising is that the average NZD aluminium price was the second highest since 2012:  this was the year when the current agreements with Meridian Energy were first negotiated, with renegotiations since, in 2013, 2015 and 2018.

 

So, the fall in underlying profit in 2019 surely can’t have been due to low aluminium prices, which only fell by 11% in NZD terms in 2019.  The smelter operates as New Zealand Aluminium Smelters, NZAS, and its parent company is Pacific Aluminium (New Zealand) Ltd (PacAlNZ) which owns 79.36% of NZAS and Sumitomo Chemical Company (SCC) which owns the rest.  According to annual announcements, PacAlNZ and SCC purchase alumina as a raw material for aluminium production and sell the finished products.

PacAlNZ’s 2019 results show metal revenues fell by $18 million in 2019 due to lower aluminium prices, and a lower premium which is paid for high-purity aluminium, leaving $50 million of the change since 2018 in underlying loss unexplained by aluminium price changes.

Rio Tinto’s closure notice states the smelter “is not economically viable due to energy costs that are some of the highest in the industry globally, coupled with a challenging short to medium term aluminium outlook.”  As the chart from the London Metal Exchange shows, this year the LME aluminium price dropped sharply when covid-19 took hold, but the price has recovered half of the fall since mid-May to sit at just over USD $1,600 or around $2,465 in NZD terms:  this price is now higher than the average price shown in the table in three out of six of the years since the current agreement with Meridian was first renegotiated in 2013.

 

Rio Tinto regularly cites high electricity prices in New Zealand, but transmission prices have fallen since hitting a peak in 2017/18, and have fallen significantly again this year (by $141 million in total due mainly to a reduction in Transpower’s weighted average cost of capital), so the extra $50 million fall in profit from 2018 to 2019 can’t be due to transmission charge increases alone (restarting pot-line four in 2018 would lead to an increase, but not immediately).  In fact, the smelter would likely see a reduction of around $7 million this year, with more reductions to follow when a new transmission pricing structure is introduced in 2023.

The pricing details of the contract between Meridian Energy and the smelter are not in the public domain, but we can make various estimates of these using data that is in the public domain, and they appear not to have increased substantially since 2018, and certainly not enough to explain a $50 million rise in costs last year.

PacALNZ’s 2019 accounts show a $6.4 million increase in employee costs, which is possibly due to pot-line four starting to reopen late in 2018 and the need to hire more staff to run it;  but these costs would be covered by the increase in production from pot-line four.

Electricity consumption at the smelter also increased 187 GWh in 2019 due to the restart, but this was more than covered by a new hedge contract with Meridian, at a price we believe to be $55/MWh.  Spot prices were consistently higher than this price in 2019, which means that pot-line four production could be scaled back while NZAS made money on the new hedge.

The accounts also show that “raw materials and consumables used” increased by $47.7 million since 2018 and also note that “higher raw material, energy and employee costs” contributed to the $68 million reduction.  Which means that other raw materials used in aluminium smelting may explain where most of this ‘missing’ change in expenses arises.

One key possibility is the cost of alumina, the main solid material used in aluminium smelting, and also produced in Australia by Rio Tinto at its Yarwun alumina refinery in Gladstone, Queensland.

Various sources reported a surge in alumina prices at the end of 2019 and into the first quarter of this year due mainly to an increase in demand from China, to the point where some media reports speculated that 30% - 40% of smelters globally could be running at a loss.  But as the price of aluminium fell as the global pandemic took hold, so did the price of alumina.  But perhaps Rio Tinto has found an alternative market for alumina that has caused the price to Tiwai to rise?  For example, has Rio Tinto locked in higher prices earlier this year under long term contracts, leaving Tiwai short of cheaper alumina from Australia, and having to ship it from much further afield?

So, what do we make of all this?

I don’t wish to imply that electricity costs are not an issue for the smelter, and Rio Tinto has said many times that they want their smelters to all be in the best quartile in terms of operating costs,  which Tiwai is not.  But what we have here is a lack of transparency around what exactly caused a $68 million drop in profit for 2018 to 2019;  and it doesn’t appear to be electricity costs, which are consistently raised by Rio Tinto as one of its key areas of concern.

In fact, it was reported in the Otago Daily Times on 11^th July that Meridian Energy, Contact Energy, Genesis Energy and Mercury NZ had worked together to offer a package effectively reducing electricity costs by “$50 million initially, increasing to close to $60 million or $70 million over the next two to three years” which “would also have taken the smelter to the mid-point of energy costs globally.”

Furthermore, the table of annual results shows that this is the first year with a loss in underlying profit after five consecutive years of being in profit.  Is one poor year in six really a good reason to close the smelter?  With aluminium prices recovering and lower electricity on offer?

Rio Tinto owns smelters around the world, including the Straumsvík smelter in Iceland, which is also under review.  But this smelter has reportedly made losses for eight years in a row, making Tiwai look like a much better proposition.

Rio Tinto also owns three aluminium smelters in Australia and they are reported as having similar issues in respect of higher energy costs.  However, Rio Tinto has recently made a big play in promoting its goal of being net-zero for emissions by 2050 and has introduced its “RenewAl” brand for low carbon aluminium.  A RenewAl fact sheet identifies smelters in Canada along with Tiwai as being RenewAl sites.  So, it is puzzling why Tiwai is first to be reviewed in Australasia when smelters in Australia are not part of this brand.  Perhaps deals were done last year to keep these ‘dirtier’ smelters going?

The CEO of NZAS was quoted on RNZ last week as saying that there was still a window of opportunity to keep the smelter open but that it was closing rapidly.  This may be the case, but the good folk at NZAS will want the smelter to remain more than anyone, and will want to look at any options that arise.  Maybe there really is a possibility of keeping the smelter open, but the steps taken last week by Rio Tinto, including terminating contracts with Meridian, making the closure announcement, and giving the bad news to its employees and the people of Southland, doesn’t fill me with confidence.

But it would be good to have greater certainty about exactly why non-employee costs increased by $43 million since 2018, and how much of this was due to electricity and how much was due to alumina and other solid raw materials, or indeed other factors.