Managerial Economics Ko University Graduate School of Business - PDF document

Managerial Economics Koç University Graduate School of Business MGEC 501 Levent Koçkesen The Aluminum Industry in 1994 • Aluminum smelting is a perfectly competitive industry: 157 smelters worldwide in 1993 • Traded at London Metal Exchange (LME) • Price in 1988 over $2,500 per ton • Price at beginning of 1994 about $1,100 per ton • Mainly due to the collapse of the Soviet Union and the resulting flood of aluminum into the world markets by the Commonwealth of Independent States (CIS) 1

Annual Average Primary Aluminum Price (Dollars per metric ton) 3000 2500 2000 1500 1000 500 0 1970 1975 1980 1985 1990 1995 • 1971-74: price controls. • 1973-75: OPEC oil embargo and increase in oil prices • 1986-88: Supply shortages • 1991: Soviet Union Collapse Alusaf’s Hillside Project • At the beginning of 1994, Alusaf was considering to build the world’s largest smelter (466,000 tpy) at Richard’s Bay in South Africa • A feasibility study was done two years before, but since then the Russian flood had occurred. • Capital cost was projected to be $1.6 billion • Aluminum prices at about $1,110 • Alusaf had long-term contracts that ensured per- ton alumina and power costs at 41% of aluminum price • Should Alusaf go ahead with the project? How can we use supply-demand analysis to understand price dynamics? How does this help in entry decisions? 2

Smelting Process • Smelting is the process of extracting aluminum metal from aluminum oxide (alumina) through electrolytic reduction. • The fundamental component of a smelting operation is the electrolytic cell, or "pot" in which this reaction takes place. • During smelting, large amounts of current pass through molten alumina dissolved in a chemical bath. • This process separates out aluminum metal for removal and casting. • Smelters typically operate hundreds of pots, linked electrically in configurations called potlines. It is costly to stop and start smelters Average 1993 Operating Cost Structure ($/metric ton except where noted) Production can be varied quickly by Electricity usage (kWh/t) 15767 shutting down pots Electricity price ($/kWh) 0.02 Operating a reduced number of pots Total electricity cost: 317 requires operation of all stages of the Alumina usage (t/t Al) 1.94 production process 189 Alumina price ($/t Alumina) Scaling back production results in no Total alumina cost: 366 savings in labor or other non-materials Other raw materials 125 costs Plant power and fuel 10 Consumables 70 Maintenance 51 Labor 146 Freight 44 General and administrative 77 Total 1206 Cost Structure of a Smelter For the short-run supply decision we have to find the variable and fixed costs Case suggests the following classification Variable Costs Fixed Costs Electricity 317 Labor 146 Alumina 366 Maintenance 51 Other raw materials 125 G & A 77 Consumables 70 Plant Power and Fuel 10 Freight 44 AVC 922 AFC 284 TC = TVC + TFC If variable costs vary with output proportionally, then AVC is fixed and TVC = AVCxQ MC = AVC = $922/ton 3

Cost Structure of a Smelter Average capacity TC = 922Q + 730,000 133,000 ton/year dollars 2,500 ton/week TVC = 922Q At capacity weekly costs TVC = 2,500 x 922 = $2.35 mil TFC = 2,500 x 284 = $730K TFC = 730,000 AFC = $730,000/Q AC = 922 + AFC 2,500 tons per week Short-run supply decision: MC dollars/ton AC if P < AVC (MC) do not produce if P ≥ AVC (MC) produce at capacity 1,400 At price 1,000 the smelter produces at full capacity but makes losses 1,206 At price 1,400 the smelter produces 1,000 at full capacity and makes positive 922 profits 800 At price 800 the smelter shuts down for the week 2,500 tons per week Industry Supply Curve Suppose there are only 3 smelters: Sorocaba A, Essen, Seydisehir Smelter AVC Capacity Below price 580 nobody produces Sorocaba A 580 122 At prices between 580 and 1,125 only Essen 1,125 135 Sorocaba A produces Seydisehir 1,740 60 At prices between 1,125 and 1,740 Essen starts producing as well Prices at and above 1,740 all three smelters produce 1,740 This suggests a way to construct the price ($/ton) market supply: 1,125 1. Sort the smelters according to AVC 580 2. Calculate cumulative capacity 3. Plot AVC against cumulative capacity 257 122 317 thousand tons per year 4

Aluminum Industry Supply Curve in 1993 2,200 2,100 S 2,000 1,900 1,800 1,700 1,600 1,500 1993 market price = 1,180 1,400 1,300 dollars/ton 1,200 1,100 1,000 900 800 1993 production = 19,800 700 600 500 400 D 300 200 100 0 0 5,000 10,000 15,000 20,000 25,000 tons/year Aluminum Industry Supply Curve w/o CIS 2,200 2,100 2,000 1,900 1,800 1,700 w/o CIS 1,600 1,500 1,400 1,300 dollars/ton 1,200 1,100 1,000 900 800 700 600 500 400 D 300 200 100 0 0 5,000 10,000 15,000 20,000 25,000 tons/year 5

Alusaf’s Hillside Project • At the beginning of 1994, Alusaf was considering to build the world’s largest smelter (466,000 tpy) at Richard’s Bay in South Africa • A feasibility study was done two years before, but since then the Russian flood had occurred. • Capital cost was projected to be $1.6 billion • Aluminum prices at about $1,110 • Alusaf had long-term contracts that ensured per- ton alumina and power costs at 41% of aluminum price • Should Alusaf go ahead with the project? Entry Decision 1993 Operating Cost Structure ($/metric ton except where noted) What is the min price at 1,110 x 0.41 Average Hillside which Alusaf should enter? Total electricity and alumina cost 683 455 We have to calculate FR-AC Other raw materials 125 143 Plant power and fuel 10 17 What is average annual capital charge (AACC)? Consumables 70 32 Maintenance 51 38 $1,6 bil/466 kton = $3,433/ton Labor 146 68 Freight 44 40 At 10% cost of capital General and administrative 77 32 AACC = $343 Total 1206 825 FR-AC = 0.41P + 143 + 32 + 40 + 155 + 343 Hillside Cost Structure P = 0.41P + 713 Variable Costs Fixed Costs FR-AC = 713/0.59 = $1208 Electricity & Alumina 455 Labor 68 Other raw materials 143 Maintenance 38 What is the price going to be in a few years? Consumables 32 G & A 32 Freight 40 Plant Power and Fuel 17 Need to calculate L-R price = entry price for a typical smelter AVC 670 AFC 155 6

Entry Price Capacity of a new smelter = 225,000 tpy (Case p.5) AACC = $390/ton About $4,900/ton Cost = $1.1 billion (Case p.5) At 8% cost of capital Assume AC = $1,206 (average in 1993) FR-AC = 1,206 + 390 = $1,596/ton How about demand in 5 years? Exhibit 4: Consumption in West = 20.4 mil 10-year CAGR = 3.3% Rest of the world = 4.1 mil 20.4 x (1.033) 5 = 24 mil + 4.1 = 28.1 mil At 3.7% AGR = 6 x (1.037) 5 = 7.2 mil This is total consumption not primary Secondary production was 6 mil. Primary consumption = 28.1 – 7.2 = 20.9 mil. This is about the total capacity in 1993 How about exit? There is little scrap value to the assets and therefore exit price is minimum average cost. We can obtain the long-run supply by plotting ranked AC against cumulative capacity. 2,200 2,100 S-R Supply 2,000 1,900 1,800 FR-AC = $1,596 Western Demand for Primary 1,700 Aluminum in 1993 = 16.4 L-R Supply 1,600 1,500 1,400 1,300 1,200 1,100 Price with no demand growth 1,000 = $1,220 900 800 700 600 500 400 300 200 100 Demand in 1998 = 20.9 0 0 5,000 10,000 15,000 20,000 25,000 7

Hillside Profitability at P = $1,596 Electricity & Alumina 654 1,596 x 0.41 Other raw materials 143 Consumables 32 Freight 40 AVC 869 Labor 68 Maintenance 38 G & A 32 Plant Power and Fuel 17 AFC 155 AC 1024 (1,596 – 1,024) / 3,433 Return on Investment 17% Return on Investment at P = $1,220 is 10% What actually happened? • Alusaf did build the Hillside plant and completed it on budget: full production in 1996 • Operating costs matched estimates closely • Capacity 510 ktpy (> 466 ktpy). (This lowers the annual capital charge) • Considered to be a huge success Year Price Production 1993 1,180 19,800,000 1994 1,570 19,200,000 1995 1,890 19,700,000 1996 1,570 20,800,000 1997 1,700 21,700,000 1998 1,440 22,600,000 Asian crisis 1999 1,450 23,600,000 2000 1,640 24,300,000 2001 1,520 24,300,000 2002 1,430 26,000,000 Prices recovered: $2,508 in Oct. 18, 2007 8

London Metal Exchange: Primary Aluminum Prices Oct 18, 2002 – Oct 18, 2007 Takeaways from the Case • Cost fundamentals determine the industry supply curve – We have seen precisely how to construct various supply curves for aluminum • Short-run price movements are determined by current demand and supply curves – We have seen how this works • Entry and exit decisions are determined by cost and forecasts of price trends – Enter if long-run price > FR-AC – Exit if long-run price < AC (incl. redeployment value if any) – Economics gives us a framework to forecast price trends 9