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Optimizing Profitability Regarding Aluminum Prices and Electricity Prices by GLG Energy & Industrials Councils The Expert Network, January 9, 2009

Analysis of: Alcoa to slash jobs and sell 4 units (www.reuters.com)

Implications: The aluminum industry has seen price pressure before: "The pull of aluminum prices The push off electricity prices". Optimization requires looking at both sets of prices. Electricity is a major portion of the cost of making aluminum. For any world wide price of aluminum, some local electricity prices result in certain smelters being uneconomic. Though the price of aluminum has dropped by 50%, the price for electricity is likely to drop similarly in some parts of the world. Alcoa may be well situated to take advantage of the mix of electricity prices available to it around the world, cutting production in high cost areas, while maintaining production in low cost areas. Its flexibility depends on the contracts Alcoa has, mostly for electricity, but also for labor.

Analysis: The current bust in the price of aluminum is not unprecedented. Other commodities have seen a similar slide, such as the current slide in petroleum prices. Storage, or more accurately the lack of storage, is contributing to the slide in petroleum prices. Reputedly, at least one major has chartered a mega tanker nominally as a storage platform. The finished product is easier to store for aluminum so the decline in demand may not be as critical as it is for the petroleum industry. Since electricity is a major portion of the cost of making aluminum, the profitability of Alcoa will greatly depend on the relative prices of aluminum and of the electricity used to produce the aluminum. The availability and cost of electricity are thus major issues for Alcoa and other aluminum producers. The California electricity crisis of 2000/2001 (part of the Enron debacle) provides relevant anecdotes about the criticality of electricity to Alcoa and the rest of the aluminum industry. Electricity prices soared in California in the fall of 2000. Electricity producers in the rest of the Western US and Canada sold their surpluses into California to produce high profits. The aluminum producers in Oregon and Washington had allotments of cheap power from the Bonneville Power Administration. The contracts allowed the aluminum producers to sell the power to others whenever the power was not being used to produce aluminum. The aluminum producers found selling the power to California to be more profitable than producing aluminum, sometimes even when the aluminum producers still had to pay wages to idled production workers. The California electricity crisis also raised the price of electricity in Venezuela. In May 2001, I lead an IEEE course at University San Bolivar in Caracas on electricity restructuring. Participants roughly described the Venezuela electric industry. A major nationally owned generating company sold electricity to the grid and to the nationally owned aluminum company. The contract specified that the price for electricity would be determined on a net back basis. Effectively, if the price of aluminum doubled, the charge for electricity doubled. The cutback in production by the aluminum producers in Oregon and Washington resulted in record world wide prices for aluminum in early 2001. These high world wide prices for aluminum resulted in high prices for the electricity provided by the Venezuelan nationally owned generating company. Presumably the current drop in world wide prices for aluminum is also causing much lower prices for the Venezuelan nationally owned generating company. The effect of the California energy crisis on the profitability of the Oregon and Washington aluminum producers is a well known story. It demonstrates the importance of electricity prices to aluminum profitability. The effect on Venezuela electricity prices is a less well known story. Together the two stories illustrate the contrasting nature of the contracts covering the electricity sold to aluminum producers. The BPA contracts were for fixed amounts and fixed prices. This allowed the producers to shut down operations and sell the electricity to California. The Venezuela contracts were for a fixed ration between the price of electricity and the world price for aluminum, with the price of electricity based on the price of aluminum. This will ensure continued profitability of the Venezuela aluminum industry during the current downturn in world aluminum prices, though will considerably negatively impact the Venezuelan nationally owned electricity generator. The diversity of electricity supply contracts for the aluminum industry illustrated by the above comparison of Oregon/Washington versus Venezuela is extremely simplistic compared to the fuel supply situations facing the electric industry. Many generating plants have multiple fuel contracts. As a result, utilities have invested huge sums of money into dispatch programs that minimize their cost of production by shifting production away from plants with higher fuel costs to plants to lower fuel costs. It is unclear how well the aluminum industry, and Alcoa, is prepared to make similar production shifts. However, the diversity of Alcoa's production facility probably also involves a great diversity in electricity supply contracts that will allow the cost minimization to occur during this period of reduced demand and lower world prices of aluminum. However, one story suggests that the acuity shown by the Oregon/Washington aluminum producers may not be true for the industry as a whole, or at least may not have been at one time. Aluminum production is very sensitive to continuous availability of electricity. When electricity supply is interrupted, the pot lines at the smelters can harden or freeze. When pot lines have frozen, especially unintentionally such as when there is a prolonged power interruption, the pot lines have to be cleaned out, an extremely difficult, costly, and time consuming operations. Allegedly, an electric company negligently interrupted the supply of electricity to an aluminum producer. The aluminum producer sued for consequential damages, not just for the cost of cleaning out the pot lines, but also for the lost revenue associated with not being able to sell the aluminum. Analysis of the alleged damages required an offset for the price of electricity. That analysis showed that the aluminum producer was paying more for electricity at that location than it was currently collecting for aluminum in the world market. The net of the analysis was that the interruption improved the profitability of the aluminum producer, just as the Oregon/Washington aluminum producers improved their profitability by shutting down production and selling electricity, bought under fixed priced contracts, at the prevailing market price for electricity. Alcoa presumably has the analytic tools to make the calculations to be able to dispatch its aluminum production plants in the way that electric companies dispatch their generation plants, where Alcoa seeks to minimize electricity and labor costs while the electric companies generally seek to minimize fuel costs. However, the aluminum industry has not always used those analytic tools, as is illustrated by the supply interruption story.