Aluminum Smelter Price Agreements With Electricity Companies Outdated?

The BHP Billiton-Eskom deal is far from unusual.

Most aluminum smelters have a sliding price agreement with power generators that is tied into the market price for the finished metal. As metal prices fall, so does the price of the power partially shielding smelters from the consequences of low prices.

The drawback of this arrangement is that it prolongs oversupply.

If smelters paid a consistent price for their power, they would shut production as metal prices fell below a certain level, but with costs falling in line with sales prices, smelters have less incentive to close capacity.

As a result, the world is awash with aluminum – probably around 10 million tons of inventory in futures and off-market stocks – an oversupply that would have been closed off years ago, if electricity prices followed the commercial electricity market rather than the long-term formulas the smelters negotiated at the time they were set up.

To be fair, most would never have happened without such power deals. The life of a smelter is typically 30+ years and investors need assurance that the plant will be profitable in spite of volatile cost inputs (such as electrical power and alumina), which traditionally has also been tied to the price of finished aluminum.

But in a world more focused on global warming and the emissions consequences of power production, the continuation of these sometimes-lossmaking supply agreements has already caused the closure of some smelters.

It will be interesting to see if South Africa can arrive at a politically acceptable solution to their deal with BHP Billiton when the power consumed is so desperately needed at an economically viable price elsewhere in the economy.