Novelis details hefty costs associated with aluminum can ceilings

US aluminum sheet maker Novelis was unable to pass through $350 million of metal price increases as a result of metal price ceilings in its aluminum can sheet contracts for the nine months ended September 30, it said in a Thursday US Securities and Exchange Commission filing. And it estimates that during the fourth quarter, it will be unable to pass through an additional $130 million.

"Based on a current aluminum price of $2,700/mt, and our best estimate of a range of shipment volumes, we estimate that we will be unable to pass through aluminum purchase costs of approximately $230-$255 million in 2007 and $380-$430 million in the aggregate thereafter," it told the SEC.

For 2007, Novelis has partially mitigated this impact by purchasing fixed forward contracts priced at $2,500/mt. "At a market price of $2,700, we would expect to generate positive cash flows of approximately $10 million from these derivatives which would increase cash flows from investing activities," said Novelis.

While Novelis said it has not entered into any fixed forward derivative contracts beyond 2007, "we are partially protected against further increases in metal prices due to our smelting operations in South America and global recycling operations. These operations act as a natural hedge against metal
price increases because both of these sources of internally generated supply have historically been less expensive than purchasing metal from third parties."

Novelis on December 12 received a comment letter from the SEC as a result of its review of its Form 10-K for the fiscal year ended December 31, 2005, and Form 10-Qs for the fiscal quarters ended March 31, June 30 and September 30. The letter requested that Novelis provide enhanced disclosures relating to the metal price ceilings in its customer supply contracts in the management discussion and analysis of financial condition and results of operation section of its periodic reports filed with the SEC.

Novelis explained that certain customer contracts contain a fixed aluminum (metal) price ceiling beyond which the cost of aluminum cannot be passed through to the customer. Novelis' can sheet contracts expire at varying times and its estimated remaining exposure to contracts with these ceilings approximates 20% of estimated shipments in 2006 and 10% of estimated shipments in 2007.

"In the recent past, we have observed a structural shift in aluminum prices, which have risen to unprecedented, sustained levels and reacted suddenly upward and downward based on market events," said Novelis. "Before this recent rise in prices, the long-term historical average price for
aluminum was approximately $1,500/mt. We do not try to predict aluminum prices, but market consensus indicates that it is unlikely that they will return to this level in the short-term."

Novelis said in the long-term, it uses the LME forward curve model "as a reasonable approximation of what aluminum prices may be in the future, however, the LME is a marketplace and there can be considerable variability in actual prices from forward prices. As we migrate away from the contracts with metal price ceilings and toward a pure conversion model, the price of aluminum should not influence our bottom-line results in the long-run, other than its effect on ultimate customer demand, although there are short-term implications of sudden increases or decreases in price as a result of our internal processing time."

Novelis said it believes the impact of the metal price ceilings "will not cause us to be in default of the financial covenants of our credit facility and our senior notes in either the short-term or long-term." However, cash flows from operations will be negatively impacted by the amount of metal
purchase price that Novelis is unable to pass through to its customers, adjusted for the timing of customer receipts and vendor payments.