Managerial Economics Ko University Graduate School of Business - - PDF document

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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)

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• 1971-74: price controls.
• 1973-75: OPEC oil embargo and increase in oil prices
• 1986-88: Supply shortages
• 1991: Soviet Union Collapse

Annual Average Primary Aluminum Price (Dollars per metric ton) 500 1000 1500 2000 2500 3000 1970 1975 1980 1985 1990 1995

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?

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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.

Average 1993 Operating Cost Structure ($/metric ton except where noted)

1206 Total 77 General and administrative 44 Freight 146 Labor 51 Maintenance 70 Consumables 10 Plant power and fuel 125 Other raw materials 366 Total alumina cost: 189 Alumina price ($/t Alumina) 1.94 Alumina usage (t/t Al) 317 Total electricity cost: 0.02 Electricity price ($/kWh) 15767 Electricity usage (kWh/t)

It is costly to stop and start smelters Production can be varied quickly by shutting down pots Operating a reduced number of pots requires operation of all stages of the production process Scaling back production results in no savings in labor or other non-materials costs

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

AFC Plant Power and Fuel G & A Maintenance Labor Fixed Costs 922 44 70 125 366 317 Freight 10 Consumables 284 AVC 77 Other raw materials 51 Alumina 146 Electricity Variable Costs

TC = TVC + TFC If variable costs vary with output proportionally, then AVC is fixed and TVC = AVCxQ MC = AVC = $922/ton

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Cost Structure of a Smelter

TFC = 730,000 TVC = 922Q TC = 922Q + 730,000 tons per week dollars

Average capacity 133,000 ton/year 2,500 ton/week At capacity weekly costs TVC = 2,500 x 922 = $2.35 mil TFC = 2,500 x 284 = $730K AFC = $730,000/Q AC = 922 + AFC

2,500 2,500

tons per week dollars/ton

922

MC

1,206

AC

Short-run supply decision: if P < AVC (MC) do not produce if P ≥ AVC (MC) produce at capacity At price 1,000 the smelter produces at full capacity but makes losses

1,000

At price 1,400 the smelter produces at full capacity and makes positive profits

1,400

At price 800 the smelter shuts down for the week

800

Industry Supply Curve

Suppose there are only 3 smelters: Sorocaba A, Essen, Seydisehir

1,740 1,125 580 AVC 60 135 122 Capacity Seydisehir Essen Sorocaba A Smelter

Below price 580 nobody produces At prices between 580 and 1,125 only Sorocaba A produces At prices between 1,125 and 1,740 Essen starts producing as well Prices at and above 1,740 all three smelters produce

122 580 1,125 257 1,740 317

This suggests a way to construct the market supply: 1. Sort the smelters according to AVC 2. Calculate cumulative capacity 3. Plot AVC against cumulative capacity

thousand tons per year price ($/ton)

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100 200 300 400 500 600 700 800 900 1,000 1,100 1,200 1,300 1,400 1,500 1,600 1,700 1,800 1,900 2,000 2,100 2,200 5,000 10,000 15,000 20,000 25,000

Aluminum Industry Supply Curve in 1993

dollars/ton tons/year

1993 market price = 1,180 1993 production = 19,800

D S

100 200 300 400 500 600 700 800 900 1,000 1,100 1,200 1,300 1,400 1,500 1,600 1,700 1,800 1,900 2,000 2,100 2,200 5,000 10,000 15,000 20,000 25,000

Aluminum Industry Supply Curve w/o CIS

dollars/ton tons/year

D

w/o CIS

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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?

1206 77 44 146 51 70 10 125 683 Average 1993 Operating Cost Structure ($/metric ton except where noted) Hillside 825 Total 32 General and administrative 40 Freight 68 Labor 38 Maintenance 32 Consumables 17 Plant power and fuel 143 Other raw materials 455 Total electricity and alumina cost Hillside Cost Structure AFC Plant Power and Fuel G & A Maintenance Labor Fixed Costs 670 40 32 143 455 17 Freight 155 AVC 32 Consumables 38 Other raw materials 68 Electricity & Alumina Variable Costs

Entry Decision

1,110 x 0.41

What is the min price at which Alusaf should enter? We have to calculate FR-AC FR-AC = 0.41P + 143 + 32 + 40 + 155 + 343 P = 0.41P + 713 What is average annual capital charge (AACC)? $1,6 bil/466 kton = $3,433/ton At 10% cost of capital AACC = $343 FR-AC = 713/0.59 = $1208 What is the price going to be in a few years? Need to calculate L-R price = entry price for a typical smelter

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Entry Price

Capacity of a new smelter = 225,000 tpy (Case p.5) Cost = $1.1 billion (Case p.5) About $4,900/ton AACC = $390/ton 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% 20.4 x (1.033)5 = 24 mil + 4.1 = 28.1 mil This is total consumption not primary Secondary production was 6 mil. At 3.7% AGR = 6 x (1.037)5 = 7.2 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. Rest of the world = 4.1 mil

100 200 300 400 500 600 700 800 900 1,000 1,100 1,200 1,300 1,400 1,500 1,600 1,700 1,800 1,900 2,000 2,100 2,200 5,000 10,000 15,000 20,000 25,000

FR-AC = $1,596 Western Demand for Primary Aluminum in 1993 = 16.4 L-R Supply Demand in 1998 = 20.9 S-R Supply Price with no demand growth = $1,220

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Hillside Profitability at P = $1,596

17% Return on Investment 1024 AC 155 AFC 17 Plant Power and Fuel 32 G & A 38 Maintenance 68 Labor 869 AVC 40 Freight 32 Consumables 143 Other raw materials 654 Electricity & Alumina 1,596 x 0.41 (1,596 – 1,024) / 3,433 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

26,000,000 24,300,000 24,300,000 23,600,000 22,600,000 21,700,000 20,800,000 19,700,000 19,200,000 19,800,000 Production 1,180 1993 1,890 1995 1,570 1994 Price Year 1,430 2002 1,520 2001 1,640 2000 1,450 1999 1,440 1998 1,700 1997 1,570 1996 Asian crisis Prices recovered: $2,508 in Oct. 18, 2007

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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