Gordon Campbell on the smelter fiasco, and its impact on the asset sales programme

Mum and Dad investors were supposed to be plain ordinary folks that the government was rewarding with the option of buying ..er, of re-buying a stake in the energy companies they already own. Not any more. Clearly, those ordinary Mums and Dads will now need the investment savvy of Warren Buffett and the predictive power of Nostradamus if they are to make any kind of rational judgment about what’s likely to happen to electricity demand, to electricity prices and to the subsequent profitability of state energy companies over the next five, ten or twenty years. At his press conference yesterday, even Prime Minister John Key confessed that he didn’t know how the possible closure of the Tiwai Point aluminium smelter might affect the value of the state’s three other energy companies, besides Meridian. If Key doesn’t know, how are Mum and Dads – or institutional investors – supposed to make a rational decision about whether to invest their money?

Obviously, the closure of the Tiwai Point aluminium smelter would have major implications for Meridian, the energy company that supplies its electricity. Meridian could well end up being better off if it can shed this giant customer that has been getting its power at an estimated one third of the cost faced by other potential business users, and at a price estimated last year to be one fourth the price paid by ordinary householders.

Yep, that’s right – Rio Tinto with its $16 billion profits last year has hitherto been paying a fraction of the price paid by actual Mums and Dads trying to heat their homes. Think about that this winter. In 2007, Meridian signed a contract with Pacific Aluminium (the Rio Tinto subsidiary that owns the smelter) that runs all the way through until 2030.

While the deal’s details remain confidential, the contract is believed to contain a pricing formula based on a basket of factors and an agreement that the electricity prices paid by Rio Tinto would rise significantly on January 1st this year – which unfortunately happens to have coincided with something of a trough in the global price of aluminium. To compensate, Rio Tinto has been pressing for a new, cheaper electricity deal but Meridian has baulked at coming to the party – saying that it has done all it can to save the smelter, and it is now up to Pacific Aluminium to make concessions. Also, to “smooth” the short term costs – and to artificially stabilise the electricity market and calm skittish investors until it can get its asset sales programme out of the way – the government has offered Rio Tinto a short term subsidy. Since the government’s offer deliberately didn’t address the underlying, long term problem of electricity pricing, one has to suspect the subsidy offer was mainly made for political reasons, to make it appear as if the government was doing something to try and save smelter jobs in Southland. In any case, Rio Tinto treated the subsidy offer as tokenism, and turned it down flat.

What happens next? Well, Meridian’s CEO Mark Binns made it clear on RNZ this morning that he believes the ball is now firmly back in Pacific Aluminium/Rio Tinto’s court. Since the smelter eats up nearly 15% of NZ’s entire electricity generation, its closure would reverberate throughout the electricity market. The perceived value of all four energy companies would take a hit, long before the excess electricity flooded onto the grid. Inevitably, any excess would drive down electricity prices and take down with them the expected profits basic to making the asset sales programme seem attractive to some investors.

The same excess capacity would also be likely to make some existing coal and coal/gas fired operations (such as the coal fired Huntly station operated by Genesis) no longer profitable. For a number of reasons, Genesis – and not Meridian – is the more likely downstream casualty of any Tiwai Point closure. Arguably, Meridian could even thrive if it shed Tiwai Point and sold its power to the more profitable clients now in the offing. At the press conference yesterday, Key cited by way of example, a new infant formula factory at Pokeno. Yet would there be a short term impact on Meridian, as it stitched up new deals? Probably, but to what extent? No one really knows.

As Binns said on RNZ this morning, each of the state electricity companies have modelled the likely impact on their operations of the smelter closure and the flood of Meridian’s excess capacity onto the market. Presumably, some of that data will be released this Friday, when Finance Minister Bill English and SOEs Minister Tony Ryall are scheduled to provide further information relevant to the Mighty River Power share offer. Smelter shut, with what repercussions? Smelter kept open, at what actual cost (and opportunity cost) to Meridian? And with what ripple effects on the plans and market share of all the other companies? For the public, such matters remain deeply opaque, even though we’re now right on the eve of the Mighty River Power prospectus going out. As NZ Herald columnist Brian Fallow pointed out in January, it was folly for the government to proceed with the asset sales before locking down the future of the smelter.

It would be easier to make decisions on the smelter’s future if the current decline in the global price of aluminium was merely a temporary hiccup. However, all signs are that the decline will be chronic, and 40 year old smelters such as Tiwai Point are not top priorities for saving. Global aluminium prices tend to be a direct response to demand from China, the metal’s biggest global user. Yet not only is the Chinese economy remaining in a relatively weak state – as its manufacturing exports continue to be hit by the turmoil in the Eurozone – but the Chinese themselves are building high quality smelters at home at an increasing rate, in order to exploit their massive bauxite deposits. To cap things off, the future of aluminium is one where it will face increasing competition from other materials:

The materials being used to make things are changing as well….For example, carbon fibre composites are replacing steel and aluminium.

While the government is under the gun as these uncertainties endanger its asset sales programme, Rio Tinto is also caught somewhere between a rock and a hard place. With each passing day, Rio Tinto has to pay prices for its electricity that the smelter arguably cannot sustain – and this is happening while its head office continues to struggle to get its aluminium operations back in the black after Rio Tinto’s foolhardy decision to pay a hugely inflated $US38 billion to buy the Canadian aluminium giant Alcan back in 2007. Yet even if Rio Tinto gave notice tomorrow that it aimed to close the smelter, the gradual shutdown and remediation of the site over the next five years – as per the contract conditions – would still be an extremely expensive exercise.

Of all the players, Meridian seems to have the strongest hand provided it can resist government pressure to settle. That pressure seems unlikely. One can read recent developments as being entirely consistent with the government regarding the smelter closure as being a fait accompli – unless of course, Key and Minister-of -Everything Steven Joyce can scrape together a deal during their visit to China next week for a Chinese buyer to ride to the rescue. For the thousands of people in Southland who are directly or indirectly dependent on the smelter for their jobs, the outlook is bleak – and that’s despite the grounds for cautious optimism about the jobs potential of the Southland economy cited by business commentator Rod Oram on RNZ’s Nine to Noon programme yesterday.

Once again – as with the Solid Energy debacle a few weeks ago – the lack of political management in this episode has been stunning to behold. Even if all had gone swimmingly from the outset, the asset sales programme never did make economic sense. And in recent months, the additional actual costs (and opportunity costs) as time and resources at each of the state energy companies have been diverted into keeping the asset sales programme on the rails must be horrendous.

It won’t get any better. Any gains for Meridian from shedding the smelter albatross around its neck will almost certainly be offset by the uncertainty created about its future prospects and about the ripple effects on Genesis, Solid Energy and Mighty River Power. The market will be factoring those risks and uncertainties – as best it can – into the sale price of the assets, and this can only be serving to drive down their value. The real Mums and Dads, and their sons and daughters – should be feeling enraged at this wanton wreckage of their assets.