Rio Tinto has today announced that is it undertaking a strategic review of New Zealand’s Aluminum Smelter (NZAS) operations at Tiwai Point, to determine the operations’ ongoing competitive position and viability. We think:
The probability of closure versus 2013 has increased
Weak commodity prices, energy and transmission costs are the main issues
As in 2013, the electricity industry may bow to Rio Tinto’s pressure, but possibly not the Government this time
Higher volatility in share prices and wholesale electricity prices is likely near term
Today’s announcement by Rio Tinto provides a reminder to investors that, when investing in the electricity sector, earnings and dividends can be at risk from shocks. NZAS currently consumes around 13% of NZ’s electricity generation with the principal contract being supplied by Meridian Energy. The review outcomes could have significant implications for electricity prices and the dividends from electricity companies.
The key reasons for the strategic review that Rio has cited are low aluminum commodity prices with a weak outlook, plus the plant operating at the lower end of global comparatives. The company also has an impending capital expenditure of around $60m on one of the pot lines and finally they have called out the high energy costs. These costs are the electricity price provided by Meridian and transmission costs. Rio has, in the last few months, been to see government and all interested parties with negotiation in mind.
So, is this just posturing by NZAS to get a cheaper electricity price? In our opinion, that seems one possibility. The economics of the smelter, whilst not stellar, do appear to be cashflow positive according to Meridian and others. The smelter also produces some of the purest aluminum in the world using “green energy” so it would be a big call by Rio to close. However, compared to 2013 when the last negotiation took place, the NZ electricity industry is in better shape should there be a closure. In addition, the impending IPO of Meridian previously placed pressure on the Government to also lend financial support. Today the Government announced that they will not use taxpayers’ money to support the smelter.
Where to from here?
It is our understanding that NZAS currently pays a blended price of around $57/mwh for its electricity from Meridian and is seeking to get that cost down by circa $10-12/mwh, which equates to a direct hit to the earnings of the electricity industry of $50-80m per annum. We would expect negotiations to continue to take place and for participants to meet somewhere in the middle but, at the same time, Meridian will want to also get a win-win outcome, whether that is for a longer contract term or other terms such as demand management. Other generator /retailers will also have a vested interest in this as the counterfactual of the smelter shutting down is not a great outcome for any electricity company.
What would happen if the smelter did shut down?
There are notice periods which will give some time for the industry to make some adjustments, however in the short term it will be negative for the industry. Investment will be required to be made by Transpower, enabling transmission upgrades in the lower South Island to allow the trapped hydro generation at Manapouri and Clutha to be moved plus an upgrade to the HVDC link between the South Island and North Island and some mid North Island upgrades. It is estimated that this would take around 3 summers for the major work but up to 8 years in total and at a cost of between $400-500m. We would also likely see closures of thermal plant and deferment or cancellation of geothermal and wind development projects that are currently in the pipeline.
It is our expectation that, until the review is completed, we will see a period of increased volatility in the sector’s share prices. The companies’ share prices have moved materially today reflecting the news but, in our opinion, probably moved more than that justified by the potential downside from a collaborative package that will likely be offered for the smelter to stay.
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