Transforming the economics of the marketplace
The aluminium industry’s inability to adjust supply makes it extremely difficult for economic fundamentals to be applied
The EnPot technology has the potential to transform the economics of global primary aluminium production.
In recent decades three factors have had a major influence on the economics of aluminium smelting, they are; supply and demand, the pursuit of marginal profits, and the influence of power generation prices.
The economics of supply and demand is underpinned by some basic fundamentals. When supply exceeds demand, then demand pressure falls, closely followed by price. As price falls, profit margins are squeezed to the point that the least efficient producers either cut back on their production, or leave the market altogether. This shrinks supply, and demand pressure rises, allowing prices to follow suit.
When demand exceeds supply, prices can rise and suppliers can enjoy increased margins and profits. Usually at that point the rising market has attracted new entrants and investment, which expands supply and the cycle starts again.
The current dynamics of the aluminium industry, with the inflexibility to adjust supply, makes it extremely difficult for the fundamentals of supply and demand to be applied.
Even short periods of oversupply can lead to stockpiling, which keeps prices depressed for a much longer period than the original oversupply.
With limited ability for smelters to back off from full production, one could argue that the aluminium industry is in fact being supported by its own stakeholders, somewhat counter-intuitively, to overproduce during times of low prices and keep prices depressed.
Occasionally the closing down or decommissioning of an uneconomic aluminium smelter does occur. Usually these are aging smelters whose initial capital investment has long since been returned. These closures haven’t resulted in a net reduction of capacity for very long however, as larger smelters have come on stream and steadily pushed up worldwide production over the past few decades. As each new smelter comes online it means there will be an even larger production base oversupplying the market if and when demand falls.
As power makes up around 40% of the cost to produce a kilogramme of aluminium, new smelters, not unsurprisingly, have come online closer to cheaper sources of power generation, hence there has been a geographic shift of aluminium production to China and the Middle East.
Geoff Matthews, Vice President of Energia Potior Ltd, says compounding the macro issues of supply and demand, are the microeconomics of the pursuit of marginal profits.
Marginal profit is the profit earned by a firm when one additional unit is produced and sold. It is often used to determine whether to expand or contract production, or to stop production altogether. Under mainstream economic theory, a company will maximise its overall profits when marginal revenue is equal to marginal cost, or in other words, when marginal profit is exactly zero. This is known as perfect competition.
“The desire for smelters to eke out every last tonne of production is understandable given the enormous capital investment, but adds up to a collective headache for the industry at times of oversupply,” Geoff Matthews says.
“The idea is that on an individual tonne produced basis, some of the most profitable tonnes of production would be the last additional tonnes produced, after the overheads are covered and cost of capital repaid,” he says.
“The problem is that the theory of marginal profits and perfect competition relies on the ability of producers to easily enter and exit the market. For example, agriculture with its millions of small producers is regarded as the industry closest aligned to perfect competition.
“Aluminium smelting however, with just 200 producers, high cost of entry, and no ability to easily back off supply without economic disruption to shareholders and local economies, is probably the industry furthest removed from perfect competition.
“So not only do you have the structural problem of the smelting process itself, but the industry has over the long-term been geared up for profit maximisation through maximum production.
“In times of oversupply in the market, this has led to a situation where everyone keeps producing at maximum and no one wants to blink first,” Geoff Matthews says.
New Technology Enables New Thinking
Dr. Pretesh Patel, Chief Engineer of Energia Potior Ltd, says that as with many other industries when new technology is introduced it has the potential to disrupt the market. “This often requires new economic paradigms to be developed, as well as new ways of thinking.
“The aluminium smelting industry has had an exceptionally long period of operating without the introduction of any new disruptive technologies or major changes to the market environment. The smelters who can adapt and utilise the new flexibility that EnPot offers will equip themselves best for survival long-term.
“If you look at what TRIMET are trying to achieve in Germany, they are really future-proof their business by seeking to become an integrated part of the national power grid,” he says.
Dr. Patel also says some smelters with their own power generation are already interested in EnPot as it could allow them to enter the power supply market, by freeing up power at peak times to sell to the grid.
“It may be that some smelter owners can maximise profits by actually reducing production at peak power price times, and selling the excess power into the grid, something that couldn’t even be considered before now.
“Flexibility in production may also enable smelters who are faced with a high power price differential between peak and non-peak power, to remain competitive into the future. This could possibly slow the geographic relocation of smelting that has occurred in recent decades,” he says.
Dr. Patel says smelters that have the capacity to take advantage of the EnPot technology’s ability to increase production, will also have a significant strategic advantage when demand rises again, as it is predicted to do in the future.
“Smelters who can use EnPot to increase amperage and production will not only increase financial returns in good times, but also use this flexibility as a defensive strategy. Being able to respond almost immediately to increased demand will make it less attractive to new players thinking about entering the market when the price of aluminium is high.
Dr. Patel says that while not all smelters will be able to immediately use the EnPot technology in the same way, he is certain that EnPot can be economically beneficial to 90% of the world’s smelters.
“Each smelter has its own specific set of circumstances and some will be able to utilise the new technology more readily to their financial advantage than others.
“The great thing about the EnPot technology however is that even when operating in the normal energy use window, the energy savings are significant enough for the technology to pay for itself in a relatively short period of time.