On 23rd October, Rio Tinto announced a strategic review of New Zealand’s Aluminium Smelter (NZAS). The smelter, generally known as the Tiwai Smelter due its magnificent location on Tiwai Peninsula across the harbour from Bluff, is majority owned by the Australian mining giant as part of its Pacific Aluminium business.
Rio Tinto commented in their announcement: “The aluminium industry is currently facing significant headwinds with historically low prices due to an over-supplied market”. New smelters in Asia have combined with slowing demand to push the aluminium price down 30% from its most recent peak in early 2018. This is challenging the profitability of aluminium smelters globally, and the Tiwai smelter has higher than average operating costs.
Despite this, and previous price negotiations initiated by Rio Tinto when the aluminium price has been weak (see chart above), the New Zealand share market was caught by surprise with this latest development. This was for a number of reasons.
Firstly, the best estimates from local analysts suggest the smelter is broadly breakeven. This is a better financial position than when previous negotiations have been entered into.
Secondly, Rio Tinto entered into a contract with Meridian Energy in mid-2018 to increase its electricity consumption and restart its fourth potline. This provided some reassurance Rio Tinto was committed to the smelter’s long-term future.
Finally, and most importantly, the Tiwai smelter has a much smaller carbon footprint than Pacific Aluminium’s Australian assets given it is powered by renewable rather than coal generated electricity. Although the Australian smelters are likely lower cost currently, they are less attractive long-term assets if the price of carbon rises.
An optimist may surmise that Rio Tinto is simply posturing for a discount at an opportune moment. The Electricity Authority has proposed a new approach to electricity transmission pricing which would reduce transmission costs for the smelter. The review, which has been subject to continued delays, was under consultation until the end of October. In addition, most of the New Zealand generators have this year announced an intention to build new generation assets. This additional electricity supply will make it incrementally harder for the industry to adjust to lower demand.
The smelter currently consumes 13% of New Zealand’s electricity. Crucially, it is located close to large South Island hydro schemes and the existing transmission network cannot re-route all the electricity currently utilised by the smelter to the North Island where the bulk of demand is located. It will cost grid operator Transpower an estimated $250m, and take a number of years, to upgrade the required South Island links. This gives Rio Tinto significant leverage as wholesale electricity prices would fall substantially should the smelter shut with only twelve months’ notice.
Meridian Energy, the provider of electricity to the smelter, is prepared to continue negotiations with Rio Tinto, but is seeking increased certainty such as a longer notice period to exit or an extension to the contract length in return for lower prices. A longer notice period would be particularly beneficial to the New Zealand electricity sector. 12 months is alarmingly short and provides little time to for the market to adjust.
The share prices of Meridian Energy and Contact Energy fell over 10% in the week following the announcement. While significant, this is not material in the context of the prior 12-month performance (Meridian Energy +74%, Contact Energy +52%) which has been predominantly driven by the attractive dividend yields on offer in a falling interest rate environment.
For more recent investors in the sector, this is a timely reminder that equities have a higher risk profile than bonds or cash, and dividend yields cannot be directly compared to the returns of these lower risk assets.
There will likely be further share price volatility across the electricity sector as the negotiations between Rio Tinto and Meridian Energy progress. Investors will not have dividend certainty until the strategic review is completed in the first quarter of 2020.
For long-term investors however, this sector remains very attractive with high barriers to entry and a positive demand picture from the electrification of vehicles and dairy processing.