Aluminum Industry in 1994

Topics: Supply and demand, Aluminium, Economics Pages: 5 (1572 words) Published: January 31, 2009
The Aluminum Industry in 19941
Aluminum Smelting in South Africa: Alusaf’s Hillside Project2

1) Is primary aluminum production an attractive industry? Why or why not?

Within the framework of the Structure-Conduct-Performance (SCP) model3, the primary aluminum production industry (“the industry”) in 1994 can be described as perfectly competitive. The industry is characterized by a large number of competing firms – the largest of which has only 4.1% of total industry capacity; homogeneous, commodity-type products and low-cost entry and exit into and out of the industry (assuming capital is available where returns are greater than cost of entry). Within the industry, market prices are established via a commodities exchange (the London Metal Exchange, or LME) and individual firms have little ability to set market prices. In a perfectly competitive industry social welfare is maximized – due largely to the lack of product differentiation and the number of competitors, while expected firm performance is normal.

In the early 1990’s the collapse of the Soviet military caused Russian and other Soviet State smelters to flood the market with capacity that had previously supplied military needs. During 1993, LME inventories of primary aluminum increased by nearly a million tons, to over 2.5 million tons, while producer inventories increased by over 300,000 tons. This surge in supply & inventory levels drove world aluminum prices to all-time lows - $1,110/ton at the end of 1993, compared to over $2,500 per ton in 1988.

In addition, the industry faces the threat of substitution (per Porter’s Five Forces Model4) – especially from secondary aluminum. Secondary aluminum’s advantages are driven largely by significantly lower energy costs vs. primary aluminum smelting. 1993 showed secondary aluminum growing at a 3.7%, 5-year CAGR rate. Meanwhile, primary aluminum production grew at a 1.4%, 5-year CAGR. The growth in secondary aluminum placed additional price pressures on primary aluminum. Steel, copper, magnesium, plastics and carbon fiber materials also increases the threat of substitution for primary aluminum.

In early 1994, the industry formally acknowledged the crisis it was facing & representatives of the major aluminum producing countries met in Brussels to discuss the situation. The result was a non-binding “Memorandum of Understanding” which recognized the existence of 1.5 – 2.0 million tons/year of excess production. As a result, a number of producers agreed to voluntary production cuts & the idling of capacity. The result was a slow, steady climb in prices in the first quarter of 1994.

While the aforementioned production cutbacks began to show some early signs of promise, at this point they are not enough to overcome the overall negative state of affairs; historically low prices and inherent unattractive qualities of the industry structure described above. As such, we arrive at the general conclusion that the primary aluminum production industry in 1994 is not attractive. That does not mean, however, that all firms participating in the primary aluminum industry are destined for economic parity. Rather, differing cost structures among the industry’s firms (especially related to power and alumina) allow for some degree of (cost) differentiation and the potential development of competitive advantages.

2a) At what rate do you expect primary aluminum demand to grow over the coming years? It is expected that demand for primary aluminum will remain relatively flat in the 5 years following 1993. Using statistical forecasting tools5 and historical data, we see that world-wide aluminum consumption is projected to grow from approximately 24.5 million tons (1993) to 28 million tons in 1998. Over the same time period secondary aluminum production is expected to grow from approximately 6 million tons to almost 7 million tons. Assuming that secondary production will be the first to fulfill demand...
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