The extraordinary implosion in the value of Rio Tinto’s aluminium business that claimed its chief executive, Tom Albanese, last night raises an obvious question. How could one of the world’s oldest, largest and most sophisticated of resource houses have got it so wrong?
The latest writedowns of $US10 billion to $US11 billion within its aluminium division, most of it relating to its Alcan business, bring the total writedowns since Rio paid $US38 billion for Alcan in mid-2007 to $US29 billion. In the space of 5½ years that business has lost 75 per cent of its value.
While there are some complicating strands to the explanation the simple answer to that basic question is that Rio paid too much for an acquisition that at the time represented 40 per cent of its market capitalisation.
Before Rio and Alcan announced the agreed acquisition Alcan had been targeted by its arch rival Alcoa via a hostile $US28 billion offer. Rio didn’t just over-bid; it outbid Alcoa by an extraordinary $US10 billion. Its offer was 33 per cent higher than Alcoa – with far greater synergies in prospect – was prepared to pay and a remarkable 65 per cent premium to the all-time high for Alcan shares before Alcoa launched its offer.
At the time there was speculation that BHP Billiton and Brazil’s Vale were also talking to Alcan but there has always been a suspicion that Rio paid the premium it did, and funded the acquisition with debt, because it was acutely aware that it was being stalked by BHP, which had just appointed Marius Kloppers chief executive with a mandate to go after Rio.
On that basis Alcan was designed by the then quite dominating Rio chairman, Paul Skinner, as something of a poison pill.
While Kloppers did try to mount a bid for Rio the combination of the financial crisis, Rio’s debt and regulatory opposition killed that offer off – and nearly killed the debt-laden Rio in the process.
The imminence of the crisis, of course, exacerbated the consequences of Rio overpaying, with much of the developed world pushed into a recession from which it is still struggling to emerge. Aluminium prices plummeted from about $US2800 a tonne at the time of the Alcan deal to around $US2000 a tonne.
It would also seem reasonable to conclude that some of the key assumptions Rio made about the outlook for the aluminium industry have been proven wrong and would have been proven wrong even without the financial crisis.
At the time of the acquisition demand for aluminium had been growing strongly – global annual growth in demand had averaged almost 8 per cent a year in the previous four years, underpinned by a more than doubling in China’s demand over the prior decade.
Rio saw a long-term continuation of those trends – and a rising price – as the intensity of consumption of aluminium in China continued to increase and it also saw Alcan’s mainly hydro-powered smelters as providing an increasing competitive advantage in a pre-Copenhagen carbon-conscious world.
The other premise on which the strategy was built was that China’s producers would progressively be pushed out by their position on the cost curve. China dominated the highest quartile of industry costs.
Most of the assumptions which underpinned the takeover have proven wrong. The financial crisis depressed the price of aluminium and while global warming remains an intensely topical issue it isn’t one the Chinese have paid much heed to. The collapse of the carbon price in Europe also undermines Alcan’s hydro advantage.
In fact, Chinese and Middle Eastern production of aluminium has continued to increase and, with far lower coal prices, increasing hydro-based generation and more modern smelters located closer to domestic bauxite deposits, the view that Alcan’s more efficient and more energy-efficient production would displace high-cost and carbon-intensive Chinese production turned out to be profoundly wrong.
The other problem Rio has faced is that there has been a change occurring in the structure of the industry that works against integrated producers and particularly against Alcan because it has a balanced position in alumina and aluminium metal.
The Chinese and Middle Eastern producers tend not to be as integrated and tend to be short alumina. Where the alumina price used to be directly linked to aluminium prices it has diverged, which is good news for alumina and bauxite producers or integrated producers with long positions in alumina but not good news for an Alcan because its overall margin gets squeezed.
Alcoa, with a strong position in alumina, would, with hindsight, have been a better buy (or not as bad a buy) and indeed within Rio was always seen as a more attractive target.
It was, however, Alcan that was in play at that moment when the UK-oriented Rio could feel the hot breath of the colonials at BHP and therefore it was Alcan that Rio chose as its vehicle for aluminium industry leadership and its continued independence.
That decision ultimately cost Skinner and Albanese their jobs (the $US3 billion writedown of the $US4 billion Riversdale coal acquisition played a role in Albanese’s departure) and Rio, of course, $US29 billion.
The aluminium atrocity that ravaged Rio Tinto
Likely unsettled by concern about a BHP Billiton takeover, Rio Tinto got its aluminium assumptions woefully wrong. It turned into a nearly six-year nightmare of historic scale.
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