Frances Sweetman: Smeltdown in the electricity sector

Rio Tinto's Tiwai Point smelter is powered by the Manapouri hydro station. Photo / Supplied

COMMENT:

Following a long review process, Rio Tinto confirmed in July it has given notice to terminate its electricity contract on expiry at the end of August next year in preparation for the closure of the Tiwai Point Aluminium Smelter. The market's surprise was reflected in the $2.6 billion of value wiped from the electricity sector on the day of the announcement, led by the Contact Energy and Meridian Energy share prices (-14.0 per cent and -10.8 per cent respectively).

Cynics will no doubt have taken note of Rio Tinto's carefully chosen wording in the announcement, which suggests some hope the exit could still be avoided should Meridian Energy offer a more attractive electricity contract.

'Rio Tinto will start planning for the wind-down and the eventual closure of New Zealand Aluminium Smelters'.

We would suggest optimism is misplaced. Rio Tinto recognised a US$741 million ($1.1b) impairment to the value of its Australasian and Icelandic smelters in its interim 2020 result on 29 July, driven by high operating costs and a challenging outlook for the industry. Three smelters, including Tiwai Point, were written down to zero. In the face of challenging demand / supply dynamics, we believe Rio Tinto has re-assessed the size of its aluminium business.

The news this week that the fourth potline may re-open in September is also a red herring. The potline was closed in March to better enable social distancing through Covid-19 disruption. Rio Tinto should resume paying for the electricity contracted to power the potline following the agreed 6 month shut-down period. While re-opening would suggest that the economics of the smelter are currently more attractive than re-selling the electricity at the spot price, we doubt the short-term economics change the long-term fate.

Electricity prices will fall

The closure of Tiwai Point will see New Zealand electricity prices fall. The question is, by how much? Transmission constraints, limiting the ability to deliver surplus power to the North Island, mean that there will be a significant difference between North and South Island prices should the smelter close before the grid is upgraded. The current price of electricity future contracts expiring December 2021 (post the potential shutdown date) illustrate this dynamic. The price at Benmore, the South Island grid reference point, is down 34 per cent vs a 16 per cent drop at Otahuhu in the North Island.

Timing, however, could make a difference.

Transpower is investigating options to accelerate the upgrade of the Clutha to Upper Waitaki power line, the key bottleneck limiting the transmission of power generated at Manapouri to be transferred to the North Island. The project will take a minimum of two years. Once completed, most of the electricity currently utilised by Tiwai Point (approximately 13 per cent of national supply) could make its way to the North Island with the installation of storage at the top of the HDVC inter-island link. Those in the South Island looking forward to a few years of cheaper power bills could be disappointed should Rio Tinto decide to delay the shut-down.

Once the surplus power can make its way to the North Island, we are of the view that it will competitive dynamics that dictate the electricity prices. The emergence of new sources of demand, such as the electrification of coal fired dairy boilers, could be meaningful but are likely long-dated and require further upgrades to the grid.

We will be watching the following closely:

• The willingness of the New Zealand electricity generators to shut down higher cost generation and defer planned generation projects.

• The level of competition operators will engage in to secure customers, vs leaving generation capacity under-utilised or 'spilling' more water at hydro schemes.

For those interested in behavioural economics, the next few years in the sector will be a fascinating case study.

Short-term dividend pain for long-term sector gain

Investors need to be mindful that the reduction in profitability across the sector as a result of the smelter's closure will mean lower dividends from the most exposed operators for a number of years.

The decision facing the Directors of these companies is not an easy one. All will be keenly aware the sector's attractive dividends are highly valued by investors in the current low interest rate environment. However, prioritising shareholder returns above a prudent capital structure is potentially reckless and rarely rewarded.

We hope Directors take a longer-term view. With strong balance sheets, a more balanced demand profile and the ability to grow dividends once the excess demand has been digested, the sector could be an even more attractive investment proposition should this period of volatility be successfully navigated.

- Frances Sweetman is a senior analyst at Milford Asset Management.

Disclosure of interest: Milford Funds Ltd. holds shares of Meridian Energy, Rio Tinto and Contact Energy on behalf of clients.