Prices and production cost in aluminium smelting in the short and the long run

Abstract

The main objective of this study is to reflect the institutional changes that have characterized the aluminium industry as a result of the introduction of London's Metal Exchange (LME) trading. In doing this, it is shown that product prices are taken exogenously and linked to input prices via risk sharing agreements. This forces producers, in a competitive environment, to minimize costs. The latter is completed with a description of their investment decision–making mechanism, in which investment is determined by cost, and a measure of Tobin's q.

 As it is noted by Figuerola-Ferretti (2002), the crude oil industry has been subject to similar structural changes. It was highly concentrated up to the 1980s when the OPEC discipline broke down resulting in the introduction of crude oil futures on the New York Mercantile Exchange (NYMEX) in 1983 and the International Petroleum Exchange (IPE) in 1988.

The main contributions of this study are: the use of a proprietary and complete industry data set that allows one (a) to set up the short run input and output price relationships; (b) to model the optimizing behaviour of the sector via a flexible cost function (translog) allowing scale economies and non–constant factor substitution; and (c) to describe the investment–process that has emerged with the introduction of LME trading.

Acknowledgements

I would like to thank Christopher L. Gilbert and Yannis Paraskevopoulos for their valuable comments. I am also thankful to my colleagues from Carlos III Andrea Fosfuri and Josep A. Tribó for their helpful suggestions. Finally I would like to thank Wayne Wagner for his useful references. I would also like to thank Anthony Birds Associates for providing me with the data set. Of course all errors are my own.

Notes

 As it is noted by Figuerola-Ferretti (2002), the crude oil industry has been subject to similar structural changes. It was highly concentrated up to the 1980s when the OPEC discipline broke down resulting in the introduction of crude oil futures on the New York Mercantile Exchange (NYMEX) in 1983 and the International Petroleum Exchange (IPE) in 1988.

 For figures and discussion in concentration and market power, see Figuerola-Ferretti (2002), pp. 11–15.

 Up to the late 1990s the price of alumina and power was linked to the aluminium price in about half of the contracts. With the increase of Chineese aluminium production over the last three years the amount of contracts priced under this arrangement has been reduced to a third of the world supply.

 Dickey Fuller tests results were inconclusive. Results can be provided by the author upon request.

 For a detailed discussion on these results see Figuerola-Ferretti (2002).

 Note that we justify the modelling of alumina, power and aluminium price relationships by showing that the three sets of prices are cointegrated. Johansen-test cointegration results are in Figuerola-Ferretti (2002). They can also be provided by the author upon request.

 For a theoretical discussion see Paraskevopoulos (2000).

 The Weighted Average Variable Cost also includes a small residual cost, which is not modelled. Instead it was chosen to model the sum of alumina and power costs. Fitted Weighted Average Variable Cost, is referred to as C _f .

 For a discussion on the parameter estimates see Figuerola Ferretti (2002).

 Figure 1 shows that fitted weighted average variable cost values (

) are positive at all points and highly correlated with the true values. Figures 2 and 3 show that fitted alumina and power input share values (

and

respectively) are also positive at all points over the sample period and highly correlated with the true values suggesting that the translog cost function is monotonic.

 As can be seen in Figs 4 and 9, own price and substitution elasticities are negative at all points, and cross-substitution and price elasticities are positive at all points, demonstrating that the concavity property is not violated.

 This is verified by the eigenvalues of the mean Allen price elasticity matrixes that are both negative (−1.5402, −0.7427) indicating that the matrix is negative semidefinite.

 See Paraskevopoulos (2000) pp. 45–6 for discussion on restrictions for testing different models.

 It is assumed that investors make their decisions on the basis of current share prices which in turn are based on rational expectations of future corporate cashflows.

 This figure was reported by an aluminium industry consultant who estimated that the depreciation rate for aluminum smelters is linear on a 20-year basis.

 Six dominant players Alcoa (USA) Alcan (Canada), Pechiney (France), Reynolds (USA), Kaiser (USA) and Alusuisse (Switzerland) have traditionally dominated the industry. These produced 60% of the world total in 1975, 50% in 1984 and 42.4% in 1990. Share price data were unavailable for Aussuise, Kiser and Pechiney. This is why their share prices are not used to calculate the industry average. See Figuerola-Ferretti (2002) for a more detailed explanation.

¹⁵ This is a variable measuring profit determined by the ratio of aluminium price to fitted cost. Profits are expected to be significant in explaining investment, and be able to derive a long run relationship from cost to prices.

¹⁸ Note that for the LM test in both equations use a lag length of 2 and results are robust to an increase of the lag length.

 The lag length used for the LM residual correlation test is 2. Results are robust to the extension of the lag length.

 Note that this result is not robust to the extension off lags as LM(5) F=2.0579 (0.1739).