The Fate of Secondary Aluminum Smelting

For secondary aluminum smelters who can survive the industry’s current host of challenges, the future looks bright indeed.

By Lynn R. Novelli

Lynn R. Novelli is a writer based in Russell, Ohio.

It’s clearly the best of times and worst of times to be a secondary aluminum smelter in North America.

On the one hand, smelters enjoy incredibly bright demand prospects for their products—secondary aluminum ingot, sow, and molten metal—thanks primarily to burgeoning aluminum usage in the automotive sector.

On the other hand, smelters face problems ranging from intense competition to thin margins to industry consolidation to heavy regulatory burdens.

For secondary aluminum smelters, then, the future can be summarized like so: Survive the current gauntlet of challenges, and your rewards promise to be great.

A Driven Market

In the secondary aluminum industry’s good news/bad news scenario, let’s first start with the good news.

Demand for secondary aluminum is expected to shift into high gear, driven mainly by strong automotive consumption. In the next five years, smelters anticipate annual increases in aluminum demand by the Big Three automakers that will make last year’s 8-percent jump seem puny in comparison.

In 1996, the transportation sector consumed nearly 28 percent of aluminum produced in the United States, and this year the total may exceed 30 percent, according to the Aluminum Association (Washington, D.C.). By year’s end, the U.S. and Canadian transportation industries are expected to have consumed nearly 6 billion pounds of aluminum, with secondary metal accounting for a reported 60 to 70 percent of that total.

What’s behind this swelling demand is the steadily increasing use of aluminum in new cars and trucks. To illustrate the trend, consider this: In 1991, the average passenger car contained 191 pounds of aluminum. In 1996, it had 252 pounds, reports the Aluminum Association. That’s an increase of 32 percent in five years. Similarly, light trucks, which carried an average of 166 pounds of aluminum in 1991, contained 241 pounds in 1996, reflecting 31-percent growth in the period.

And automotive aluminum usage is expected to continue climbing, with some transportation industry experts predicting that the average vehicle will contain 350 pounds of aluminum by 2000.

The auto industry’s interest in aluminum is due, in large part, to its ongoing need to lightweight vehicles to meet the federal government’s corporate average fuel economy—or CAFE—standards. The industry is also responding to the diverse desires of the car-buying public. Budget-conscious, environmental-minded, safety-savvy Americans want fuel economy, better recyclability, improved emissions control, and crashworthiness without sacrificing size or safety. And thus far, aluminum has been the answer.

Where is all the metal going? Aluminum in cars used to be limited to windshield wiper housings and alternator brackets. Now, aluminum engine components such as intake manifolds, cylinder heads, and engine blocks are common. All Saturns and Hondas, in fact, have aluminum engines, and Ford and Cadillac offer them as options on some models. Further, the Big Three automakers reportedly plan to convert more engine blocks to aluminum by 2000 and complete the conversion in all vehicles by 2005.

While such forecasts thrill secondary aluminum smelters, at least one aluminum specialist tempers his enthusiasm with caution. “We should be wary of building the entire business around transportation,” he says. “If there’s any lesson to be learned from the past, it should be that all it takes is a year or two of recession to destroy the automotive market.”

Bearing the Regulatory Burden

So much for the good news. Even as the industry looks forward to its automotive windfall, it’s grappling with serious internal and external changes and challenges.

One of the most notable external challenges is the ever-increasing environmental regulation of secondary smelters.

As air quality and other standards tighten, smelters are faced with the necessity of upgrading equipment to stay in compliance. Many in the industry believe environmental regulations will spell the end for operations that can’t afford or choose not to invest in the necessary technology.

And as Joseph Viland, president of Wabash Alloys (Wabash, Ind.), notes, “It’s not just a question of meeting standards but of being able to maintain profitability. The new particulate standards, for instance, will make it almost impossible for anyone to survive without investing in new technology. Meeting these regulations costs money, yet at the same time there’s tremendous pressure to lower our prices.”

Though smelters believe that their business is being over-regulated in the environmental arena, they see no relief in the near term. “Dealing with ever-more-oppressive environmental conditions will be one of the industry’s major challenges in the next five years,” predicts Marvin Fink, president of Allied Metal Co. (Chicago).

On top of environmental standards, secondary aluminum smelters are also experiencing trickle-down pressure from the automotive industry to achieve registration under quality assurance standards such as ISO 9000 and QS 9000. There’s no question that these programs are driving quality initiatives among smelters, asserts Mitch Kvasnick, vice president of purchasing for Spectro Alloys Corp. (Rosemount, Minn.).

Overall, he notes, consumers’ quality tolerances are tightening, and many have created their own specifications for the secondary metal they purchase. “Generic ingot isn’t good enough,” says Kvasnick. “Consumers want a product that exactly meets their specs, which puts us in the custom-production business.” This ratcheting-up of quality, he predicts, “will be one of the main challenges for the industry in the next five years.”

A Shrinking Field

One of the most notable internal challenges facing smelters is the ongoing consolidation in the industry. From an estimated field of about 120 smelters 20 years ago, the North American industry has shrunk to about 46 companies with 81 smelting operations. (For a current list of secondary smelters, see “The Smelting Scene” on page 50.) And this trend of consolidation and plant closings is expected to continue thinning the field in the next few years.

Smaller operators without the cash flow to put millions into capital improvements are a hot target for mergers and acquisitions. Larger companies are on the lookout for opportunities to strengthen their foothold in the market.
   
Yet this trend can and does affect smelters of all sizes. One of the most significant chapters in this saga, for example, occurred in late September when U.S. Reduction Co. (Munster, Ind.)—reportedly the second-largest smelter in North America—announced plans to conduct an “orderly liquidation” of its operations, including selling its Tipton, Ind., plant—and perhaps all of its six smelters—to Wabash Alloys. “It was inevitable,” Kvasnick says. “In this business, particularly today when environmental considerations are so big a piece of it, you have to keep up with technology and continue capital reinvestment in equipment. It’s too bad, but those who don’t aren’t going to make it.”

All of the mergers and acquisitions are changing the secondary aluminum industry in varied and permanent ways, notes Tom Rogers, senior vice president of sales and marketing for Imco Recycling Inc. (Irving, Texas). “Depending on who is doing the buying, acquisitions are blurring the lines between the different segments of the secondary aluminum industry, as well as the lines between the primary and secondary industries.”

As an example, he points to Imco’s recent acquisition of Alchem Aluminum Inc. (Coldwater, Mich.), a producer of specification aluminum alloys for automotive manufacturers. “Imco has always been primarily in the tolling business, but we see transportation as a big, booming market and want to participate in it,” Rogers says. “The aluminum can market remains a big part of our business, but we’re diversifying. Alchem is Imco’s entree into the specification ingot business.”

But what’s the cost of all of this consolidation? Fink asks, noting that he’s concerned about how the trend is depersonalizing the industry. “Many consolidations involve conglomerates taking over family-owned businesses, and the character of the industry itself is changing as a result,” he says. “Yes, acquisitions mean the market is in fewer hands, so the competition is different and the balance of power will be altered. But what concerns me even more is the loss of identity that occurs. With these big conglomerates in the picture, there’s a different feel to the industry.”

Stepping Up the Competition

Ironically, even as the secondary aluminum industry is consolidating, new smelting operations are popping up, potentially exacerbating the already-intense competition.

This isn’t a new trend. Given its traditionally low cost of entry, the aluminum smelting business has always been dynamic, with new players coming and going based on the industry’s fortunes or misfortunes. Currently, with the market apparently on the verge of a major boom, the business is attracting new startup operations. “Some of them are legitimate, but others are guys who get in as cheap as possible, thinking they are going to make a killing without investing anything up front,” says an industry analyst. “They undercut the rest of the business to attract customers, who then beat their regular secondary suppliers over the head with price.”

The landscape is littered with low-budget smelting wannabes who failed, but that doesn’t stop others from trying it. The results are usually disastrous for everyone, says Rogers. “When these players come in, they upset the whole market,” he says. “They bring the price down and pull down the entire pricing structure industrywide.”

Misguided upstarts aren’t the only ones upping the ante in the smelting industry, however. Several large, established companies such as Imco, OmniSource Corp. (Fort Wayne, Ind.), and Metal Exchange Corp. (St. Louis), for instance, have announced plans to build new smelters, choosing to ignore charges that the industry already has excess capacity.

Major smelters are also investing offshore to capitalize on European, Asian, Mexican, and South American automotive manufacturing operations. New American-owned smelters, for example, are under construction in Wales and Mexico.

Competitive threats also loom on the outskirts of the smelting circle, with one being the possibility of die casters integrating backward into the smelting niche. Although it hasn’t happened successfully on a large scale yet, some casters have dabbled in it. If this trend ever takes off, it could have significant effects for smelters in the areas of scrap supplies and pricing.

But die casters should be wary, Viland says, asserting that their foray into the smelting business could be disastrous for all parties. “Casters may think they can save money by melting their own scrap, but they don’t realize the difficulties of making good alloy,” he says. “They don’t know the business, they don’t have the capability to clean dirty scrap, and their overall costs will be greater.”

Secondary smelters also face the possibility of greater competition from primary aluminum producers and their first-tier suppliers. “They’ve expressed an interest in increasing their use of scrap,” Kvasnick says. “If that happens, it’ll put the squeeze on higher-quality scrap for smelters, and we’ll be forced to use lower grades than we’d prefer.”

While current scrap supplies are sufficient, the day could come when smelters have to face-off against primaries and their first-tier suppliers for raw material and “compete pricewise with them in the market,” says Kvasnick.

Survival Skills

All of this real and potential competition promises to perpetuate a problem that has plagued the industry for years—its inability to make a decent profit even during periods of booming demand. “Business is good, demand is strong, supply is adequate, but making money is tough,” says Fink, adding poetically, “we’re at a banquet, but we’re still going hungry.”

In short, smelters get caught in a squeeze of having to pay high prices for scrap due to competition for the material and yet are unable to raise their selling prices, also due to competition as well as efforts by consumers to keep prices in check.

Given this stark price scenario, survival in the future, Viland says, “will depend on a company’s ability to manage collection, processing, and marketing to meet the challenges of a more competitive environment and the tremendous pressure to sell our product for less.”

Imco, for one, is integrating backward by forging alliances with large consumers of metal who need tolling services. The company is in the forefront of what some predict will be a growing trend. More and more, smelters will form alliances with scrap suppliers in much the same way as the automotive industry is moving toward single-source suppliers. “However you want to look at it, the name of the game is control of metal units,” Rogers says. “To be successful, a company needs to control the supply of metal units and be able to convert efficiently.”

Kvasnick agrees that efficiency will be the name of the game. Though bigger can sometimes be better, it’s not necessarily a requirement for success “if a company is willing and able to keep up by bringing new, more-efficient equipment online,” he maintains, adding, “it’s through new technologies that the industry has greater capacity today than when there were three times as many firms in the business.”

But efficiency and technology are expensive, Kvasnick notes. Spectro’s new aluminum shredder, for example, cost $1.5 million. While such a price tag is daunting, smelters who don’t, won’t, or can’t make such investments are writing their own obituary in today’s competitive, environmentally conscious market, he maintains.

Secondary Contract Critics

And then there’s the issue of the London Metal Exchange’s (LME) secondary aluminum alloy contract, which was introduced in 1992 as a hedging and trading vehicle for the secondary aluminum market. To date, the contract has won few fans among smelters and remains thinly traded compared with other LME metal contracts.

Smelters criticize the contract for imposing an element of artificiality on the secondary industry. Since it’s based on the world market, the LME’s contract has more to do with financial negotiations than actual supply and demand, some smelters assert. When a smelter enters into a contract, they explain, his or her price for raw material is no longer based on domestic market conditions but on fluctuations in the world commodity markets. The contract is too out of touch with their real business, these smelters say, also noting that it takes control out of their hands and puts it in the hands of bankers and brokers.

In their view, the contract also adds volatility to raw material prices. “By making scrap a commodity that gets traded on the world market, the contract plays havoc with their business,” says an industry analyst. “Prices can fluctuate 2 to 3 cents a day, making it difficult to know what you’re buying or selling and for how much.”

The lackluster participation in the LME contract thus far further lessens its appeal to smelters. With fewer traders involved, the contract reportedly over-responds to relatively small amounts of money. Potential traders watching these swings are scared off, when what the contract needs is more participation to stabilize it, according to some smelters.

In response, the LME says the smelters’ comments, while understandable and similar to those expressed by producers when the LME primary aluminum contract was introduced, are based on a lack of understanding of the market. The fact is that prices for secondary aluminum alloy were always volatile, but simply not transparent, the exchange says, adding that previous published prices weren’t reliable.

The LME price is a clear presentation of the market value at any given time based on the fundamentals of supply and demand, the LME maintains. There will be volatiliy, as with any commodity in a free-market economy, but that’s the raison d’être of futures markets. They enable buyers and sellers to use hedging contracts to lock in fixed prices against future activity and so avoid the risk of losses due to fluctuating prices, the exchange notes.

While the LME concedes that its secondary aluminum alloy contract is small in world terms, it points out that the contract has been growing steadily and will continue to grow, boosted by the expected gains in secondary aluminum production and consumption in the next few years.

The more smelters understand the benefits of the LME contract, the more they will use it, which will increase liquidity and so lessen the volatility, the LME says.