New Zealand Professional Investment Services Firm, Forsyth Barr

Forsyth Barr

New Zealand Professional Investment Services Firm

We are proud to be a New Zealand owned firm, with 21 offices throughout the country and over 300 employees. We assist personal, institutional and corporate clients providing a full range of investment services.

Forsyth Barr is a foundation New Zealand Exchange firm (NZX) and accredited market participant. We have been confirmed by the Financial Markets Authority as a Qualifying Financial Entity (QFE).

Research is the cornerstone of our advice. We have one of New Zealand's leading teams of analysts. Our global affiliations ensure comprehensive research coverage of all major investment markets.

Equity Bottom-Up

<h2><a target="_blank">Electricity Sector</a></h2>
Calling RIO’s Bluff
We are calling Rio Tinto’s (RIO) bluff that closure of its NZAS aluminium smelter at Tiwai Point near Bluff is imminent without more favourable terms. Fundamentally its actions make little sense in the context of climate change and minimising carbon emissions. This paper reviews NZAS economics, looks at its position within RIO’s portfolio and within global aluminium smelters, and considers the four possible outcomes from RIO’s strategic review. We retain our view that NZAS will remain open, although whether RIO remains a 79% owner is another question.
Long-term future secure if a global price is placed on carbon
NZAS’s long-term future should be&nbsp;secure. We estimate that a global carbon price of ~US$16/tonne is enough to shift NZAS into the lower half of the aluminium cost curve. This is because coal-fired power stations emit significant quantities of carbon. The current carbon price in New Zealand is ~US$19/tonne and in Europe it’s higher still. With 61% of the world’s aluminium production coal-backed, NZAS is in a strong position long-term. If RIO were to close NZAS, it would lose the option value associated with NZAS remaining open.
A sale is far more likely than closure
We believe a sale is far more likely than closure as fundamentally we do not believe there are no buyers. In the past three years RIO has sold (or almost sold) its European smelters, so deals are being done. Arguably, RIO paying a third party NZ$200m to take NZAS off its hands is a better outcome than closure. In addition, a sale fits the facts better than closure.
High on the cost curve due to the electricity contract, but NZAS doesn’t fit the profile of recently closed assets
We estimate that NZAS is at the 93rd&nbsp;percentile on the cost curve. Whilst that is not great, we still believe NZAS is profitable based on ~75% of its production being “value-added” product and RIO’s disclosed 2019 product premium vs. the LME aluminium price being +19%. In addition, all smelters that have closed in recent years (that we could find) are significantly smaller than NZAS and most use fossil-fuel electricity. NZAS does not fit the profile of recently closed aluminium assets.
No change to underlying views — closure is highly unlikely
There is no change in our underlying view that NZAS will remain open. Whether it’s RIO owning it or someone else, we are less certain. Our current electricity generator/retailer valuations assume (conservatively) a 20% chance of closure, with the value impacts less than 5% (on a weighted basis). We do assume Meridian Energy (MEL) lowers its electricity price -$13m and Contact Energy (CEN) -$5m.
RIO’s strategic review is expected to be completed by the end of March 2020, assuming it sticks to its timetable.
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Investment View
We have a positive long-term view on the electricity sector. In our view the closure risk of NZAS is small and even if it were to close, the impacts on the electricity sector (in the long-term) should not be material. Our preferred stocks are CEN and Genesis Energy (GNE), which have OUTPERFORM ratings. We are NEUTRAL on MEL, Mercury (MCY) and Trustpower (TPW).<a target="_blank">&nbsp;</a>
</div>
Andrew Harvey-Green andrew.harvey-green@forsythbarr.co.nz +64 4 495 8185&nbsp;
Scott Anderson scott.anderson@forsythbarr.co.nz +64 4 914 2219

Electricity Sector
Calling RIO’s Bluff
We are calling Rio Tinto’s (RIO) bluff that closure of its NZAS aluminium smelter at Tiwai Point near Bluff is imminent without more favourable terms. Fundamentally its actions make little sense in the context of climate change and minimising carbon emissions. This paper reviews NZAS economics, looks at its position within RIO’s portfolio and within global aluminium smelters, and considers the four possible outcomes from RIO’s strategic review. We retain our view that NZAS will remain open, although whether RIO remains a 79% owner is another question.
Long-term future secure if a global price is placed on carbon
NZAS’s long-term future should be&nbsp;secure. We estimate that a global carbon price of ~US$16/tonne is enough to shift NZAS into the lower half of the aluminium cost curve. This is because coal-fired power stations emit significant quantities of carbon. The current carbon price in New Zealand is ~US$19/tonne and in Europe it’s higher still. With 61% of the world’s aluminium production coal-backed, NZAS is in a strong position long-term. If RIO were to close NZAS, it would lose the option value associated with NZAS remaining open.
A sale is far more likely than closure
We believe a sale is far more likely than closure as fundamentally we do not believe there are no buyers. In the past three years RIO has sold (or almost sold) its European smelters, so deals are being done. Arguably, RIO paying a third party NZ$200m to take NZAS off its hands is a better outcome than closure. In addition, a sale fits the facts better than closure.
High on the cost curve due to the electricity contract, but NZAS doesn’t fit the profile of recently closed assets
We estimate that NZAS is at the 93rd&nbsp;percentile on the cost curve. Whilst that is not great, we still believe NZAS is profitable based on ~75% of its production being “value-added” product and RIO’s disclosed 2019 product premium vs. the LME aluminium price being +19%. In addition, all smelters that have closed in recent years (that we could find) are significantly smaller than NZAS and most use fossil-fuel electricity. NZAS does not fit the profile of recently closed aluminium assets.
No change to underlying views — closure is highly unlikely
There is no change in our underlying view that NZAS will remain open. Whether it’s RIO owning it or someone else, we are less certain. Our current electricity generator/retailer valuations assume (conservatively) a 20% chance of closure, with the value impacts less than 5% (on a weighted basis). We do assume Meridian Energy (MEL) lowers its electricity price -$13m and Contact Energy (CEN) -$5m.
RIO’s strategic review is expected to be completed by the end of March 2020, assuming it sticks to its timetable.

Investment View
We have a positive long-term view on the electricity sector. In our view the closure risk of NZAS is small and even if it were to close, the impacts on the electricity sector (in the long-term) should not be material. Our preferred stocks are CEN and Genesis Energy (GNE), which have OUTPERFORM ratings. We are NEUTRAL on MEL, Mercury (MCY) and Trustpower (TPW).&nbsp;

Andrew Harvey-Green andrew.harvey-green@forsythbarr.co.nz +64 4 495 8185&nbsp;
Scott Anderson scott.anderson@forsythbarr.co.nz +64 4 914 2219

Electricity Sector: Calling RIO’s Bluff

<h2><a target="_blank">Electricity Sector</a></h2>
RIO Cries “W<a target="_blank"></a>olf”
In our view Rio Tinto’s (RIO) decision to announce a strategic review of the future of NZ Aluminium Smelters (NZAS) is a case of crying “wolf”. We believe the likelihood of closure is low (less than 10%) and that the announcement of the strategic review is primarily an effort to obtain lower transmission charges. Nevertheless, the decision has shaken the sector out of its complacency that NZAS closure risk was negligible and once again puts the threat of NZAS closure in the front of investors’ minds.
Strategic review announcement reveals NZAS frustration over transmission prices
RIO has announced a strategic review of NZAS, citing high electricity and transmission costs, difficult trading conditions and upcoming capex. In announcing the strategic review, NZAS commented repeatedly about its high transmission prices. We believe NZAS is looking to circumvent the Electricity Authority’s (EA) transmission pricing reform (TPM) process by applying pressure to politicians (and the regulator). The TPM is showing ever diminishing benefits for the smelter. In 2015, the EA’s draft TPM proposal saw NZAS benefiting more than $50m per annum. That upside is now little more than $10m. We have sympathy for NZAS’s position that it is paying for North Island grid upgrades that it gets no benefit from. There is a deal to be done given if NZAS were to close, all consumers would wear increased transmission costs.
Closure is unlikely, a sale is more likely and a deal more likely still
We believe closure is unlikely (less than 10%) for many reasons, including the fact that we estimate NZAS is cash positive at present. Given the cost of closure is above $300m, a sale appears more probable, even at a token price. However, we believe a deal is even more likely. The deal may not even be that material but our analysis suggests closing the smelter makes limited sense at present. Given the global trend favouring sustainable aluminium production, NZAS should be well positioned to be a long-term producer of aluminium.
Meridian Energy (MEL) and Contact Energy (CEN) would be the most impacted by closure
Nevertheless, by announcing a strategic review the threat of closure is once again overhanging the sector. The uncertainty the review creates means it is unlikely there will be any generation build announcements in the near-future.
If NZAS were to close, MEL and CEN will be the most affected because transmission constraints will curtail their far-south hydro generation for two to three years. Even after a transmission upgrade, there is likely to be North Island/South Island price separation favouring North Island generators. Seven years ago, when RIO last threatened closure, Genesis Energy (GNE) was expected to be greatly impacted because of its long-dated, out-of-the-money take-or-pay gas contracts. Those contracts are almost at an end, meaning GNE is no longer the most impacted.
<div class="content-highlight">
Investment View
Whilst we have not made any adjustments to our sector valuations or earnings at this stage, we estimate the potential value impact on CEN and MEL to be between -9% and -19% and between -3% and -12% for the other generator/retailers. Given share prices have fallen between -5% and -10% since the NZAS announcement, and our view that closure is unlikely, we see limited further downside risk (pending the completion of the strategic review).
</div>
Andrew Harvey-Green
<a target="_blank">andrew.harvey-green@forsythbarr.co.nz</a>
<a target="_blank">+64 4 495 8185</a>

Electricity Sector
RIO Cries “Wolf”
In our view Rio Tinto’s (RIO) decision to announce a strategic review of the future of NZ Aluminium Smelters (NZAS) is a case of crying “wolf”. We believe the likelihood of closure is low (less than 10%) and that the announcement of the strategic review is primarily an effort to obtain lower transmission charges. Nevertheless, the decision has shaken the sector out of its complacency that NZAS closure risk was negligible and once again puts the threat of NZAS closure in the front of investors’ minds.
Strategic review announcement reveals NZAS frustration over transmission prices
RIO has announced a strategic review of NZAS, citing high electricity and transmission costs, difficult trading conditions and upcoming capex. In announcing the strategic review, NZAS commented repeatedly about its high transmission prices. We believe NZAS is looking to circumvent the Electricity Authority’s (EA) transmission pricing reform (TPM) process by applying pressure to politicians (and the regulator). The TPM is showing ever diminishing benefits for the smelter. In 2015, the EA’s draft TPM proposal saw NZAS benefiting more than $50m per annum. That upside is now little more than $10m. We have sympathy for NZAS’s position that it is paying for North Island grid upgrades that it gets no benefit from. There is a deal to be done given if NZAS were to close, all consumers would wear increased transmission costs.
Closure is unlikely, a sale is more likely and a deal more likely still
We believe closure is unlikely (less than 10%) for many reasons, including the fact that we estimate NZAS is cash positive at present. Given the cost of closure is above $300m, a sale appears more probable, even at a token price. However, we believe a deal is even more likely. The deal may not even be that material but our analysis suggests closing the smelter makes limited sense at present. Given the global trend favouring sustainable aluminium production, NZAS should be well positioned to be a long-term producer of aluminium.
Meridian Energy (MEL) and Contact Energy (CEN) would be the most impacted by closure
Nevertheless, by announcing a strategic review the threat of closure is once again overhanging the sector. The uncertainty the review creates means it is unlikely there will be any generation build announcements in the near-future.
If NZAS were to close, MEL and CEN will be the most affected because transmission constraints will curtail their far-south hydro generation for two to three years. Even after a transmission upgrade, there is likely to be North Island/South Island price separation favouring North Island generators. Seven years ago, when RIO last threatened closure, Genesis Energy (GNE) was expected to be greatly impacted because of its long-dated, out-of-the-money take-or-pay gas contracts. Those contracts are almost at an end, meaning GNE is no longer the most impacted.

Investment View
Whilst we have not made any adjustments to our sector valuations or earnings at this stage, we estimate the potential value impact on CEN and MEL to be between -9% and -19% and between -3% and -12% for the other generator/retailers. Given share prices have fallen between -5% and -10% since the NZAS announcement, and our view that closure is unlikely, we see limited further downside risk (pending the completion of the strategic review).

Andrew Harvey-Green
andrew.harvey-green@forsythbarr.co.nz
+64 4 495 8185

Australia

Rio Tinto Limited is an international mining company.  The Company has interests in mining for aluminum, borax, coal, copper, gold, iron ore, lead, silver, tin, uranium, zinc, titanium dioxide feedstock, diamonds, talc and zircon. Dually-listed company with RIO LN.

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Rio Tinto Ltd (RIO AU)

Electricity Sector: Calling RIO’s Bluff

Electricity Sector Calling RIO’s Bluff We are calling Rio Tinto’s (RIO) bluff that closure of its NZAS aluminium smelter at Tiwai Point near Bluff...

Forsyth Barr

Electricity Sector: RIO Cries “Wolf”

Electricity Sector RIO Cries “Wolf” In our view Rio Tinto’s (RIO) decision to announce a strategic review of the future of NZ Aluminium Smelters...

Forsyth Barr

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