Many world aluminium contracts similar to Eskom's – BHP Billiton

JOHANNESBURG (miningweekly.com) – The aluminium smelter contracts struck with South Africa's Eskom were similar to many contracts elsewhere in the world and should be valued on the entire duration of the agreement rather than on a single year, BHP Billiton said on Friday. In reporting an unprecedented R9,7-billion loss for the 2009 year, South Africa's State-owned Eskom said that it intended to sit down with its commodity-linked-discounted customers in an attempt to negotiate a possible restructuring of the commodity-price-linked agreements. BHP Billiton, which has large aluminium smelters in Southern Africa and which is headed by South African CEO Marius Kloppers, has a long-term agreement with Eskom, which results in the company paying less for power during periods of low aluminium price, as is currently the case. BHP Billiton South Africa investor relations and media head Bronwyn Wilkinson told Mining Weekly Online in a statement that the company's supply contracts with Eskom were multidecade and that the price BHP Billiton paid for power to the smelters was internationally competitive. "The terms of the contracts are similar to many contracts of this nature in other parts of the world across various energy intensive industries and are structured to benefit both parties over the life of the contracts by offering power companies the certainty of demand and thus underpinning their investment in power stations while offering industrial customers a guarantee of long-term and secure supply," Wilkinson said, In valuing such contracts, Wilkinson said that it was important to consider the entire length of such agreements. "Looking at one year in isolation can be misleading. For example, in times of high aluminium prices - as occurred during 2007/8 - BHP Billiton pays significantly higher than standard tariffs to Eskom but in times of low aluminium prices, the price of power is lower than the standard tariff," she said. Eskom calculated an accounting loss of R9,5-billion as a result of not being able to charge its commodity-linked customers at the standard tariff during its 2009 financial year to end June. Eskom chairperson Bobby Godsell told Mining Weekly Online on Thursday that Eskom would be engaging its commodity-linked customers, with a view to achieving more equitable pricing. “Eskom values all of its customers, including customers with commodity-linked contracts. Also, as South African citizens, we would rather that they were here doing business than not. It is so that these contracts were concluded a long time ago, under very different circumstances. "Let me make an analogy, the South African coal-mining industry sold Eskom a lot of coal last year at very high prices. You could say, why would the coal-mining industry, in any way, contemplate a different basis of doing business with Eskom, than what they did last year, which was their best year, on a unit sales basis, probably ever. “But they have done so because they are in the business for the long term, because actually the export coal industry is a product of Eskom. Without Eskom’s long-term contracts, there never would have been collieries that could also export metallurgical and steam coal into international markets. “So, often customers have long-term interests as well as short-term interests. We will simply sit down with the commodity-linked customers and explain why these contracts are problematic; they are problematic not only in price. They impose an accounting uncertainty on Eskom that makes proper strategic management of its resources very difficult. “So, we will be looking at the form and the content of the commodity-linked contracts and I would hope that we could come to a good long-term basis of doing business with our commodity-linked customers. “Their businesses will always fluctuate with market circumstances, and the smelters came on stream, not because Eskom asked them to, but because they couldn’t sell their product in international markets. “In this conversation, we will sit down in the same way that Eskom’s Brian Dames and his colleagues have sat down with the coal-mining industry, and why shouldn’t we hope for the same kind of outcome?” Godsell asked. "The embedded derivatives arise because the revenue from the commodity-linked contracts is linked to commodity prices and dollar currency rates, which cause short-term fluctuations in the paper 'value' of the contracts," Wilkinson said. Eskom CEO Jacob Maroga told Mining Weekly Online: "Correcting embedded derivatives is a big issue. Going forward, we want to limit or remove this exposure. "Both the accounting treatment and just the exposure to commodity prices in terms of revenue and the differential between the commodity-linked electricity price and the standard electricity price is becoming an issue," he said. It can be pointed out that a loss that is attributable to embedded derivatives is not a cash loss, but an accounting one, arising from the implementation of strict accounting standards. But it also reflects the opportunity loss of not benefiting from the revenue stream that could have resulted from commodity-linked customers being at the standard tariff. BHP Billiton's power price, in the contracts with Eskom for its aluminium smelters, is linked to commodity prices and dollar currency rates, which give rise to embedded derivatives. The effect is that, in times of high aluminium prices and/or a weak rand, the embedded derivative benefit is carried through to Eskom's balance sheet as an asset. In their past two financial years, Eskom showed embedded derivative assets of R5-billion. Conversely, in times of low aluminium prices and/or strong rand, the embedded derivative is carried through as a liability. This reversal of assets into a liability is not a cash loss and results from the implementation of strict accounting standards. BHP Billiton has invested $6-billion through the building and operation of its South African smelters. The decision to make that investment was based on the availability of long-term power contracts and without these contracts, investment may not have taken place. These contracts were agreed when South Africa had an abundance of power and encouraged industries to set up in the country in order to make use of this stranded power, create employment and help develop the South African economy. Godsell said that the scale of Eskom's financial losses incurred were "clearly unsustainable" and that he hoped for an equitable outcome in his talks with the commodity-linked customers similar to the outcome Eskom achieved in its talks with the coal-mining industry to moderate its coal prices. BHP Billiton is also a major supplier of coal to Eskom and is bringing on stream its new Klipspruit project and will commission the new Douglas Middelburg optimisation project next year. Eskom spent more than R25-million on coal last year, R7-billion more than in the previous year, to overcome an extraordinary stockpile shortage, through the purchase of coal on short-term contract.