Rusal goes head-to-head with Kiev in a battle over natural resources

A clash is looming between the Ukrainian government and Russian Aluminum (Rusal), the second-largest aluminum producer in the world, over the latter’s promise to build a new aluminum smelter at Pervomaisk, in the Kharkov region of Ukraine. If Ukrainian government officials have their way, Rusal could lose control over a vital, low-cost source of the alumina supplies required for its Russian smelters.

On June 24, Mikhail Chechetov, chairman of the Ukrainian Fund of State Property announced publicly that Ukrainian Aluminum (Ukral), a wholly owned affiliate of the Rusal group, has failed to commence construction of the smelter at Pervomaisk, violating one of the key conditions it had accepted when it won the privatization bidding for control of Nikolayev.

The transfer of the 30 percent state shareholding in Nikolayev to Ukral occurred in early 2000, after bidding rivalry for the plant between Oleg Deripaska’s Sibirsky Aluminum, a predecessor of Rusal, and the London-based Trans World group during 1999. Among the conditions of the privatization deal, Rusal agreed that, within two years, it would expand alumina output at Nikolayev to 1.3 million metric tons, halt tolling operations at the plant and start building the new 200,000 ton capacity smelter.

Tolling contracts, through which Rusal lowers the cost of the refinery operations and reduces its local tax payments, were to have been halted last year. But Ukral sources appealed for a two-year postponement to 2004.

The Nikolayev refinery, the largest alumina plant in Europe, is located near the Black Sea coast. Equipped by Pechiney during the Soviet period with modern technology, it had the capacity at acquisition by Rusal to produce 1.1 million tons of alumina per year. This represented about 23 percent of Rusal’s feedstock requirement. In 2002 the plant produced 1.1 million tons. The promised upgrade to 1.3 million tons of output was the subject of a negotiation with the Ukrainian government, which agreed last August to postpone the deadline for another two years. Rusal officials told the group of visiting analysts that a plan for expansion of output to 1.2 million tons will commence this year. They did not reveal to the analysts that they knew the Ukrainian government is pressing hard on the smelter promise. One of the analysts told The Russia Journal he did not learn about the Ukrainian move until after the Rusal roadshow was over.

According to Chechetov, because the new smelter project has not started, the government in Kiev will insist on canceling the transfer of shares and will reprivatize them. He claimed his agency is preparing an application to a local court.

A spokesman for Ukral responded by confirming that Chechetov has made this threat, but denying his charge. The source said Ukral has started construction. It has bought the land, completed the feasibility study, chosen a general contractor for the project, and made an advance payment. "The fund is not in a position to dictate to us at what pace we should proceed with construction," the Ukral official told The Russian Journal.

Asked to comment on local press reports linking the trouble to Ukrainian rivals interested in taking over Nikolayev, the Ukral official said he would not comment. The press has suggested that Rinat Akhmetov, owner of the Industrial Union of Donbass, Ukraine, which controls a pipe plant, a steelmaker and other companies, is pressing Kiev into retrieving the 30 percent stake and then offering the entire 55 percent bloc of state-owned shares in Nikolayev to a new owner. The Deripaska group, which started its quest for control of Nikolayev in 1999 with less than 40 percent of the shares, would potentially lose majority control of the plant and face ouster.

Nina Burlyuk, spokesman for the Ukrainian State Property Fund, told The Russia Journal that "indeed, the chairman of the fund has raised the issue of reprivatization of shares at a session of the control commission on privatization." But she added that "the fund has not yet made official statements nor formal appeals to declare earlier deals invalid."

Ukral sources are reported in the press to complain that construction work at Pervomaisk has been delayed because electric-energy tariffs have not yet been agreed with the government. The high cost of electricity in Ukraine was one of the reasons industry sources close to Nikolayev’s management in 2000 expressed doubt about the feasibility of the Rusal smelter promise.

Vyacheslav Smolyaninov, a Moscow metals analyst, told The Russia Journal that there is no telling for certain how serious is the threat of reprivatization of the Nikolayev shareholding.

"I do not rule out such a possibility," Smolyaninov told The Russia Journal, "but it’s hard to say whether it will be successful. As Ukral must invest about $300 million into construction of the new plant, energy tariffs are a very crucial matter. It doesn’t make sense to invest into construction of a new plant if energy tariffs will make its operations unprofitable."

Because the government in Kiev controls the energy tariff, this could be used to hold the Russians hostage to a promise that is costly to keep. But the alternative is the risk of rising alumina prices. In nearby Romania, the Rusal acquisition of an alumina refinery at Oradea has also faced serious cost pressures that have been accentuated by the decline of alumina prices off the highs of three years ago. According to a report by Renaissance Capital in Moscow, that refinery has production capacity of 230,000 tons per year, but high transport and electricity costs make it uneconomical. Rusal halted its operations in late 2001, when, the report says, it decided to only "resume [refinery operations] if the price of alumina on the international markets rises above $200 per ton." With the current alumina spot fob price at $285 and a predicted average this year of $245 – well above last year’s $151 – Rusal officials are saying they may consider reopening the Romanian unit.

At the moment, Rusal depends on Nikolayev, together with the Achinsk alumina refinery in Russia, for roughly 45 percent of its annual alumina requirement. The remainder is bought on the open market from Russian rival Siberian Ural Aluminum, Pavlodar in Kazakhstan and other sources.

Bauxite from Rusal-controlled mines in Guinea, plus alumina from Comalco of Australia, fuel the Nikolayev refinery. Rusal has projected expansion of bauxite mining in West Africa, but the Ukrainian threat to change shareholding control at Nikolayev casts a shadow over these plans.

Maxim Matveyev, Alfa Bank's metals analyst, told The Russia Journal that "strategically, this asset [Nikolayev] is very important for Rusal, and the company is likely to adopt all the necessary measures to preserve it and keep the status quo. This is not the first attempt by the Ukrainian authorities to pressure Rusal and change the situation, but I think Rusal is likely to find some way to reach an agreement with the Ukrainian government. As for construction of an aluminum plant in Ukraine, it is hard to say whether Rusal wants or doesn't want to build it, since this was one of the conditions of the initial investment agreement. At the same time, Rusal has other projects that are easier to realize and more-understandable, such as the second part of the Sayansk aluminum plant or the Alukom-Taishet project. I think Rusal will develop these projects first and attract investment for them before anything else."

Vasily Nikolayev of Troika Dialog said that he thinks that the chances of reprivatization of part of the shares of Nikolayev are "not very big. Most likely, some sort of an agreement will be reached between Rusal and the Ukrainian government, probably a political agreement."