Energy security is a key concern for Alcoa (NYSE:AA) because the aluminum business is very energy-intensive. Energy and electricity account for 25% of total costs for alumina refining and 26% of the total costs for production of primary aluminum. The magnitude of its energy requirement can be gauged by the fact that in Australia, Alcoa consumes 20% of Victoria’s electricity and about 24% of Western Australia’s gas supply.
Alcoa has been making sustained efforts to secure energy supplies for its aluminum operations in Australia. It has thus far invested close to $200 million in small gas exploration companies in exchange for future supplies from their projects. A lot of these companies are involved in exploration and production of shale gas and coal seam gas for which plentiful supplies are available in the country.
Alcoa has enjoyed the benefits of cheap energy in Australia for decades due to government subsidies and has had almost 95% of its carbon tax exposure waived, even if temporarily, by the Gillard government. However, it is still struggling to operate profitably at a number of its Australian facilities due to other factors like the strong Australian dollar and low aluminum prices. The price of aluminum has fallen from an average of $3325 a tonne during the 10 years to 2008, to about $1800 a tonne now. Hence, securing cheap and plentiful energy supply is essential to long-term prospects of the company in Australia. 
Which Energy Companies Is Alcoa Dealing With Right Now?
Alcoa of Australia, which is 40% owned by Melbourne-based Alumina Ltd., is involved in all three stages of the aluminum cycle-bauxite mining, alumina refining and finally aluminum smelting. It operates three alumina refineries in Western Australia, as well as bauxite mines, aluminum smelters and other businesses in the country. It is invested in three energy companies listed on the Australian Stock Exchange(ASX), with deals in place with Empire Energy, Buru Energy and shale gas producer Transerv. None of these companies have begun production yet. Empire Energy is expected to be the first to begin production from the Gingin West and Red Gully gas fields near Perth, starting January next year. Buru Energy, to which Alcoa has paid $40 million, will deliver gas from discoveries in the Canning Basin in the Kimberley region. Transerv Energy will deliver shale gas from its reserves in the Perth Basin. 
Why Is Alcoa So Concerned About Future Supplies?
The natural gas industry has really taken off in Australia in the last decade or so. Energy companies have invested billions of dollars to develop resources and an increasing quantity is now being exported as liquefied natural gas to countries in Asia because the exported gas fetches very high prices in global markets. This has reduced the availability of gas for local industries who have been persuading state and federal governments in Australia to ensure that sufficient domestic supplies are available in order to keep energy prices down. Some companies like Alcoa have gone ahead and made their own supply deals with producers directly. However, even Alcoa has now called upon the government to reserve gas supplies for domestic use.
How Does Securing Future Supplies Benefit Alcoa?
Alcoa’s smelters at Point Henry and Portland in Victoria are in a bad shape despite large subsidies from state and federal governments. This is primarily due to a strong Australian dollar and low aluminum prices. The Point Henry facility got almost shut down earlier this year but a bailout deal from the state and federal governments secured its future until 2014. Alcoa contends that productivity improvement in operations at its plants is not sufficient for their survival. The key to the future would be the strength of the Australian dollar and aluminum prices. The least Alcoa can do at this stage is to hedge against uncertain energy supplies and volatile gas prices. 
In Australia, power used by Alcoa is generated from extensive brown coal deposits covered by a long-term mineral lease held by Alcoa of Australia Limited (AofA), and that power currently provides approximately 40% of the electricity for the company’s smelter in Point Henry. The State Electricity Commission of Victoria provides the remaining power for this smelter, and all power for the Portland smelter.
The power contracts for the two smelters will end in 2014 and 2016, upon which they will purchase power from the Australian National Energy Market (NEM) variable spot market. Although Alcoa has entered into swap contracts to manage exposure to variable energy rates, these are limited to Point Henry and Portland smelters. Gas supplies will help in hedging energy costs for refining operations in the country. 
Overall, Alcoa produces 22% of its own power requirements and buys the rest under long term Power Purchase Agreements (PPA’s).
We recently revised the Trefis price estimate for Alcoa to $10 after the third quarter earnings results.Notes: