Russian Raw Materials: Converting Threat into Opportunity

by Kevin McDonald, May-June 1993

Import barriers won’t stop the flood of cheap Russian minerals into Western markets. Russian consumption will.

Most Western businesspeople take for granted that the companies now being formed in the old Soviet Union won’t be competing in the West for another 15 or 20 years. Russia and its newly independent neighbors will need at least that much time to build a market economy, generate entrepreneurial spirit, and train a generation of young managers. But in the raw-materials sector, a competitive threat exists today partly because the economies of the newly independent states (NIS) are in such disarray.

As a result of huge structural changes, such as the radical shrinkage of the Soviet defense industry, vast quantities of nickel, zinc, aluminum, magnesium, potash, diamonds, and other critical materials are now being sold in the West at fire-sale prices. In fact, the challenge to Western raw-materials suppliers is so formidable that they find themselves lowering production, laying off workers, and cutting back investment; and when companies like Alcoa, Dow Chemical, and Inco start canceling plans and reducing budgets, shock waves begin to travel through the businesses they buy from and supply.

How the large metals companies respond to this competition will have a deep and perhaps lasting effect on Western and NIS economies. So far, most of them have reacted defensively, curtailing production and lobbying Western governments for protection. But there may be a better way. One Western business, Reynolds Metals Company, has found a means of stemming the competitive flood with a form of intervention that should assist the NIS economies, give RMC a firm foothold in NIS markets, and perform an invaluable service for some of RMC’s oldest customers – all with someone else’s money.

Cause and Effect

The shriveling of the Soviet defense industry and the ruble’s instability are the two most prominent factors contributing to the deluge of NIS raw materials into Western markets, but other forces have played a part as well.

Consider aluminum. The NIS produces about 20% of the world’s aluminum supply, almost all of it in Russia. Until recently, Russian industry absorbed most of this output, but the sudden decline in military spending beginning in 1991 reduced demand by some 40%. In addition, inflation and price controls forced domestic prices to fall considerably below export prices, and government subsidies became unpredictable. So when intermediaries arrived to provide financing and contacts with Western markets, Russian aluminum producers leaped at the opportunity to sell their surplus.

Russian exports surged. Shipments from Russia to the United States increased by a factor of 370, from 806 metric tons in 1991 to approximately 300,000 in 1993, worth half a billion dollars. The Russian share of Western markets rose from just over 1% in 1989 to more than 11% in 1993.

Nickel has undergone similar export growth. Russia produces almost half the world’s nickel supply and traditionally sold most of it domestically. In 1991, however, the primary market for Russian nickel abruptly dried up.

The growth in exports was led by the Norilsk Nickel Combine (NNC), a newly privatized Russian company and the largest nickel producer in the world, accounting for nearly 30% of global output. It has so many employees – 150,000 – and its social services are so extensive that the enterprise, located near the Arctic Circle, is almost a small kingdom unto itself. In the 1980s, most of NNC’s output was used by the Soviet military, primarily to make stainless steel and the superalloys used in jet engines. But in 1991, defense cuts took their toll: approximately half the company’s capacity was surplus and, as a result, became available for other markets.

The ruble’s fall compounded the problem. From a position of near parity with the dollar in 1988, the ruble virtually collapsed in 1991. That devaluation, together with domestic price controls, drove a wedge between prices for nickel in Russia and in other countries. In January 1991, when the world price was $3.65 per pound, the price in Russia was just 5 cents per pound – less than 1.5% of the world price level. The Russian government moved quickly to reduce the gap to about 50%, but the disparity still gave NNC a huge incentive to export.

Unfortunately for the West, NNC responded rationally. In 1991, production problems reduced Russian output by approximately 10%, but Russian exports increased by 75% to 145,000 tons (counting unauthorized shipments as well as licensed sales) – which is 15% of world production. Global demand for nickel has been relatively soft for several years now, but NNC has continued to export at least 100,000 tons a year. As a result, reserves held on the London Metals Exchange have grown by 250% while prices have fallen by 35%. Some Western producers are barely hanging on.

As for zinc, Western supply and demand had been in balance at a sustainable price to producers for some years before the NIS entered the market. Zinc’s primary use is in galvanizing steel to prevent rust, but it also goes into brass and is used in die-cast parts, such as gears and carburetors. Global consumption was in the vicinity of 7 million tons per year; reserves on the London Metals Exchange were well below 100,000 tons; and prices held steady in the neighborhood of 60 cents per pound. The NIS was a net importer of zinc; it exported none at all to the West.

Then, as industrial distribution chains in the NIS broke down and NIS economies began to unravel, zinc consumption plummeted. The NIS responded by cutting production 10%, but in 1992 it also shipped approximately 280,000 tons to the West – about 30% of its capacity and 4% of world demand. That trend continued in 1993, and by year-end, inventories on the London Exchange had risen more than ten times to one million tons, and prices had fallen to less than 40 cents per pound.

Magnesium, used principally to increase the hardness and corrosion resistance of aluminum, is another case in point. The United States exports approximately 140,000 tons annually, but last year it also imported about 12,500 tons from Russia and Ukraine because of the low price. The European Union (formerly the European Community) tripled its magnesium imports in 1993, buying some 8,000 tons. Based largely on the recent surge of NIS exports, worldwide inventories have doubled, prices have dropped 20% in a year, and Western producers are losing money, some nearly to the point of insolvency. Similar situations are developing with other defense-related raw materials, such as chromium, ferrosilicon, and titanium, and with copper. The new competition in raw metals is costing Western companies many billions of dollars and tens of thousands of jobs.

Nor are metals the only commodities affected. A dearth of financing for NIS farmers and an inadequate supply of currency for trade among the new republics has suddenly driven Belarusan potash for fertilizer into the United States in massive quantities. Increasing uranium exports stem from yet another cause: the Chernobyl disaster has led to a reduction in the growth of nuclear power generation in the NIS. Diamonds are another potential problem. Russia produces both gemstones and industrial diamonds for internal consumption, but those markets, too, have collapsed.

Barriers often do more harm than good. In the case of uranium, government intervention backfired.

To date, few of the Western companies affected by this sudden wave of exports have found long-term strategic solutions to the problem. In some cases, stopgap expedients have made the situation worse. Cutting production and laying off workers are not a recipe for survival and growth. And requests for government intervention may actually backfire. In the case of the uranium industry, they already have.

At the request of U.S. companies, Washington negotiated a price-floor arrangement by which NIS companies and their agents could not sell uranium to U.S. buyers unless the market price rose to $13 per pound. This measure appeared likely to protect U.S. uranium producers, which could generate a profit at that price. But it is the Western European producers that dominate the industry and set the market price, and their response was to hold prices slightly below the $13 mark, keeping both NIS and U.S. uranium producers out of the market. Washington will now renegotiate this agreement with the NIS, but a lot of damage has already been done.

All in all, defensive reactions have done little to alleviate the problem, which calls for new thinking and a new approach. One ideal solution would be for NIS raw materials never to reach Western markets to begin with, but there are only two ways to achieve this goal. One way is somehow to close 50% to 75% of the mines and smelters that produce the ingots, which is clearly impracticable. Nothing could persuade NIS governments and enterprises to commit economic and political suicide by throwing away hundreds of thousands of jobs and millions of dollars in earnings.

The other way is somehow to rebuild domestic NIS demand for these raw materials – without re-establishing the gigantic defense industries that previously used them. This is the approach that RMC has chosen – or, rather, that circumstance and opportunity have jockeyed RMC into choosing – together with several joint-venture partners. In fact, it was a series of unplanned, unrelated events that led the company to seek to establish itself in the NIS as a manufacturer of aluminum consumer goods for NIS markets.

The decision was complex; the joint venture is even more complex. It involves a large capital investment, Italian and Russian partners, Western European investors, large Western and Eastern customers, a government finance agency, and an ongoing effort to teach Russian producers how to add value to Russian materials, create new products, and stimulate their own domestic markets. Not incidentally, it also involves using a prodigious quantity of Russian aluminum in Russia.

Too Much Aluminum

Aluminum, with its widely varied uses – beverage cans, window frames, foil for food packaging, and auto components, to name a few – is a vast industry. Ingots alone are a $15-billion-a-year business. In the West, the principal smelters are in Canada, the United States, France, Norway, and Australia. Production costs are about one-third each for energy (smelting), materials (alumina, made from bauxite ore), and everything else (labor, plant, debt service, depreciation, transportation). Because smelting uses so much electricity, the industry has recently expanded into countries with low-cost hydroelectric power, such as Venezuela and Brazil. Well-known producers include Alcan in Canada, RMC and Alcoa in the United States, and Pechiney in France.

In the late 1980s, Western producers overexpanded in anticipation of new automotive markets that proved slow to materialize. For a decade or more, the market had been growing at an annual rate of 3% to 4%, but the global recession reduced that growth to a crawl. London cash prices reflected the slowdown. Aluminum sold for $1.17 per pound in 1988, 89 cents per pound in 1989, and 74 cents per pound in 1990.

In this gloomy environment, virtually no Western manager dreamed of sudden competition from the Soviet Union. Four enterprises in Siberia produced essentially all the aluminum in Russia, and for many years they enjoyed the benefits of cheap hydroelectric power, low wages, and ample capital without using those advantages to launch themselves into Western markets. The Soviet military used almost all of their output. The four enterprises exported a few thousand metric tons to the West every year – a negligible portion of Western demand.

In 1991, however, the Russian market changed abruptly and the deluge began. Western smelters, including RMC, responded by accumulating inventory and cutting capacity. From 1990 to 1993, the inventory of aluminum ingots on the London Metals Exchange jumped 800%, from 310,000 metric tons to more than 2.5 million metric tons. Between 1990 and 1993, Western companies cut 12% of capacity, or 2 million tons, worth more than $2 billion. U.S. companies cut especially deeply, eliminating nearly 750,000 tons from mid-1991 through 1993 – a drop of 17%.

Russian aluminum began flowing west in 1992, when domestic use plummeted.

Swelling inventories depressed prices despite cutbacks in production and capacity. The London cash price plummeted from 74 cents per pound in 1990 to approximately 50 cents in 1993 – a decline of 32%. Virtually all Western aluminum producers felt the pressure. In 1991, three top U.S. producers – Alcoa, Kaiser, and RMC – showed a profit. Kaiser and RMC posted losses in 1992 and 1993, and Alcoa lost money in the fourth quarter of 1993.

Meanwhile, the Russians remained unable to use their excess capacity domestically. They were willing to make more sophisticated products, like beverage cans or construction materials for local consumption, but their rolling mills were not equipped to make such goods. Without financial support, technical knowledge, and trained management, they were unable to expand production beyond simple products such as ingots and lowgrade sheets and tubing. Western producers implored their governments to impose trade barriers, and the Russians subsequently agreed to cut production by 300,000 tons immediately and by another 200,000 tons if the West agreed to make its own large cuts.

There was ambivalence in these negotiations. Western governments had promised Russia they would open their markets to Russian goods as a reward for economic reforms, and many of those governments were now reluctant to negotiate a trade agreement that contradicted the policy of market access.

There were also ironies. To begin with, the West had earlier urged Russia to stop producing MiGs and other military equipment; now the West was almost equally unhappy with the surplus aluminum that resulted from the military cutbacks. Moreover, although the Russians were willing to curtail production in order to prevent worse medicine,they found cutbacks difficult to accomplish without reverting to the very kind of central planning the West had urged them to renounce. The producers had become independent enterprises and were to some extent beyond the reach of government control. Some in the West began forming doubts about the Russians’ readiness to comply with the international agreement.

The truth seems to be that the Russians made an effort to comply even though they also tried to preserve jobs, keep their aluminum producers healthy, and ensure hard-currency earnings. Russian exports did go down, but the basic problem remained unaddressed.

Enter Randolph Reynolds, head of international operations for RMC and now a company vice chairman.

A grandson of the company’s founder, Reynolds had long been toying with the idea of entering the NIS market in some fashion, but he had not worked out a strategy. Russia’s aluminum production was so great that he knew the company had to take some kind of role. The most logical place, he thought, was in downstream processing. Reynolds was also attracted by Russia’s pent-up demand for consumer goods and by the potential to make use of Russia’s existing plants and equipment.

He and his colleagues struggled with the possibilities. What exactly could they do? No one at RMC knew how or where to start a business in Russia. Should they make sheet, foil, or an assembled product? What could Russian suppliers produce reliably? Should RMC build a greenfield plant or upgrade existing local assets? Was it better to team up with a Russian producer or start a new company to avoid the easy mistake of choosing the wrong partner? How could they find a partner they could trust? With no experience in Russia, Reynolds had none of the answers, and the $5 billion company was not about to take a plunge in the dark.

Then one of RMC’s equipment suppliers, the Fata European Group of Turin, Italy, approached Reynolds about forming an NIS joint venture. Fata had been designing and building machinery for factories in the Soviet Union for 28 years. Now its managers wanted to build a Russian plant to make foil. They even had a potential Russian partner, Sayansk Smelter in Sayanogorsk, to supervise and troubleshoot at the local level. But Fata needed a third party to provide the necessary technological and management skills. Although the Italians could design, build, and install the plant machinery, they knew nothing about the aluminum foil industry, and without that expertise, the project would never even qualify for financing.

Reynolds turned the offer down. But over the next several weeks, in the course of routine conversations with international customers who used RMC foil to package their goods for distribution, he began having second thoughts. Several customers in the food industry told Reynolds independently that they wanted to produce and sell food products in Russia to Russian consumers but that they were afraid of the ruble’s volatility, which could keep them from importing the pack aging they would need to make their ventures work.

Reynolds in Siberia

Reynolds was at his desk one afternoon, he says, when all the pieces came together. He realized that by setting up shop inside the NIS, the company could supply locally the foil and other aluminum products its Western customers needed in Russia, Ukraine, and the other former Soviet republics. And by entering Russia and becoming a ruble-based supplier, the company could provide a new service to these Western customers by shielding them from Russian inflation and exchange-rate shocks.

Here was a competitive maneuver that none of his Western counterparts had thought of. And here was all the motivation the company needed to enter the NIS. Even if the venture broke even or lost a little money, it would enable RMC to strengthen its ties to Western customers while expanding its horizons and entering the Russian market in its own right, selling foil to Russian consumers as well. Reynolds thought back to Fata’s proposal, and suddenly the idea made sense. He called Fata’s managers and told them he had changed his mind.

The first hurdle was location. Fata wanted to establish its plant in Siberia, near Sayansk Smelter in Sayanogorsk. The smelter’s manager was talented and enthusiastic, and the Sayanogorsk plant was Russia’s only modern and environmentally clean aluminum facility. But while Reynolds approved of the Sayanogorsk partner, he preferred to build the foil plant in Moscow, near the market in western Russia, where he could minimize inventory and transportation costs, and have easier access from the United States.

The plane to Siberia made three unexplained stops – hardly the thing to put a newcomer at his ease.

A few weeks later, Reynolds flew to Sayanogorsk to meet the smelter’s manager, Gennady Abdulovich Sirazutdinov, and to put his foot down about building the new plant in Moscow. The flight to Siberia only confirmed his view. The trip was long, and the plane made three unexpected and unexplained stops – hardly the thing to put a newcomer at ease. But Sirazutdinov refused to build the plant in Moscow. A patriarch of sorts, he wanted to serve his existing employees. He also wanted to avoid the political morass in the nation’s capital.

Sirazutdinov convinced Reynolds that all the necessary parts and expertise were available locally, and, more important, he assured Reynolds that because he himself had been based in Sayanogorsk for years and knew its politicians, suppliers, and bureaucrats, he was in a position to make sure that the venture proceeded smoothly. Local knowledge and support are crucial in Russia, and Reynolds knew it. On the strength of Sirazutdinov’s assurances and skills, Reynolds agreed to set up shop in Siberia.

Under the terms of the venture, which the three parties named Sayanol, Fata agreed to supply the equipment for the mill and the local know-how that RMC lacked. Sayansk Smelter agreed to provide a new building and took on responsibility for protecting the venture against the vicissitudes of Russian politics. Sirazutdinov also brought in four additional partners – a construction company and three quasi-government organizations – to help Sayanol navigate the local political and cultural waters. The $200 million in capital that the venture needed to get off the ground came from a consortium of private investors in Western Europe and was guaranteed by an agency of the Italian government.

RMC thus minimized its risk by using someone else’s capital and by linking up with solid, experienced partners, but its truly innovative step was to focus the venture on the domestic Russian market. In a number of other countries, like Brazil, foreign aluminum producers have set up smelting operations primarily for export; here, in stark contrast, was an aluminum joint venture whose first move was to build an expensive plant to utilize indigenous production for local consumption.

And Sayanol has the potential to soak up a lot of Russian aluminum. RMC has experience with underserved consumer markets in other parts of the world, and Reynolds believes in the potential for explosive growth. Sayanol will open later this year and will process nearly 40,000 tons of aluminum in its first year of operation.

Reynolds hasn’t stopped with Sayanol. He has since initiated three other ventures in the NIS, to produce beverage cans, construction materials, and wheel rims. Eventually, each of these plants will serve one or more of RMC’s Western customers that need these products to process their goods for NIS markets. The ventures will also strengthen RMC’s own position as a consumer-goods company in the NIS.

RMC cut its risk by using someone else’s capital and by finding partners who had been there before.

Moreover, because each initiative has the capacity to consume as much aluminum as Sayanol does, the potential volume of all four – 160,000 tons a year or more – represents one-third of the production cuts that Russia agreed to make in response to pressure from the West. If two other companies did what RMC is doing, the three together would take 500,000 tons of aluminum off the export market without imposing any cutbacks whatsoever. That could end the threat to Western aluminum producers and actually eliminate the international trade crisis in this sector. The lead time to build the necessary plants is admittedly long, but the payback from so strong a presence in NIS markets may be longer by far.

Time to Move

Some NIS materials industries are unlikely ever to pose the same kind of threat to their Western counter-parts as aluminum, nickel, and zinc.

The Russian oil industry, for example, expanded rapidly in the early 1980s but declined just as quickly, primarily because the government pressed too hard for increased production to generate hard currency for debt service and imported consumer goods. The oil fields were overexploited and simultaneously deprived of capital by the imposition of a low price and a high volume for domestic sales. The industry was thus swiftly decapitalized at the same time that its need for money to repair damaged oil fields reached a critical level. Russian petroleum is not going to flood world markets. On the contrary, the Russian oil industry is seeking Western support to halt the decline in its capacity.

Foil alone could soak up 40,000 tons of Siberian aluminum each year.

In other sectors, well-established organizations have moved quickly to establish control of the Russian market and avert an export crisis. De Beers, for example, is protecting its diamond empire through an agreement to market nearly all of Russia’s vast supply of rough gem-quality diamonds. This arrangement has come under pressure lately from the Russian government, which wants more control of the market, but De Beers may succeed in retaining control of enough of the market to support international prices.

In most raw-materials industries, however, there is a compelling need for innovative, long-term responses to overproduction in the NIS. In the nickel industry, the main challenge is to develop a civilian market for stainless steel, which represents the only possible way for the Norilsk Nickel Combine to continue to utilize its capacity without disrupting Western producers. One high-growth sector might be the food industry, which needs stainless steel for new restaurants, dairy equipment, beverage trucks, and dozens of other applications. But help from the West is needed now, because NNC has expertise in military applications of stainless steel but no knowledge of consumer goods. Without the benefit of Western expertise in product design and manufacture, no Russian company will create local demand for NNC’s output, and the problem of Russian nickel exports will continue.

The prospects for zinc are similar. An official in the U.S. zinc industry has said that most Western top managers would view an investment mission to the NIS as a “boondoggle and a waste of time.” But with the help of Western technology, the NIS could use its own zinc productively and profitably. The greatest potential market for zinc is in modernizing infrastructure, which would require massive galvanizing of bridges, reinforced rods for concrete, and guardrails on highways. Other strong possibilities are the housing and automotive markets, which are high-volume users of zinc and which have grown quickly in other countries that have initiated macro-economic reforms. (For a discussion of the macroeconomic pressures on NIS enterprises, see the insert, “Inflation, Debt, and Liquidity.”)

Kazakhstan by itself could produce rapid growth in infrastructure, housing, and automobiles: the country’s GDP and hard-currency reserves soar with each auction of mineral rights. (Chevron alone paid $4 billion for oil reserves in 1993.) In Russia, mills that galvanize sheet metal have a backlog of several years; one Russian automobile manufacturer currently needs to import galvanized sheets.

For company leaders thinking along the same lines as Randolph Reynolds, there is also an available supply of that crucial ingredient, cash, in the form of government guarantees. U.S. companies can get 75% to 85% of their projects’ capital guaranteed against all risk by the Overseas Private Investment Corporation or the Export-Import Bank of the United States. Moreover, a portion of the 15% to 25% not guaranteed by OPIC and ExIm may be available from equity funds sponsored by the U.S. government. It is even possible to get the U.S. Trade and Development Agency to fund feasibility studies.

But the failure of most Western organizations so far to enter the lion’s den in the NIS may not stem from an analytical limitation or a lack of courage or even a lack of capital. Rather, it may reflect a psychological barrier that is a legacy of the Cold War, in which Western companies did not have to deal directly with companies from the Soviet Union. Soviet enterprises did not play by Western rules: they were driven to produce without having any concept of profit, and they were subsidized when they fell short of capital. The inroads they made in Western markets were thus achieved unfairly by Western standards, and their aggressiveness warranted – and often led to – trade protection from the U.S. government for national security reasons.

But the Western and NIS rules on play are rapidly converging as the NIS undergoes privatization and eliminates government subsidies. And if Western companies do not make the effort to change their mindsets and tackle NIS markets head-on, the NIS economies will continue to strike back — haphazardly as they struggle, aggressively as they gain their footing.

Kevin R. McDonald is a management consultant based in Waban, Massachusetts. Since January 1990, he has spent much o this time in Eastern Europe and the former Soviet Union, advising local and Western companies and governments.

Inflation, Debt, and Liquidity

The current macroeconomic instability in the NIS need not mean that there will be chronic inflation and thus permanent financial pressure on companies like the Norilsk Nickel Combine. Granted, Russia’s inflation in 1993 was on the order of 20% per month. But the Russian government created this inflation by printing rubles to finance a budget deficit of around 10% of GDP. Italy and Greece have comparable deficits as a percentage of GDP, but they fund them with little impact on inflation – by issuing domestic bonds and borrowing internationally. By contrast, Russia does not have the institutional sophistication to tap domestic savings on such a scale or the credit rating to borrow externally in private markets.

If Russia were to receive short-term official help financing its deficit, however, the country could reduce inflation quickly. In particular, Western grant aid and concessional loans – on the order of $10 billion to $15 billion per year – could fund part of the budget deficit and help to drive inflation down. In the longer term, Russia could borrow domestically and abroad. Indeed, the country’s current ratio of government debt to GDP is approximately 20%, which is lower than that in most OECD countries. The government debt cannot be serviced for the next few years, largely because of inadequate fiscal policy, but it is likely to be manageable in the long run. Thus the problem is one of short-term liquidity, not of long-term debt capacity.

Assistance from the West could enable Russia to overcome the current liquidity crisis, restore its credit rating, and establish non-inflationary means of financing its deficit. As a result of this and other measures, foreign investment would increase and companies like the Norilsk Nickel Combine could be recapitalized. In fact, such aid has been promised by multilateral financial institutions but not yet delivered.

Kevin R. McDonald and Jeffrey D. Sachs, the Galen L. Stone Professor International Trade at Harvard University.