Articles

Russian Raw Materials: Converting Threat into Opportunity

by Kevin McDonald

This article was published in the Harvard Business Review, May-June 1994.

Most Western businesspeople are betting that companies in the former Soviet Union will not become a threat to the West for another 15-20 years. According to this widespread view, Russia and its newly independent neighbors will need decades to establish a market economy, to instill an entrepreneurial spirit, and to train a generation of young managers. My experience with firms in Russia and the West indicates that in the raw materials sector, the Western bet is drastically wrong -- that companies from the new independent states (NIS) have already begun to invade the West, establishing a competitive threat that requires an immediate and innovative response from raw material producers, their customers, and their suppliers.

It is time for a wake-up call: firms from the NIS producing primarily metals and minerals, worth billions of dollars, have created a living nightmare for their Western competitors and an uncertain future for their customers and suppliers. The NIS producers have been propelled into Western markets by the collapse of their traditional sales base, and they have gained market share by cutting prices, sometimes as much as 50 percent from Western levels. This invasion presents the likes of Alcoa, Dow, and Inco with a problem they must deal with today.

The issue is how they should respond. The goal is not just to keep NIS firms from selling in the West; indeed, it is the policy of Western governments to provide market access to NIS firms, at least in the long run. Accordingly, the goal is rather to integrate NIS firms into the West and in the process to establish an advantageous position. To achieve this, Western firms will have to develop local demand for NIS raw materials. The effort will entail teaching NIS producers to add more value to NIS materials and to stimulate domestic sales of new products that use those materials -- in some cases by enlisting the help of Western users of materials, suppliers of the necessary equipment, and government finance agencies.

Three industries recently hit by NIS competitors -- nickel, zinc, and aluminum --illustrate the severity of the threat and also the initial response of Western firms. By contrast, a potentially successful venture of the Reynolds Metal Company provides an ideal response for these and other sectors.

Nickel from Norilsk
Nickel is a $7 billion industry that is crucial to many products with markets 100 times greater. Used mainly as an alloy, nickel metal is valuable for its corrosion-resistance and heat-resistance. More than 60 percent of the world's nickel goes into stainless steel, which is used both in consumer goods (e.g., household appliances, kitchen facilities, and medical equipment) and in industrial products such as vessels or pipes used to make chemicals, beverages, pulp and paper, and pharmaceuticals.

In the West, nickel is mainly a Canadian industry. Canada has rich veins of nickel (including by-products such as copper and cobalt), and it has low-cost energy for processing the ores. Accordingly, the country accounts for more than one-fifth of world output. Canada's largest two nickel producers -- Inco and Falconbridge -- are the largest two such firms in the West. Four other countries are also important, including New Caledonia (10 percent of world output), Australia and Indonesia (seven percent each), and Cuba (four percent). The largest producer of nickel metal in these four countries is Australia's Western Mining Corporation, followed by Sumitomo (Japan), and Jinchuan Non-Ferrous Metals Co. (China).

The market for nickel is worldwide. Japan is the world's leading producer of stainless steel and thus the largest buyer of nickel. Western Europe, the U.S., and South Africa also represent large markets for nickel metal. Taiwan uses about 20,000 metric tons of nickel metal, mainly as a producer of stainless steel for export. Another application for nickel, "superalloys" used to make jet engines, is located largely in the West; this application has recently declined along with the production of aircraft.

In 1990s, Western nickel producers began to encounter trouble even without pressure from the NIS. Things had gone well in the mid-1980's, as Western demand grew four percent per year, to nearly 670,000 metric tons at the end of the decade and a record high monthly average price of $8.17 per pound in 1988. In 1991, however, recession in North America and Europe took hold. Instead of growing another four percent, demand actually dropped slightly. Also in 1991, prices fell seven percent, to $3.80 per pound.

Meanwhile, developments in the NIS were ominous for Western producers of nickel. First, capacity was suddenly becoming available for Western markets. The largest nickel producer in the NIS is also the largest such producer in the world, accounting for nearly 30 percent of world output. Located near the arctic circle in Russia, it is a newly privatized firm called the Norilsk Nickel Combine (NNC). (NNC's employment is so high -- 150,000 people -- and its social services so extensive that the enterprise is almost a small kingdom unto itself.) Unlike its Western counterparts, NNC had served mainly military markets, which were rapidly downsizing by the end of the 1980s. By 1990, approximately one-half of NNC's capacity was surplus and thus available for other markets.

The second dangerous development was the fall of the ruble. From a position of near parity with the dollar in 1988, the ruble virtually collapsed in 1991. This devaluation along with domestic price controls drove a wedge between nickel prices in Russia and abroad. By January of 1991, when the world price was $3.65 per pound, the price in Russia was a mere five cents per pound -- less than two percent of the world level! This gap was quickly reduced to about 50 percent, but the disparity nonetheless created a huge incentive for NNC to export, especially in light of plummeting demand in the NIS.

NNC responded rationally to this incentive, with dire consquences for Western nickel producers. In 1991, Russia reduced its output approximately 10 percent, due to technical problems. Yet it increased exports 75 percent to 145,000 tons, including licensed sales and unauthorized shipments. Those exports represented 15 percent of worldwide production, a huge increase in the supply to Western customers at any time, let alone when demand was falling the same year. The drop in global demand and the surge in Russian exports drove worldwide inventories up 46 percent and prices down eight percent.

Things have gone from bad to disastrous since 1991. Worldwide demand has remained soft, and NNC has continued to export at least 100,000 tons per year. As a result, stocks held on the London Metals Exchange (LME) have grown 250 percent, from 84,000 to 208,000 metric tons. Meanwhile, prices have fallen 35 percent, from $3.70 per pound to around $2.40.

Western nickel producers have responded mainly by cutting production, capacity, and investments. As an example, Inco cut its output by 10 percent or 200,000 tons in the first quarter of 1994, and it has given early retirement to 1,665 workers. Falconbridge has also cut production and has terminated at least 200 jobs. Minor expansion was initiated in Australia and Indonesia, but those initiatives ran counter to the worldwide trend.

Norilsk too faces difficulties in this turbulent period. NNC has unstable supply lines, increasing energy costs, and perhaps declining ore grades. These manifest themselves in NNC's output decrease of approximately 20 percent in the past few years. Moreover, Norilsk must eventually finance and install pollution controls and process controls, cut social assets, and establish a cost-management system. On top of that, the Russian Government could impose unsustainable taxes or create a hyper-inflation that disrupts supplies and capital flow.

NNC is nevertheless a force that calls for a long-term response from Western competitors. Norilsk is not just ruining the market for Western giants today, and it will not go away if Western competitors wait patiently. Rather, Norilsk has the economic assets and evidently the determination to survive in the long run.

Moreover, the current macro-economic instabililty in the NIS does not mean there will be chronic inflation and thus permanent financial pressure on the likes of NNC. Granted, Russia's inflation in 1993 was on the order of 30 percent per month. The Government of Russia created this inflation by printing rubles to finance a budget deficit of ten percent. Italy and Greece have larger deficits, but they fund them with no 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. So the government issues rubles to pay its bills, with high inflation as a consequence.

If Russia receives short-term help financing its deficit, however, the country can reduce inflation quickly. In particular, Western grant aid and concessional loans -- on the order of $10-15 billion per year -- could fund much of the budget deficit and drive inflation down. In the longer term, Russia could borrow domestically and abroad. Indeed, the country's ratio of debt to GDP is approximately 20 percent, lower than in most OECD countries. The 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 long-term debt capacity.

Western assistance 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 such as NNC would be recapitalized. Significantly, such aid has been promised by multilateral financial institutions but not yet delivered.

On this basis, the main challenge to Western nickel producers is to find a way into Russia now, to develop a civilian stainless steel market. It is only through the growth of such a market that NNC can continue to utilize its capacity without disrupting the West. A domestic market would consume NNC's output and thereby remove some production from export markets. One high-growth sector would be the food industry, which needs stainless steel for new restaurants, dairy farms, beverage trucks (milk, beer, juice), and other such applications. Western help is needed because Norilsk has expertise in military applications of stainless steel, not consumer goods. Without such assistance, no Russian firm will create local demand for NNC's output, and the problem of Russian nickel exports will continue.

Western firms have not yet, however, attempted to divert NNC production by this measure. For the most part, the West has focussed internally, on cutbacks and layoffs. There has been some contact with NNC, but mainly to assist in reducing the firm's environmental pollution. For example in 1993, a Scandinavian consortium led by Elkem won a bid to upgrade one of NNC's nickel smelters on the Kola Peninsula. Meanwhile, NNC has been left with a market development task that far exceeds the firm's ability.

Western nickel producers may eventually team up with NNC to develop a local market for Russian nickel. But they have spent three years sustaining losses from a problem they might already have begun to solve.

Zinc: a Dramatic Debut
Zinc metal is a $5 billion industry, similar to nickel in that it serves a wide variety of products with large markets. The main use of zinc is in galvanizing steel to prevent rust. Zinc is also used to make brass, which can be up to 40 percent zinc, and to produce many die-cast parts such as gears, brackets, carburetors, and electrical boxes. The main markets are the U.S., the NIS, Japan, and Germany.

Global output is concentrated in four places -- Canada, Japan, the NIS and China -- that account for 37 percent of production. More than 30 other countries generate the remaining 63 percent. The NIS is the third largest producer, with nearly eight percent of world zince metal, mainly from Kazakhstan, which has abundant ores and low-cost hydro-electric power for processing them. The U.S. is a medium-size player, generating 350,000 metric tons, or five percent of world supply; producers are Zinc Corp, Big River Zinc, and Union Zinc.

Unlike nickel, however, the Western zinc industry was fairly stable before the NIS entered the scene in 1992. Western supply and demand had been in balance at a sustainable price to producers. Volume had been in the range of seven million tons; LME stocks were well below 100,000 tons, enough for one or two weeks of demand; and prices were holding steady in the range of 60 cents per pound. Significantly, the NIS was a net importer of zinc; it had no Western exports at all.

Then all of a sudden the NIS turned the zinc industry upside down. The precipitating event was the drop in consumption in the USSR and Eastern Europe. The NIS responded by curtailing its production 10 percent, but it also initiated Western exports to keep capacity utilization from falling farther. In 1992, the NIS shipped approximately 280,000 tons, or 35 percent of its capacity, to the West. This surge represented four percent of world demand. The trend continued in 1993, with great consquences. By year end, inventories on the LME had risen ten times to one million tons, enough for five months. And prices had dropped 50 percent, to less than 40 cents per pound. Western producers cut output and capacity dramatically, and all were reportedly generating a loss on operations.

The outburst of zinc exports reflects a dysfunctional economy in the NIS. The chain of production was abruptly broken, as traditional customers lost their downstream buyers or their liquidity to keep production going. As a result, the NIS is flinging out to the West all sellable goods from the production chain, mainly unwrought materials. The worse the situation becomes in the NIS, the harder the exports hit the West. The solution is not to take body blows or erect a wall but instead to treat the cause of the problem -- in other words to rebuild NIS markets.

Fortunately, Western zinc producers can identify products with growth potential in the NIS. The leading idea is to modernize infrastructure, which would require massive galvanizing of bridges, reinforced rods for concrete, and guard rails 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 initiating macro-economic reforms. Kazakhstan by itself could produce rapid growth in infrastructure, housing, and automobiles: the country's GDP and hard currency reserves soar with each auctioning of mineral rights (e.g., $4 billion from Chevron for oil reserves in 1993). Russia also apparently has high growth potential for zinc. Russian mills that galvanize sheet reportedly have a backlog of several years; a large automotive manufacturer currently needs to import galvanized sheets.

Yet Western zinc producers have not taken steps to develop such demand. On the contrary, they have concentrated on pulling levers at home, for example cutting production and laying off surplus workers. They have also focussed on reducing exports of low-priced metal -- in Europe by initiating anti-dumping cases, and in the U.S. by seeking to prevent duty-free status for Kazakhstan under the general system of preferences (GSP). One industry official speculated that top management would view an investment mission to the NIS as a "boondoggle and a complete waste of time."

Aluminum from Siberia
Aluminum is a $15 billion industry that serves produces of a wide variety of goods, especially beverage cans, construction materials (e.g., window frames), food packaging, and automobile components. Its growth in recent years has come as a replacement for other materials, mainly steel, by virtue of its light weight.

In the West, aluminum is produced mainly in Canada, the U.S., France, Norway, and Australia. Production costs are approximately one-third each for energy (smelting), materials (alumina, made from bauxite ore), and all else. The energy intensity has enabled the industry to expand recently in places with low-cost hydro-electric power such as Venezuela and Brazil. Well-known producers include Alcan (Canada), Reynolds Metals and Alcoa (U.S.), and Pechiney (France).

Like the nickel industry, aluminum producers became vulnerable to a Russian invasion in the late 1980s. Western producers over-expanded, in anticipation of new automotive markets that have proven slow to materialize. In the meantime, global recession reduced market growth to a crawl, versus three to four percent per year in the preceding decade. Pressure on the industry was indicated by the decline in LME cash prices: $1.17 per pound in 1988; 89 cents per pound in 1989; and 74 cents per pound in 1990.

In this gloomy context of the late 1980s, virtually no Western manager thought that the Soviet Union would exacerbate matters. Aluminum was produced there mainly by four enterprises in Siberia. For many years, those firms had had the potential to export, based on low-cost hydro-electric power, capital, and wages; but the producers had seen steady demand from the Soviet military market, so they exported only a few thousand metric tons per year to the West -- a negligible proportion of the Western market.

Things changed suddenly in Russia, however, preparing the way for a surge in Russian exports. In 1992, overall NIS demand for aluminum fell approximately 40 percent; domestic prices fell, due to inflation and price controls, to a small fraction of export prices; government subsidies became unpredictable and although the government set up export controls, it lacked the means to enforce them. When intermediaries arrived to provide financing and contacts with Western customers, the stage was set.

In 1992, Russian exports began to soar. The U.S. data alone are indicative: shipments from Russia to the U.S. jumped from 806 metric tons in 1991 to approximately 300,000 tons in 1993, an increase by a factor of 370, worth half a billion dollars. Meanwhile, the Russian share of Western markets rose from just over one percent in 1989 to more than 11 percent in 1993.

Western smelters responded by accumulating inventory and cutting capacity. From 1990 to 1993, aluminum ingots on the London Metals Exchange (LME) increased from 310,000 metric tons to more than 2.5 million metric tons, a jump of 800 percent. Between 1990 and 1993, Western firms cut 12 percent of capacity, or two million tons (worth more than $2 billion). U.S. firms cut especially deeply -- nearly 750,000 tons from mid-1991 through 1993, a drop of 17 percent.

The large and swelling inventory depressed prices, despite cutbacks in production and capacity. The LME cash price fell from 74 cents per pound in 1990 to approximately 50 cents in 1993 -- a decline of 32 percent.

The combination of declining volume and prices led to losses by virtually all Western aluminum producers. As an example, in 1991 three of the top U.S. producers -- Alcoa, Kaiser, and Reynolds -- all showed a profit. Yet two of the three showed losses in 1992 and 1993. Even the third producer (Alcoa) lost money in the fourth quarter of 1993. Meanwhile, the Russians were unable to divert capacity that they had recently trained on the West. They were exporting simple products such as ingots and "lawn chair" grade sheets and tubes, which have limited growth potential. They were willing to make more sophisticated products such as beverage cans or construction materials for domestic consumption. But their rolling mills are not equipped or trained to make such sophisticated goods.

Western industry as a whole -- including Reynolds Metals Company -- responded by imploring Western governments to impose trade barriers. This effort led to an agreement by the Russians to cut back production by 300,000 tons immediately, and 200,00 more if the West also made large cuts.

There was irony in these negotiations. The West had earlier urged Russia to stop producing MiGs and other military goods. Russia curtailed such production and closed many defense plants. One consequence was a surplus of aluminum that had been used in the bodies of the aircraft. Now the West was living with that consequence -- a surge of aluminum exports from Russia -- and asking the Russians to stop shipping all those surplus ingots!

There was also ambivalence on the part of some governments doing the negotiating. Western nations had earlier promised Russia that they would open their markets to Russian goods in reward for Russia's economic reforms. Some of those governments were reluctant to negotiate a trade agreement in contradiction to the policy of market access. At the same time, the Government of Russia was trying to impose production cutbacks as a way of preventing worse medicine. Yet the government no longer controlled those producers and did not want to revert to central planning to force Russian firms to slash output. Not surprisingly, there were immediately some doubts in the West about Russian compliance with the international agreement.

In any case, with or without such compliance in the near term, there was still a need for a solution for the long run. The Russians would need to preserve jobs and keep their aluminum producers healthy -- to ensure hard currency earnings, even if at a reduced level from recent years.

Staying Outside
Even though the Western producers hit by the NIS see the potential to re-cast the threat into an opportunity, they have generally responded with defensive, stop-gap remedies. Admittedly, cutting costs and seeking trade barriers may be crucial when an industry is up against the ropes. Yet the much greater impact of developing demand in the NIS highlights the enormous difference that the right approach can make. It also shows that individual firms can play an important role in tackling problems often left for governments to solve.

The difference in approach comes from having top management zero in on the right response. Most Western executives do not want anything to do with the NIS, and they wish the producers from that region would return to their historical hunting grounds. Others are willing to dip their toes in the water, but they don't know where the water is shallow or deep. They often fall into a pattern of hoping the government will erect import barriers, and they neglect the positive steps they can take on their own. Without such initiatives, the result is a steady decline of profit and sales, even to the brink of insolvency.

Sadly, these approaches even have the negative effect of eroding government support for the industry. There are only so many times a Western government will go to bat for domestic industry. There is enough ambivalence about protectionism within each Western government to limit the potential to protect all industries from a recurring problem. In addition, government intervention may be unsuccessful, or impose unforeseen hardship. An example comes from the uranium industry in the U.S. The U.S. Government negotiated a price floor for the import of Russian and Ukranian uranium. NIS firms or their agents could not sell into the U.S. unless the market price rose to $13 per pound. This measure appeared likely to protect American producers of uranium. Unfortunately, although the American producers could generate a profit at this price, they could not force market prices up to this level. Rather, west European producers that dominate the industry set the price. In this case, they responded by setting prices slightly below the $13 mark, thus enabling them to keep both the NIS and American producers out of the market! The U.S. Government will re-negotiate this agreement with the NIS, but only after many months of unintended consequences.

The failure of Western firms to enter the lion's den in the NIS so far does not stem from an analytical limitation or a lack of courage. Rather, it reflects a psychological barrier that is a legacy of the cold war, in which Western firms did not have to deal directly with competitors from the Soviet Union. Soviet enterprises did not play by our rules: they were driven to produce without any concept of profit, and they were subsidized when they fell short of capital. The inroads they made were thus achieved unfairly by Western standards, and their aggressiveness warranted -- and often led to -- trade protection from our government for national security reasons. The Western and NIS rules of the game are rapidly converging, however, as the NIS undergoes privatization and eliminates government subsidies. But the mindset in the West is not changing apace.

In this context, Western firms have to force themselves to view the NIS in a new light, and to find ways to re-direct local materials back into local markets. This task requires action now, in view of long lead time to free up corporate resources, find foreign partners, and engage Western customers and suppliers. Firms that miss this focal point now may lose the chance entirely.

The following example of a joint venture by Reynolds Metals Company in the aluminum industry illustrates the initiative needed to find a solution that goes beyond the defensive measures of cutting costs and seeking trade barriers.

Reynolds Wraps the Problem
Reynolds Metals Company (RMC) has quietly developed a new venture in Russia that represents a long-term solution to the problem of excess Russian aluminum. In 1989, RMC formed a joint venture called Sayanol to make aluminum foil, primarily for the Russian consumer market. Construction of the new mill began late in 1990; the plant will become operational this summer. The cost was $200 million, representing the largest foreign investment made to date in Russia.

RMC's approach to Russia was led by the firm's Vice-chairman and head of international operations, Randolph Reynolds, who developed his thinking about Russia in stages. A grandson of RMC's founder, Reynolds first viewed the Russian opportunity in the most general terms. Russia's ingot production was so great -- equal to the volume produced in North America, for example -- that Reynolds believed RMC had to be there in some role. And the most logical place, given Russia's existing, low-cost production of ingots, was in downstream processing. Reynolds was also enticed by Russia's pent up demand for consumer goods and the potential to utilize some existing plant and equipment. But those features only aroused interest at RMC; they were not sufficient to make a $5 billion firm take the plunge.

Reynolds felt truly compelled to enter the market, however, after talking with the firm's worldwide customers. Some of them, especially in the food industry, wanted to enter Russia but were afraid of the ruble's volatility, which could prevent a proposed Russian plant from importing the necessary packaging. Reynolds saw that by entering Russia and becoming a ruble-based supplier he could provide a new service to his existing Western customers, namely buffering them from Russian inflation and exchange-rate shocks. This was an opportunity the firm could not ignore. It was a way for RMC to expand its horizons and simultaneously reinforce its existing customer base.

Yet Reynolds and his colleagues struggled with the question: what exactly should they do? No one at RMC knew how or where to start a business in Russia. Should RMC make sheet, foil, or an assembled product? What were Russian suppliers capable of producing reliably? Should RMC build a greenfield plant or upgrade existing local assets? Was it better to team up with a Russian producer or start with a new company to avoid the easy mistake of choosing the wrong partner? Whom could Reynolds trust as a partner? With no prior experienc in Russia, Reynolds was at a loss to answer these questions. He needed more than vision. He needed to know how to operate in this strange new land.

Then came a breakthrough: Reynolds discovered the local know-how in his own back yard. It turned out that one of RMC's equipment suppliers had been building plants in the former Soviet Union for 28 years. This firm, FATA/Hunter of Italy, now wanted to build a Russian plant to make foil and even had a Russian candidate for a partner. FATA one day mentioned the idea to Reynolds, who snapped it up quickly. The idea made sense commercially, and it provided a way for RMC to acquire FATA's knowledge of doing business in Russia.

At first Reynolds resisted FATA's notion of locating the plant in Siberia, near the raw material supplier. On the one hand, Reynolds wanted to work with the suggested partner from Siberia, the Sayanogorsk smelter. The manager was very talented and also driven to succeed. And the Sayanogorsk plant is Russia's only modern (pre-bake) and environmentally clean smelter of aluminum. On the other hand, Reynolds preferred to establish the foil plant near the market, in western Russia, to serve customers better, to minimize inventory and transportation costs, and to provide easier access from the U.S.

Reynolds was persuaded to settle in Siberia, however, after meeting the local partner in Sayanogorsk. Reynolds had actually embarked on the trip to convince Mr. Sarcidinof, the plant manager, to base the new plant in Moscow. The flight to Siberia only confirmed Reynolds' view: the trip was long and had three unexpected and unexplained stops, hardly the thing to set a newcomer at ease! Yet Sarcidinof refused to build in Moscow. A partriarch of sorts, Sarcidinof wanted to serve his existing employees. He also wanted to avoid the political morasse in the nation's capital. He persuaded Reynolds that he could get all the necessary parts and expertise locally. And more importantly, he himself was in Sayanagorsk, and he would make sure the venture proceeded smoothly. Such local support was crucial and ultimately swayed Reynolds to set up shop in Siberia.

The joint venture took form accordingly. FATA would supply the equipment for the mill and know-how that RMC lacked. Sayanogorsk agreed to build the new mill facility, and it would protect the venture against the vissicitudes of Russian politics. Sayanogorsk also brought in four additional partners -- a construction firm and three quasi-government organizations -- that would also help buffer Sayanol against various local shocks. The $200 million of capital came from a consortium led by the Government of Italy.

RMC thus minimized its risk by conventional means, namely using some one else's funds and linking up with solid partners. The truly innovative step however, was to focus the venture domestically: indeed, the objective of the new plant would be to develop the local market for consumer foil. Unlike for example in Brazil, where aluminum producers had set up smelting operations primarily for export, here was an aluminum smelter whose first move in the country was to set up a very expensive plant that would utilize existing domestic production of ingots for local consumption.

Reynolds did not project Sayanol's sales growth with any precision. But he drew upon extensive experience in emerging markets to conclude that the plant would probably do exceedingly well. An analogy is one of RMC's can plants in South America, which sold 700 million cans in its first year and 2.5 billion cans three years later.

Sayanol has the potential to soak up a lot of Russian aluminum. The plant will begin operating in 1994, a year later than projected due to a disruption in the supply of steel from a Russian vendor. (Reynolds has learned how to avoid this problem in future endeavors.) In its first year, Sayanol will consume nearly 40,000 tons per year of aluminum.

Other such businesses planned by RMC for the NIS are based on Western applications, including beverage cans, construction materials, and wheel rims. Each of these initiatives could consume as much as Sayanol will, for a total of 160,000 tons. Signficantly, this potential volume represents one-third of the production cuts (500,000 tons) Russia agreed to make in response to Western pressure. Thus if two other companies did what RMC is doing, the three firms would take 500,000 tons off the export market without imposing cutbacks on anyone. As a result they would stop the hemmorhaging of Western producers and also eliminate the international trade crisis. The lead time to build the necessary plants is long, but the trade crisis may also have a long tail.

The model for defining such opportunities is clear from the RMC example: choose a business that will serve existing customers; develop the opportunity with help from Western suppliers; and refine the plan based on the strengths of a local partner.

Other aluminum companies have the means at their disposal for using this template. The crucial ingredient is cash, which is available on the basis of Western government guarantees. In the U.S., firms can get 75 to 85 percent of a project's capital guaranteed against all risk by engaging the Overseas Private Investment Corporation or the Export-Import Bank of the United States. Moreover, a portion of the 15 to 25 percent required by OPIC and ExIm may be available from equity funds sponsored by the U.S. Government. Funds for a feasibility study are also obtainable, from the Trade Development Agency. The second ingredient is the Russian partner. Reynolds' experience illustrates the potential to find a network of partners by starting with a reliable Western supplier or customer that leads eventually to some solid Russian organizations.

This sort of investment is attractive not only to Western producers but also to Russian aluminum smelters. The Russian enterprises are run mainly by top management, not so much by directors. These managers want market prices to rise just as Western firms do, and they are willing to divert production to local uses provided there is local demand. If Western firms can help introduce products that will sell in Russia, they will receive a warm welcome among their erstwhile rivals.

The next venture to process Russian aluminum for domestic sales will likely involve Reynolds Metals since this company has gotten a head start. Yet others will probably follow soon, based on preliminary feedback of RMC's success. And if CEOs from other industries get a close look at Sayanol, they too may soon venture forth into the NIS.

Time to Move
There is more than one constructive way for Western firms to respond to the NIS invasion. For instance DeBeers has endeavored to protect its diamond empire by negotiating the right to market nearly all of Russia's vast supply of rough, gem-quality diamonds. This arrangement has come under pressure lately from the Government of Russia. But DeBeers may nevertheless retain control over a significant share of Russian pricing.

There are also some materials industries in the NIS that will ultimately not pose the threat already seen in nickel, zinc, and aluminum. A parable comes from the Russian oil industry, which declined after a highly expansionist period in the early 1980s. The industry deteriorated mainly due to pressure from the government to produce quickly, in order to generate hard currency for consumer goods and debt service. Russian oil fields were exploited too hastily, and the Government of Russia deprived them of capital by imposing a low price on domestic sales and a requirlement to sell a high volume domestically. As a result, the industry was swiftly decapitalized despite needing increasingly more funds to recover damaged oil fields. Now there is no threat of a Russian export barrage; rather, Russian oil is seeking Western support to halt the decline in production.

Nevertheless there are already many other industries following a course that is parallel to nickel, zinc, and aluminum. For example, the U.S. exports approximately 140,000 tons of magnesium metal, but last year it imported approximately 12,500 tons from Russia and Ukraine, while the European Union tripled its imports from the NIS to 8,000 tons. Based largely on the surge from the NIS in the past year, worldwide stocks have doubled, prices have dropped 20 percent in one year, and producers are losing money, nearly to the point of insolvency. Not far behind are chromium, ferrosilicon, copper, and titanium, together worth many billions of dollars and tens of thousands of Western jobs.

The impetus for the NIS export export drive is not just the collapse of the defense industry. Defense cuts played a large role in the re-routing of nickel, zinc, aluminum and other metals. But other factors are at work, making the problem more complex and extensive than a military reduction alone could trigger. As an example, potash from Belarus has flowed into parts of the U.S. in flash floods, driven by a dearth of financing for NIS farmers and inadequate currency for trade among the new republics. Other materials, such as copper, have been catapulted into the West based on the decline of industrial output in the NIS. Uranium exports stem from yet another cause: NIS consumption has fallen since the Chernobyl disaster, which led to a reduction in the growth in Russian nuclear power generation. The list of factors goes on.

In most cases, however, the need for a response is compelling. Western firms in materials industries need to move now, to integrate NIS suppliers in a way that is mutually advantageous, as the RMC venture demonstrates.

Principals

Kevin McDonald
25 years of experience in investment banking, consulting, private equity, and international business
Michael Lehner
In the high technology field for 30 years, as an operating manager, consultant, venture capitalist, and investment banker
Copyright © 2010 McDonald-Lehner. All Rights Reserved.