Aluminium has been the least preferred metal among equity investors given its high inventory levels, dependence on energy prices, and excess-supply situation. Aluminium prices remain 25% below their prerecession peak at nearly $2,500 per metric ton while prices for copper and tin are at record highs. We believe the long-term fundamentals of aluminium are sound given its attractive properties, widespread usage, and consumption patterns for countries entering high-growth stages of economic development. However, we think aluminium prices could be challenged in the near term due to an oversupply problem unlikely to recede in the next couple of years.
Geography Plays a Key Role in Cost Structure
The largest costs in producing aluminium are its primary raw material alumina (which is essentially refined bauxite ore) and energy (as a significant amount of electricity is needed to run an aluminium smelter).
Bauxite deposits are most plentiful in Australia, Western Africa, and Brazil and ownership of these assets is concentrated among the largest aluminium producers. The need for bauxite and the limited supply relative to aluminium production capacity has caused a high degree of consolidation within the aluminium industry, with Alcoa (AA), Aluminum Corp. of China (601600), United Co. Rusal, and Rio Tinto Alcan (RIO) producing the lion's share of global aluminium needs. The next stage of aluminium production is smelting, which is more economical in areas that have access to cheaper energy sources such as Russia, Scandinavia, and the Middle East. Soaring energy prices have caused aluminium-smelter construction to shift to these areas in recent years. The geographic discrepancy between bauxite sources and cheap electricity puts an emphasis on proximity to a port and economies of scale to spread the cost burden of operating in distant areas. Aluminium is priced in US dollars so currency movements can have a significant impact on short-term profitability. Naturally, the aluminium companies with the lowest operating costs are those with the greatest bauxite supply and the largest percentage of aluminium capacity in geographies with plentiful electricity.
China Brings New Demand Sources, but Added Supply Creates a Dilemma for Pricing
Demand for aluminium has grown at a faster rate than the other base metals during the four decades prior to the financial crisis and our long-term demand outlook is strong. Infrastructure and automotive demand should drive aluminium consumption while penetration into new applications, particularly transportation, should support growth. Aluminium consumption in the US primarily comes from transportation and packaging, but emerging-market demand is fuelled by construction and equipment manufacturing. China is following the typical path of an emerging economy, with demand for aluminium rising dramatically after per capita income rose above $5,000. This growth likely will moderate after income exceeds $15,000 per capita, but this is still a few years away. China was the only major region to have positive aluminium consumption growth in 2009 but that changed in 2010 as developed countries started to recover.
While growth in China will inevitably slow in our view, other areas such as Russia, India, the Middle East, and Brazil are speeding up. Aluminium giant Alcoa has forecasted global-demand growth of around 6% per year through 2020, which would double current consumption levels. This could be a tad aggressive, in our view, but trying to forecast 10 years of consumption is nearly impossible in any cyclical industry. Aluminium producers' demand-growth forecasts for 2011 range from 8% to 12%. We think it will fall somewhere in the middle, which is just below 2010's growth rate and much stronger than we expect for steel and other base metals.
The supply side of the equation is more troubling. While China does not appear to be an attractive place to make aluminium due to its relative lack of both bauxite and cheap energy, the rise of aluminium demand in China during the last decade for cars, infrastructure, and machinery has also caused a rapid increase in smelter construction. Smelting capacity in China grew more than 20% per year for the last decade and China is now the largest producer and the largest consumer of aluminium. While China's capacity is only 23% of the world's total, around 40% of aluminium was produced in China in 2010 as most of the world's idled facilities are in the US, Europe, or other areas where producing aluminium is actually less costly than in China. This is worrying as it demonstrates the resistance toward curtailments by the marginal-cost producers when signs of oversupply turn up.
China's new capacity was economical when aluminium prices were strong, but prices plummeted in late 2008 to levels far below the cash costs of production for many Chinese smelters. Aluminium is a highly cyclical product due to its heavy usage in transportation and construction sectors and the severity of the recession caused an oversupply as consumption fell faster than output. The oversupply looks even greater if we take into account the growth in warehoused inventory at the London Metals Exchange, which surged to 4.6 million metric tons in 2009 compared to historical averages of less than one million metric tons. We believe much of this inventory is tied up in financing deals spurred by low interest rates, yet the stockpile has remained stubbornly high for the last two years, currently sitting at just over 4.5 million metric tons. Given the oversupply, aluminium prices have moved in line with the marginal cash cost of production. Chinese smelters who buy their electricity from the power grid (about half of them) likely have the highest cash costs in the world, which we estimate to be around $2,400 per metric ton. Over the long run, this should create a floor for aluminium prices in the absence of recession.
Elimination of Excess Supply is Necessary for Sustainable Price Improvement
We believe the estimated surplus of production relative to consumption was north of 1 million metric tons in 2010. Regardless of financing deals, we think LME inventories are an indication of the excess-supply situation globally. And the vast number of smelters that have opened while aluminium consumption was declining is troubling. Even if demand continues to climb at a strong pace, there still are numerous smelters that currently sit idle and we think it could take several years for the oversupply to dissipate. Most estimates are for a declining oversupply in 2011, but we think it could actually rise if tight monetary policy squeezes demand in China or power restrictions are lifted. Both of which are strong possibilities in our view. Power restrictions put in place by the Chinese government last fall cut aluminium production by 20% in some areas, but we view these output cuts as a temporary solution to reaching a national energy efficiency goal. Aluminium represents more than 5% of all power usage in China and many smelters were unprofitable, making aluminium an easy target for production restrictions. But these mandates are starting to lift, and we see few signs of any permanent output cuts in China. We think these curtailments were a primary driver of the aluminium price run-up that began around the same time. This further supports our view that supply will be the primary determinant of aluminium pricing in the near term.
Still, primary aluminium production is limited by its key raw material, alumina, which is in much tighter supply due to limited bauxite sources. Therefore, we believe aluminium prices will be supported over the long run by greater demand, tight alumina availability, and rising production costs, namely energy prices. Inexpensive electricity and raw materials will be the key drivers of competitiveness and China does not have much of either. It makes economic sense for the marginal-cost producers in China to idle in 2011, and this would provide the most support for aluminium prices in the coming year.
The only other path we see to higher aluminium prices this year is the potential launch of a physically-backed aluminium exchange-traded fund, which would tie up about 3 million metric tons for the next several years. The success of precious-metal ETFs has prompted some investors to show interest in funds backed by physical base metals, and an aluminium ETF is in the planning stages for a launch later this spring. ETFs backed by nickel, copper, and tin were launched last December to mixed reviews. Clearly the storage costs will be higher for aluminium due to the lower value of aluminium per ton--it costs a lot more to store $10 billion worth of aluminium than to store the same value in copper and significantly more than to store $10 billion in gold. So we are not convinced that aluminium ETFs are a hot enough commodity to positively impact aluminium prices.
