--Clyde Russell is a Reuters columnist. The views expressed are his own.--
By Clyde Russell
LAUNCESTON, Australia, July 22 (Reuters) - Rising Chinese output is likely to act as a brake on aluminium's 15 percent rally since May, even as the global outlook for the industrial metal improves.
It's no secret that much of Chinese aluminium smelting capacity operates at a loss and is reliant on subsidies from local and regional governments to survive.
But the price gain in the second quarter resulted in capacity that was either idled, or about to be shut, remaining in operation, according to a July 17 report from Beijing-based consultants AZ China.
This is despite some 80 percent of Chinese smelters, representing some 20 million tonnes of annual capacity, operating at a theoretical loss, AZ China said.
The average cash cost for a Chinese aluminium smelter in the second quarter was 14,161 yuan ($2,282) a tonne, above the Shanghai Futures Exchange (SHFE) spot price of 13,435 yuan, the report said.
Still, the average cash cost for Chinese smelters was 2 percent lower in the second quarter than the first as inputs such as electricity and alumina decreased in price, allowing plants to remain in business.
AZ China also said that capacity additions since the beginning of the year totalled 2 million tonnes of annual capacity, with a further 1 million tonnes slated to come online in the next few months.
This is likely to ensure that the Chinese aluminium market remains over-supplied, putting downward pressure on aluminium imports and upward pressure on exports.
China is a large net exporter of semi-finished products such as wire, foil, plates, sheets and strip, as well as aluminium alloy.
Exports of semi-finished aluminium rose 3.7 percent in the first six months of 2014 from a year earlier to 1.54 million tonnes, while shipments of alloy rose 20.4 percent to 255,933 tonnes, according to customs data.
Chinese aluminium output is also rising, with National Bureau of Statistics data showing June production of 1.95 million tonnes, up 4.8 percent from May, and year-to-date output of 11.54 million tonnes, up 7.4 percent some the same period in 2013.
While official statistics may not capture all of China's aluminium output, they do reveal a rising trend, which shows that even the parlous state of profitability at smelters isn't resulting in production cutbacks.
SHANGHAI PREMIUM TO LONDON NARROWING
This is leading to a growing disconnect between Chinese and London aluminium prices.
London Metal Exchange benchmark three-month aluminium ended Monday at $2,020 a tonne, the highest since February 2013.
The price is being bolstered by an improving demand outlook, led by increasing use of the lightweight metal in vehicle manufacturing, as well as issues surrounding the load-out queues at LME warehouses.
With almost 3 million tonnes of aluminium waiting for delivery, physical premiums have soared in the West, increasing costs for manufacturers seeking the metal.
In contrast, SHFE three-month futures are down 2.9 percent this year in U.S. dollar terms and are virtually flat in yuan terms.
This means the premium of SHFE over LME futures has narrowed from $515.94 a tonne at the end of last year to just $226.81 on Monday.
In early 2012, LME futures rallied while SHFE contracts were flat, taking the gap to $219.18 a tonne on March 1 of that year.
In the next six months LME futures slid almost 22 percent, while SHFE prices dropped only 6 percent.
This doesn't mean something similar will happen now, but it does suggest that when LME prices gain relative to SHFE futures, it's more likely that the London contracts will ease if the more normal gap between the two is to be restored.
This is especially the case given the pressure on margins at Chinese smelters and the ongoing over-supply situation, which makes it unlikely domestic prices have much upward potential. (Editing by Muralikumar Anantharaman)