ANALYSIS-China setting up for aluminium supply bubble

By Polly Yam and Tom Miles

HONG KONG/BEIJING, April 7 (Reuters) - On the surface, China's aluminium smelters have little cause to complain about intensifying pressure from provincial governments to step up production.

After all, domestic prices have outperformed the global market because of a Beijing-backed buying plan and investment in the power sector, while discounted electricity rates have taken pressure off the cost side of the equation for some smelters.

Trouble is, a rush to restart production now may sow the seeds of an even worse price collapse unless Beijing imposes restrictions to turn back a surge in imports, expected to soar beyond 100,000 tonnes in March, 10 times recent monthly averages.

Whether Beijing and provincial governments decide to prick the supply bubble will be key to deciding how long the world aluminium market remains sunk under the weight of surplus stocks.

"If the State Reserves Bureau and the provincial governments don't buy as they have said, there will be a surplus," said Wang Feihong, a senior aluminium analyst at state-controlled research group Antaike.

"If the reserve-buying plans materialise, there will not be a surplus, even if smelters start one million tonnes of capacity in the second quarter."

But soaking up today's surplus may just prompt more tomorrow.

Provincial governments in Henan and Shanxi are leading the push to get idle smelters back to work, with 700,000 tonnes of annual production capacity already coming back on line, smelter officials told Reuters last week. [ID:nHKG349996]

"The local government has pressure in terms of GDP targets so they urged the smelters to start up to achieve these targets. At the moment the government is thinking about GDP and employment first," said Bonnie Liu, an analyst at Macquarie in Shanghai.

At the height of the cuts, China shut in over 4 million tonnes of annual capacity. And 2-3 million tonnes of newly-built, relatively low-cost capacity has never been put into operation.

In Henan alone, another 700,000-1 million tonnes of idle and new capacity may start up in coming months, analysts warn.

"The production cuts should be kept for the rest of this year," said Wang. "Many people, including us, have assumed consumption will recover in the second half of this year. But nobody can say for sure it will happen."

SWIMMING IN ALUMINIUM

The world is already awash with the metal. The London Metal Exchange's warehouses hold a near-record 3.47 million tonnes, enough to supply the world for over a month.

This overhang has seen LME aluminium prices MAL3 fall 4 percent this year, against hefty rises for copper and oil and a 13 percent gain for aluminium SAFc3 traded in China.

The widening gap with world prices -- touching a record 2,200 yuan ($321.9) a tonne premium at the end of March -- mean shipments into China are set to soar, prompting caution from a few smelters.

"We can't see the end of the tunnel," said a senior executive at one large Chinese smelter which is resisting a local government request to reopen almost 100,000 tonnes of production.

Industry leader Chalco (2600.HK)(601600.SS), which has warned of "enormous difficulties and challenges in 2009", plans to watch the market for two months before deciding on restarting capacity, the firm's president Luo Jianchuan told Reuters last week.

But some aluminium smelters are bullish, partly because 6 regional smelters, as well as 9 of Chalco's facilities, have cheap electricity under a pilot scheme to buy directly from generators, cutting their biggest production cost.

With prices above many smelters' break-even of 12,000-13,000 yuan per tonne, restarts can turn a quick profit.

Michael Komesaroff, head of commodities consultancy Urandaline Investments and a former vice-president of strategy for aluminium at Rio Tinto (RIO.L)(RIO.AX), calls it China's "phoenix capacity", which re-emerges whenever prices heat up.

The local market has been spurred by government purchases and hopes that a 4 trillion yuan stimulus package will stimulate demand.

Buying by the State Reserves Bureau, already at 590,000 tonnes, is widely expected to hit 1 million tonnes in the next few months, and the State Grid Corporation has bought about 400,000 tonnes, which market sources said came from Chalco.

Provincial governments have said they will buy a combined up to 900,000 tonnes, but smelter officials in the provinces report less than 100,000 tonnes of purchases so far.

For a factbox on China's reserve buying, click on [ID:nPEK324588].

The danger is that all this aluminium will just be piling up. Standard Chartered analyst Judy Zhu sees China's total consumption rising only 1 percent in 2009 to 13.3 million tonnes due to weak demand for cars and construction, against a 4 percent increase in production to 13.7 million tonnes.

To stem the flow of imports, some merchants and fabricators are expecting a 5 percent import tariff to be imposed next month, traders say, which has caused a rush for available cargoes and caused spot prices to spike even further. [ID:nSP168008]

Beijing already postponed a decision on tariffs in February and has instead used strict customs checks to slow the pace of imports, traders said. [ID:nSP397104]

Liu at Macquarie said the restarted smelters would worsen the oversupply on the local market in the medium term, but falling prices would at least close the window for arbitrage trades.

And the state would keep buying up the surplus, effectively offering to use its huge dollar reserves to bail out local firms.

"The government is trying to diversify their risk from U.S. Treasury bills to commodities. It's still better than holding U.S. Treasury bills," Liu said. "So why not? It's too soon to make a judgment on whether it's right or wrong." ($1=6.833 Yuan) (Editing by Michael Urquhart)