- Andy Home is a Reuters Columnist. The opinions expressed are his own -
By Andy Home
LONDON Aluminum has become the in-vogue defensive play amid the broader sell-off across the LME metals markets.
This is partly due to the fact that there was less speculative premium built into the light metal than, say, copper. It also reflects the unwinding and reversal of previous long copper/short Aluminum trading strategies, a trend that appreciably accelerated last week.
As of the Friday close at $2,545, three-month Aluminum had fallen by "only" 3.2 percent from its 2011 high of $2,628 recorded on March 3. Most of the other LME base metals peaked earlier in February and have tumbled harder over the last few days of speculative blow-off.
There are good reasons why Aluminum is currently out-performing. The market is drawing strength from precisely the same combination of Middle East instability and high oil prices that is pressuring the rest of the complex.
The light metal has also been evolving its own fundamental bull narrative, although it is one that could easily be derailed by the recent run-up in prices.
SUPPLY-SIDE RISK (PART I)
Political turmoil across the Middle East generally and fighting within Libya specifically have shaken the risk asset universe, including industrial metals.
Aluminum, however, is unusual within the base metals complex in having significant production located in the region.
Indeed, the Gulf is currently registering the fastest Aluminum output growth anywhere in the world. Annualized production rates were 3.18 million tonnes in January, up 42 percent from year-earlier levels.
Accelerating regional production is primarily down to the ramp-up, slightly delayed, of the new 585,000-tonne per year Qatalum smelter in Qatar. The joint venture between Norsk Hydro and Qatar Petroleum is expected to reach full-capacity run-rates in June of this year.
More will come. Waiting in the wings for a 2013 debut is Alcoa's Maaden joint venture in Saudi Arabia The integrated complex will include 740,000 tonnes of annual smelting capacity.
No operating smelter has experienced any production issues from the wave of protests that have swept the Middle East. Nor is there any suggestion that existing projects will not go ahead.
But political risk has just risen sharply across the region and there is potential for further escalation specifically in Bahrain, which hosts the 860,000-tonne per year Knuff smelter.
As the only base metal with a clear supply-side relationship with the Gulf, Aluminum will continue to be supported by the rapidly-unfolding events across the Middle East and North Africa.
SUPPLY-SIDE RISK (Part 2)
Aluminum also has a far more ambiguous relationship with rising energy prices than any of the other base metals.
Oil price spikes, such as that resulting from the Middle East turmoil, are negative for base metals because of the dangers they pose to economic growth and therefore metals demand.
Emerging economies are particularly sensitive to energy price inflation, which is doubly problematic for industrial metals prices leveraged to China and other fast-industrializing countries such as India and Brazil.
Aluminum is no exception. But because of the energy-intensive nature of the smelting process higher energy prices also feed directly into rising production costs for the light metal.
For this reason Aluminum is a hybrid metal-energy play for many market participants. Higher energy prices are therefore medium-term neutral for price with negative impact on demand offset by positive impact for production cost.
SUPPLY-SIDE RISK (Part 3)
Even prior to the political whirlwind in the Middle East aluminum's bull narrative was improving on the back of production trends in China, the world's largest producer of the light metal.
China's national output slumped by an annualized 2.65 million tonnes to 14.67 million tonnes over the second half of 2010 as capacity was forced off-line to meet Beijing's energy-usage targets ahead of the December expiry of the old five-year plan.
Affected smelters are widely expected to reactivate potlines just as soon as they can. It is simply a question of timing. The longer it takes for Chinese production to "normalize," the greater the impact on domestic supply-demand dynamics and the bigger the hit on domestic stocks.
January figures from the China Nonferrous Metals Industry Association (CNMIA), carried on the website of the International Aluminum Institute, showed Chinese production rising in January but only by a relatively modest 212,000 tonnes annualized.
Severe winter weather in parts of China and the associated pressures on the energy grid may have been an active hindrance to restarts.
The collective reactivation process may have accelerated further in February, judging by the figures from the National Bureau of Statistics (NBS) out last week.
The NBS figures are generally viewed as less reliable than those from the CNMIA with many analysts treating them as no more than an early indicator. That said, the latest set suggests that annualized production rose by almost 500,000 tonnes last month.
That would still leave annualized production almost 2 million tonnes below last July's record of 17.32 million tonnes but the trend would be one of accelerating run-rates.
The rate of that acceleration will be at least partly price dependent, given the amount of high-cost swing capacity in China.
As such, aluminum's catch-up with the rest of the base metals, a price development that is being cemented by the metal's perceived defensive qualities in the current macro turbulence, could actively work to limit any rally both in terms of scale and timeframe.
(Graphics by Vincent Flasseur; editing by Keiron Henderson)