LONDON (Reuters) - The only way to make money out of producing aluminum, it seems, is not to produce any.
That’s the message from Alcoa, the U.S. industry leader which will split itself into two parts later this year.
The new downstream company will have all the sexy value-added bits, such as highly-engineered aircraft components. The upstream company will mine bauxite, refine it into alumina, smelt the alumina into metal and then cast the metal into shapes.
Every component of the upstream company was profitable last year with the single exception of smelting, which was hit by the continued slide in the London Metal Exchange (LME) aluminum price to a six-year low of $1,432.50 in November.
Alcoa’s response has been to take the knife again to its smelter portfolio.
It has over the last five years mothballed, closed or sold a staggering 42 percent of its global smelter capacity. By the time it’s finished Aluminum Company of America will have only one operating smelter in the United States.
Such is the bleeding heart of the aluminum market. It enjoys one of the best demand profiles of any industrial metal and there is plenty of money still to be made in mining bauxite and refining alumina.
But hardly anyone can make money out of actually producing the stuff. It’s not hard to identify the root problem but much harder to envisage a solution.
Graphic on aluminum output by region:
Graphic on Chinese aluminum output:
The problem is that there is still too much production. Global output rose by nine percent last year to 57.9 million tonnes, according to the latest figures from the International Aluminum Institute (IAI).
That compares with Alcoa’s projected global usage growth of six percent in 2016.
Not that there haven’t been plenty of production cuts by Alcoa and others.
The shifting dynamics of smelting have seen primary metal production go into what appears a terminal decline in countries such as Brazil and the United States.
European production was slashed to the bone in the immediate aftermath of the Global Financial Crisis and has since stabilized at those lower levels. Russia’s Rusal has also taken the knife to its higher-cost operations.
But any impact on the global market balance has been more than negated by expansions in the Gulf, Asian countries such as Malaysia and, more than anywhere else, China.
Chinese output grew 15 percent last year and 44 percent over the last two years. So enormous has been the growth in smelting capacity that China now produces more than half the world’s aluminum. That ratio was under 30 percent just six years ago.
If aluminum supply is going to be realigned with demand, China is the gargantuan elephant in the room.
Not that Chinese aluminum producers aren’t suffering from low prices either.
National run-rates fell by an annualized 3.2 million tonnes over the fourth quarter of last year.
The problem is that they need to fall harder.
The Chinese market is still bleeding surplus metal into the rest of the world in the form of semi-manufactured products to the tune of 3.8 million tonnes in the first 11 months of 2015.
Some of this seepage is really raw metal transformed just enough to duck China’s export tax and qualify for the tax rebates covering value-add products.
During its Q4 analysts conference call Alcoa suggested that the flow of “fake semis” has slowed but not stopped, citing the fact that 75 percent of China’s November extrusion exports went to Vietnam, accounting for 63 percent of that country’s total annual demand.
The price of aluminum in Shanghai, meanwhile, has staged only the most modest of recoveries from the all-time low of 9,510 yuan per tonne recorded in November.
Faced with such negative economics, China should do what Alcoa has done, namely close and decommission higher-cost capacity.
That, however, is not what is happening.
Sure, Chinese production started falling but it is doing so at least in part as a quid pro quo for government help.
This comes in the form of interest-free loans to a small handful of national favorites to allow them to create a “strategic” reserve of metal.
“Strategic” only in the sense that their financial survival is strategic. Quite evidently, the Chinese state has no strategic need for a stockpile of a metal which the country produces in such quantities.
The scheme amounts to no more than free financing for unsold inventory and is, quite literally, a case of stocking up more problems for the future.
The Chinese government seems all too aware of the pitfalls of a potentially unlimited stockpiling program, which is why it has tied the amount of financial support to the amount of capacity each participant idles.
“Idles” being the operative word because very little capacity is actually going to be being decommissioned.
That means a huge swathe of production capacity that can kick in any time the price starts looking more positive. And that’s not even counting the new lower-cost capacity that is still being fired up in China’s northwestern province of Xinjiang.
China, it should be stressed, is not alone in subsidizing at-risk smelters. Alcoa’s Massena West smelter only dodged the closure bullet thanks to help from the New York state government.
But the problem is magnified in China because it is by far and away the biggest producer of the metal.
You can start to see why analysts don’t like aluminum’s price prospects.
Alcoa, understandably, takes an optimistic view that the global market will be in deficit this year to the tune of 1.2 million tonnes, comprising an 816,000-tonne surplus in China and a 2.0-million tonne deficit in the rest of the world.
It’s a minority view. Just about everyone else is projecting more surplus to the point that analysts at Macquarie Bank think that “the base case aluminum surplus we have in our supply-demand balance simply cannot happen”.
“The market will not be able to sustain inventory build of this level, even with strategic stockpiling,” they explain. (“Commodities Compendium”, Jan. 18, 2016)
The only solution, it follows, is for more price pain and for more forced exits of smelting capacity. But if the world’s biggest producer won’t cut, who will and who can in sufficient quantity to make a difference?
Given that costs are currently tumbling, particularly for smelters, mainly in China, that use coal-powered energy, the best case scenario is for prices to grind ever lower.
Good news only for stock financiers. Good news even for physical market players given the rise in U.S. premiums as the country’s import dependency increases.
But bad news for the people who actually make the stuff.
Sooner or later, even the Chinese will have to learn from Alcoa that the only way to make money producing aluminum is not to make it. Just don’t hold your breath.
Editing by David Evans