Aluminum – Demand is Not the Issue

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On the face of it Alcoa might be an interesting stock given the extremely attractive valuation, an economic recovery (although muted) from the trough and thus the potential of the usual cyclical recovery.  But it has not played out that way despite strong demand growth for aluminum.  Again Alcoa has pointed to good volume growth in its quarterly results, coming from the automotive sector and the aerospace sector.  Both of these industries are on a positive growth trajectory globally and on the margin are increasing the proportion of aluminum used relative to other materials.  Aluminum is the material of choice in many light weight strength applications and its attractiveness is enhanced by the relatively low cost today.   As we illustrated in a report earlier in the year, aluminum pricing is close to all time lows relative to steel and engineering plastics where high global energy prices are setting the cost of the marginal producers.  Current aluminum pricing is weak, and while we might be lured into thinking it has recently bottomed, we would have been caught out by this assumption 3 times in the last 3 years – see chart.

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Clearly better demand is not enough to offset the flood of product coming out of China and this is where the downward price pressure is coming from.  In past cycles we would have seen a real recovery by now, as the traditional producers appear to have inventory and capacity under control.  There is plenty of rhetoric from traditional producers and some of those in China about production costs and the uncompetitive nature of many of the facilities in China, particularly the older, smaller ones, but as yet we have seen only words and no action.  In the Chemical industry China operated small facilities for many years at what we would consider to be a loss before they were closed down, but by that point the country had build larger more competitive facilities and had new nearby suppliers because of construction in places like South Korea.  China has new, larger and more competitive aluminum capacity today and more on the way and the risk is that if we get any closures they will be small, and perhaps not enough to move the supply/demand imbalance needle.

In the past, the strategy was clear; cut marginal capacity, get inventories under control, ride out the downturn and wait for the cycle to turn.  There was some consolidation in each downturn, but ultimately it was the cycle that mattered.  While there is always a risk with the phrase “it is different this time”, in this case that may be the case and the wait may be quite long – despite the very strong demand improvements.

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