Aluminum – As Speculators Throw In The Towel, Investors Might Do Otherwise

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

September 16th, 2016

Aluminum – As Speculators Throw In The Towel, Investors Might Do Otherwise

  • Later this year, Alcoa will split into two entities – company rhetoric and the current market would suggest that the commodity company is the ugly step child and the specialty business is the Princess.
    • We understand why this may be the perception, but sometimes the ugly step children turn out to be the most successful.
  • We have for a while suggested that we think Aluminum will be the first commodity to turn – given its early decline, it’s higher growth rate and a two-year slowdown in capacity adds.
    • We have been thwarted by the slowing global industrial economy – which is a bad thing; but also by a major draw down in speculative inventories, which is a good thing – Exhibit 1.
    • Some of these speculative inventories have apparently moved to a field in Mexico (WSJ article), but overall inventories appear to have fallen substantially and to more normal levels over the last 18 months.
  • While industrial demand growth has slowed, we continue to see penetration of Aluminum in the auto industry and demand growth for the metal still exceeds underlying IP growth.
    • The pressure on pricing is as much a function of the number of sellers as it is the overall supply surplus – the increase in the number of players globally probably creates opportunity.
  • We do not believe that the new Alcoa will be around in its spun out form for long. We would expect to see another round of consolidation in Aluminum, much as we are seeing in Industrial Gases and Ag (seeds and chemicals).
    • Competition authorities cannot ignore the global nature of the business and the many new suppliers in China.
    • Alcoa could instigate a merger but is more likely to be the target – either from bigger metals companies or from one of the Chinese producers.
  • Given the slowing nature of aircraft orders, we might be more inclined to own the old part of Alcoa rather than the new part, depending on how the relative valuations look post-split.
    • The fundamentals of the old piece may look better than for the new piece.

Exhibit 1

Source: Bloomberg

Overview

Yes – it seems like the horse is dead and yes, it seems like we are still flogging it, but we don’t think we are wrong. Fundamentals still look better for Aluminum, despite the alleged antics of one China based producer, than for any of the other globally oversupplied commodities:

  • Demand growth is a couple of hundred basis points higher than for the rest (such as steel, TiO2, PVC, caustic soda, and iron ore).
  • Oversupply happened earlier than for other commodities, so companies have been losing money for longer and cut back on investments some time ago.
  • The industry has cut capacity in the West dramatically.

We now believe that we will see another catalyst – consolidation. If the regulatory authorities are willing to look at Ag, PVC and chlorine as global businesses – why would Aluminum be any different? We believe that one of the primary reasons why Alcoa is separating into two companies is so that the commodity piece can participate in consolidation.

There are plenty of possible consolidation partners and as both Exhibits 2 and 3 show, even putting two of the largest players together would not have any meaningful impact on a global Herfedahl Index. The new Alcoa could get acquired, depending on value and balance sheet, but is just as likely to either participate in a merger of some nature, either with another publicly traded company or with the aluminum business of another company, perhaps using a tax efficient route such as a reverse Morris Trust.
Exhibit 2

Source: Bloomberg

Exhibit 3

Source: Bloomberg, Company Reports

Inventories Moving In Some Of The Right Directions

Assuming the Mexico aluminum stockpile is an isolated incident – i.e. there are not 10 such situations around the World, the available data suggests that inventories are coming down at the more speculative level. LME inventories are down dramatically from their peak – Exhibit 4 and are approaching the more normal levels seen prior to the widely publicized run-up in 2009 which helped create excessive apparent demand and higher pricing. Given the growth rate the industry has seen, current LME inventories in terms of days of demand are back to normal.

Exhibit 4

Source: Bloomberg

China – Clearly Still The Problem, But Slowing

China now has more than half of the world supply of Aluminum and its increasing levels of export have pressured pricing in the rest of the world – and caused the market structure response indicated in Exhibit 3. But Chinese exports are falling, assuming the official data captures all the material heading to Mexico in the last 18-24 months – Exhibits 5-6.

Exhibit 5

Source: Bloomberg

Exhibit 6

Source: Bloomberg

Pricing

Aluminum pricing continues to bounce along the bottom and is well below a 20-year average – Exhibit 7. While not at its lows relative to crude oil any more – Exhibit 8 – it is still very far below history and if crude is a proxy for the marginal producer cost it confirms that this is an industry with little to no margin today. Price are low relative to coal – Exhibit 9 – but have risen recently relative to steel – Exhibit 10 – because of lower steel prices. Aluminum remains very attractively priced versus competitive materials such as steel and engineering plastics; not as cheap as it has been on a relative basis, but cheap enough to continue to gain share in our view, particularly in autos where the driving factor is weight and while price is important, weight is the key driver.

With inventories down – the destocking will have had a negative impact on price – and China exports slowing, we believe that we are setting up for a change in direction in aluminum pricing.

Exhibit 7

Source: Capital IQ

Exhibit 8

Source: Capital IQ, SSR Analysis

Exhibit 9

Source: Capital IQ, SSR Analysis

Exhibit 10

Source: Capital IQ, SSR Analysis

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