Aluminum – Perhaps Too Cautious Too Soon!

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

June 23rd, 2014

Aluminum – Perhaps Too Cautious Too Soon!

  • Aluminum pricing has maintained the positive, albeit volatile, path we have seen since the beginning of the year. This suggests that demand growth remains very robust and that we are not seeing the persistent supply response that drove prices ever lower through 2012 and 2013.
  • There remains overcapacity, especially in China, but pricing had moved so low that exports were clearly under water economically for the local producers. Perhaps we are starting to see some more rational behavior from China or perhaps local demand is beginning to soak up some of the local overcapacity. More likely, with no new capacity outside China, the world increasingly needs China exports to meet demand.
  • China remains a major risk, as local demand growth may falter, as it has for other construction related materials, and this could throw more aluminum products into the export market. This would effectively cap pricing, but possibly at a level better than the lows seen at the end of last year.
  • Alcoa has seen positive revisions for the first time in years – Exhibit 1 – and this is helping to move the stock higher. We indicated in recent research that the easy money had been made in AA and that prices needed to rise to get more – well prices are rising and revisions are positive.
  • Aluminum remains very cheap versus competing products and even with another 10-20% of pricing would still remain very attractive.
  • Downstream moves by Alcoa may limit how much of any pricing increase can move to the bottom line, but in our view the company remains the best way to play an improving Aluminum market. We think the stock can double if Aluminum remains on its current trend.

Exhibit 1

Source: Capital IQ, SSR Analysis

Overview

When we wrote about Aluminum and Alcoa a couple of months ago we suggested that the easy money had been made and that for the stock to do better, aluminum prices had to rise. We were uncertain about when the world balance would be in such a condition to allow that to happen, but it is possible that it is already sufficiently balanced, as the pricing trend since the early part of the year has been very different than for the recent prior years.

While volatile – prices are clearly trending upwards since the beginning of this year – see Exhibit 2 – and while the pessimists can point to the drops that we saw in April and March, the recent trend is evident and it is a recovering trend.

Exhibit 2

Source: Capital IQ, SSR Analysis

The driver here is demand growth, which remains very high, and well above the historic average of 4.5% per annum. We see no reason why the growth rate should slow meaningfully as aluminum remains cheaper versus its competing materials than at any time. Moreover the strong trends in aerospace and autos are driven by fuel economy goals that will remain very aggressive, partly because of mandates and partly because of simple economics.

The demand uncertainty remains commercial construction, and while this may be a risk in China – because it could slow – there is pent up demand in the US and Europe which could be a positive.

Pricing for Aluminum can increase meaningfully before any substitution decisions occur.

Alcoa has seen some positive earnings revisions this year – for the first time since 2010 and we would expect these to continue as long as pricing continues on its current trend.

China remains the wild card as it is still unclear to us exactly what the local balance looks like. It is possible that we could see another step change in exports and that prices could fall again, but capacity additions have slowed and at some point the export pressure should begin to decline. However, given that capacity additions outside China are almost zero, global demand growth actually requires increasing exports from China.

Given that Alcoa has invested downstream, the company will likely not be able to take aluminum price increases all the way to the bottom line dollar for dollar. However, some price increases will be passed through and this should drive continued positive revisions and price appreciation. We would stick with the story at this time.

Aluminum pricing is improving but relative pricing still very low

We have shown some of these charts in prior work, but they illustrate why we believe that Aluminum demand growth can remain above the historic average. Aluminum pricing can recover quite a bit further before any of competitive dynamics change meaningfully. Again we show the relationship with crude oil because we use that as a proxy for engineering plastics derived from crude oil fractions. While chemical feedstock prices are low in the US, they are not low in the rest of the world and those markets set global pricing.

Exhibit 3

Source: Capital IQ, SSR Analysis

Exhibit 4

Source: Capital IQ, SSR Analysis

Exhibit 5

Source: Capital IQ, SSR Analysis

Exhibit 6

Source: IHS, Capital IQ, SSR Analysis

China Exports Continue On Their Upward Trend – But The World Needs The Product

Latest export data from China shows a slow continued upward trend – Exhibit 7 – but we should note that this trend is supplying a world market that is growing at more than 6% a year and is not adding any capacity. Given that there is no incrmental supply outside China – China needs to grow its exports of aluminum products to balance the market.

The day China cannot make up the additional supply that the world needs, prices will rise much more meaningfully in our view.

Exhibit 7

Source: Bloomberg, SSR Analysis

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