China Part 2: A Rational China? It Depends on Where You are Standing
In a recent interview with the China Daily, the CEO of Alcoa talked about the unprofitable nature of almost half of the China based Aluminum producers. We have no doubt that this is at least approximately accurate if not exact. Aluminum is in oversupply globally, and significantly, with capacity expansions in China the major culprit, as demand is robust and growing at a reasonable clip – see research that we published earlier in the year.
The industry hope is that rational heads will prevail in China and capacity will be cut – we offer some more pessimistic opinions here. Aluminum is not the first commodity material that a country or company has produced at a loss for a prolonged period. Moreover, it is not the first time for Aluminum nor is it for China.
Part of the problem is that Aluminum has a strong growth rate – faster in our view because the price is low (relative to steel and to engineering plastics). If you are faced with 30% over-capacity, but can see 6-8% annual local demand growth (as they can in China), the surplus capacity will in theory be used up in 3-4 years; so you hold your breath and wait. If the growth rate was only 2-3% you would struggle to see any light in the distance and you might be encouraged to take a more radical approach. Making matters worse, the good growth rate encourages new entrants – particularly in regions where a basic materials investment could be argued as a starting point to promote investment in peripheral or consuming industries. In a fast growing market, companies can go bankrupt, but the argument is almost always made to keep facilities operating or available to operate because of the expected future opportunity.
The basic chemical industry should have consolidated more radically than it did in both the early 1980s and the mid 1990s – see chart – and while plenty of companies lost money and some were restructured, most facilities still operate. The growth rate has played a big part here – 4+% global growth has encouraged companies to stay the course.
The other factor driving behavior is “peak profitability”. In the chart below one of the reasons why we saw closures in the early 1980s was that the basic chemical industry had previously made good money but not great money – when the downturn came some rational decisions were made. In the 1990s, margins were for a time lower than they were in the 1980s, but profitability had been so high in the late 1980s (returns on investment in excess of 100% for a 24 month period in some cases) that companies held on to marginal capacity with the expectation that the prior peak would be repeated (it never has been).
Aluminum is unlikely to be different, the growth rate is high, and at its 2007/2008 peak, aluminum pricing was close to double what it is today and, in 2007, AAs EBIT margins were 4x what they are today: plenty of incentive for the new guys to stay the course.
Aluminum is not alone – China is building a significant base in chemicals also, and could easily get ahead of demand (particularly when you add the expected rapid expansion of capacity in the US) – we have written extensively on this subject. We might see something similar in potash if all of the low cost producers push to replace price with volume. This is another example of where expected growth may keep people in the game, on life support but still breathing.
In all of these cases one of our favorite phrases applies – “Hope is not a strategy”. The idea that the actions of others will help your business is generally not an idea that evolves into something useful. Emerging or recently emerged economies want to have their own production base and they will continue to build – where they have a feedstock to exploit they will overbuild. Companies in the more developed regions of the world are for the most part going to need to solve pro-actively for these events and accept that the world is changing and the cycles will most likely be different.