Rising Production Costs Will Be Continuing Obstacle for Chalco

Chalco's ACH results for the second half of 2010 reflect a growing concern about cost control at China's largest aluminum producer. Strong aluminum prices in the last half of the year caused a slight increase in revenue, offsetting the lost sales volume from production cuts at some of the company's aluminum plants. However, higher production costs, primarily electricity, cut margins in half compared with the first six months of 2010. The company announced plans to tackle rising costs, which could eliminate CNY 2.25 billion （$342 million） in expenses through better procurement efforts, reduced fuel consumption, technology upgrades, and other expense controls in the year ahead, but we think inflationary pressures will keep margins depressed and we plan to modestly lower our fair value estimate.

We maintain our view that higher aluminum prices are unlikely to unfold in the near term. We think rising prices would only exacerbate an ongoing supply problem, particularly in China. Chalco expects Chinese aluminum consumption to outstrip production （excluding net imports） by about 1 million metric tonnes, even higher than Alcoa's AA earlier prediction of a 700,000-tonne deficit in China in 2011. We think this is probably too optimistic, given the country's growing capacity while smelters in lower-cost areas are starting to come back on stream. The China Nonferrous Metals Industry Association said this week that China's aluminum sector would continue in a period of low profitability where supply will exceed demand through 2015, when annual capacity could be as high as 30 million tonnes （from the current 22 million）. This is troubling because smelters in China are among the highest-cost in the world, and added capacity in lower-cost areas is under construction as well. We think permanent capacity reductions in China would improve the health of the industry.