China lobs a grenade into the aluminium supply chain

China's "Air Pollution Control" regulation was formally approved on Feb. 20 and published on Feb. 28. It came into effect on Wednesday.

It may sound pretty innocuous but, make no mistake, it represents a potential redefinition of the global aluminium market.

The world's largest producer of the metal will force aluminium smelters in four provinces surrounding Beijing to cut output by 30 percent over the winter heating season, which runs from the middle of November through the middle of March.

The news has lit a fire under the aluminium price. On the London Metal Exchange (LME) benchmark three-month metal has this week hit a near two-year high of $1,957 per tonne.

Some 40 percent of China's production capacity is potentially affected with analysts calculating a 1.3 million tonne hit on output.

That may yet prove a conservative estimate, though. The new directive will also impact raw material suppliers such as alumina refineries and carbon anode plants, sending shock waves down the length of the global aluminium supply chain.

FACTBOX on China's new pollution-cutting measures:

NO PRISONERS IN WAR ON POLLUTION

It might seem strange that Beijing's war on pollution is going to hit so hard aluminium, a metal that has been at the forefront of the "green" materials revolution.

But much of the affected capacity in the provinces of Hebei, Henan, Shandong and Shanxi sources its power from coal, which is the primary target of the new regulations.

There was understandable scepticism when the government first proposed the idea in January.

Everyone knows that you can't just turn an aluminium smelter on and off with the flick of a switch. It takes time to ramp down and ramp back up production and the financial costs on producers will be heavy.

The assumption was that powerful, politically connected companies such as Chalco would lobby aggressively against the forced curtailments or, as has so often been the case in the past, just ignore Beijing's orders with the connivance of local authorities.

But this time Beijing really means business.

The statement announcing the new law was jointly issued by some of China's most powerful bodies: the Ministry of Environmental Protection (MEP), the Finance Ministry, the National Development and Reform Commission (NDRC) and the National Energy Bureau.

It comes against a background of increasingly draconian inspections of industrial plants of all shapes and sizes led by the head of the MEP. Local environmental audit teams have been disbanded.

The message, according to Paul Adkins of AZ China, a consultancy specialising in China's aluminium sector, is "no more protecting local companies".

"If the local government guy fails to act to the standards set by the MEP, he goes to prison," Adkins told Reuters' Base Metals Forum on Thursday. It's "a sure way to gain compliance."

ALUMINA AND CARBON

It's not just aluminium smelters that will be affected.

Producers of alumina, an intermediate product sitting between bauxite and metal in the production process, will also have to cut capacity by 30 percent.

The four provinces account for almost 70 percent of China's alumina production and Adkins estimates that the winter cuts will mean the loss of 2.71 million tonnes.

This in a market that was already expected to be in marginal global supply deficit this year.

Moreover, refineries in Shandong rely heavily on imported bauxite, potentially transmitting the impact of Beijing's war on smog all the way up the supply chain to major bauxite suppliers such as Australia, India and Guinea.

The real sting in this anti-pollution tale, however, may be the hit on producers of the carbon anode that also goes into the smelting process.

As Adkins explained, carbon plants that fail to make the environmental grade will be closed over the four-month period but even those that do make the grade will have to curtail production.

"There's a large number of (anode) plants in the target area and we estimate the direct impact will be a loss of three million tonnes of aluminium capacity due simply to smelters' inability to source anodes for the production process."

The carbon shutdowns, in other words, could have a bigger impact on national aluminium production than the headline smelter curtailments.

SUPPLY SHOCK

Such a potential supply shock is unprecedented in the aluminium world.

This market's problem for many, many years has been over-supply, first and foremost in China itself.

Producers everywhere else have been forced to close smelters and curtail capacity in response to the country's ever-increasing production rate. China's share of global output has risen from 30 percent to 55 percent over the last decade.

The country has exported over four million tonnes of aluminium in the form of semi-manufactured products in both 2015 and 2016.

Only last week Russia's Russian Industry and Trade Minister Denis Manturov was mooting the idea of an OPEC-style organisation to regulate supply.

Years of excess should in theory provide a cushion against the sort of disruption planned by Beijing.

China itself was expected to generate a surplus in the order of 2.1-2.3 million tonnes this year, according to a Feb. 27 presentation by Roy Harvey, chief executive of U.S. producer Alcoa, at the BMO Capital Markets Global Metals and Mining Conference.

But with the rest of the world forecast to be in supply deficit of 1.5-1.7 million tonnes, the expected global balance is a much smaller 0.4-0.8 million surplus.

All such calculations have just been upended.

And although there is much speculative heat in the aluminium price right now, China's supply shock could translate into a fundamental reassessment of the light metal's pricing.

Of course, Chinese aluminium producers are going to pull every political lever at their disposal to try to escape Beijing's anti-pollution dragnet.

Particularly those with newer, cleaner plants, who will argue that they are being unfairly targeted at the expense of those using older, dirtier technology.

But as Adkins points out, as smog moves to the top of Beijing's policy agenda, simply ignoring its wishes is no longer an option.