Alcoa shows its mettle

Alcoa’s results overnight, and more particularly its outlook for the rest of the year, have injected a tinge of real optimism into an aluminium sector recovering from the ravages of the financial crisis.

The result, for the second quarter, also tends to confirm, albeit weakly, the emerging structural shift in the relationship between aluminium and alumina, with pricing continuing to diverge as the market for alumina appears to be disconnecting, to some degree at least, from aluminium.

The Alcoa result was better than expected, with increased demand for aluminium not quite offsetting a $US22 a tonne average price decline during the quarter. Higher production and slightly higher prices fuelled a strong increase in the profitability of Alcoa’s alumina business, which is good news for Alumina shareholders, given their 40 per cent interest in the Alcoa Worldwide Alumina and Chemicals joint venture.

More particularly, at a moment when the demand and prices for other major metals, like iron ore, is retreating quite rapidly as China’s economy slows and Europe and the US continue to splutter, Aloca CEO Klaus Kleinfeld raised his forecast for aluminium consumption this year from 10 per cent to 12 per cent. If that were borne out, Rio Tinto shareholders would also be overjoyed.

The aluminium industry was hit early and hit hard by the financial crisis and was forced to respond very significantly. Alcoa shut down about 20 per cent of its smelting capacity. Rio Tinto, which had completed an over-priced and over-leveraged takeover of Alcan just ahead of the crisis and was being stalked by BHP Billiton at the time, was equally aggressive in restructuring its operations and curtailing higher cost production.

So, there has been a significant withdrawal of supply and therefore a somewhat more leveraged recovery for aluminium than for other metals, like iron ore, where capacity was continuing to build despite the crisis. While prices have come off their post-crisis highs, and are still almost 40 per cent off their pre-crisis peak, they are still well above their nadirs and demand is recovering solidly.

The more intriguing sideline to the result is the performance of alumina, where the traditional linkage of alumina pricing to the aluminium price – it used to be priced as a fixed percentage of the LME price for the metal – has been breaking down. That trend seems to be continuing.

The traditional relationship between pricing of alumina and aluminium was a consequence of the integrated nature of the industry in the past. The emergence of non-integrated smelters in China and the Middle East, however, has driven the emergence of a discrete and rapidly deepening market for bauxite and alumina which functions in similar fashion to the nascent spot and short term contract market in iron ore.

The low value and high transport costs of bauxite drove the development of the integrated producers, who tend to have net long positions in alumina relative to their own internal demand. Most of the big producing bauxite resources are in Oceania and Central and South America.

With a couple of exceptions, the Chinese and other Asian aluminium producers have net short positions in bauxite and alumina and therefore they are importing increasing volumes, particularly of bauxite – driving the de-linking of alumina and aluminium prices in the process. China imports up to 30 per cent of its alumina and bauxite needs.

The overall relatively tight supply-demand position in aluminium sector, the relatively consolidated and crisis-rationalised state of production at the big end of the industry – particularly in alumina – and the growth in demand from the marginal non-integrated Chinese smelters ought to continue the decoupling of the prices of bauxite and alumina from the metal and the development of real spot and short term contract markets for those commodities.