Preparing For The Aluminium Boom

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By Greg Peel

The likely US recession has been having an adverse effect on commodity prices of late, but nevertheless the global mining sector has been clamouring to hear the latest news on what could be the creation of the world’s largest mining company. This is of particular interest for Australia of course, and very much so for China. Commentaries have centred around how a merged BHP Billiton ((BHP)) and Rio Tinto ((RIO)) would dominate the world’s iron ore market. With the iron ore price set to jump again this year – anything from 50% to 100% – the bulk commodity is very much in focus.

What doesn’t get quite as much coverage is that BHP Tinto would also become the world’s largest producer of aluminium. Aluminium was in the spotlight last year when Rio took over Canada’s aluminium giant Alcan, and at the time the speculation was that rival BHP would counter by taking a swing at US equivalent Alcoa. Nothing transpired, and soon enough speculators were beginning to think BHP might just have bigger fish to fry. And they were right.

Alcoa had probably been hoping for that knock on the door, for if BHP takes Rio the US producer is out in the cold. It is no great surprise that the Chinese should make some attempt to spoil BHP’s plans given China’s massive consumption of iron ore, but the spoiling party to date has not had iron ore so much in its focus. China’s national aluminium producer, Chinalco, has teamed up with left-behind Alcoa and taken a significant stake in Rio. Chinalco says it’s an investment, but most suspect the investment is really either a spoiling tactic or a springboard for a counter-bid.

Either way, the fight is in the aluminium market at present, and not in the iron ore market (if you don’t count current price negotiations). Yet aluminium has been the wood duck of the base metal complex over the great commodity bull run – idly going nowhere much while all other metals have taken to the skies at the first gunshot. Investors believing it would be one in, all in, in the Chinese commodity consumption story would be feeling pretty disappointed about any investment made in producers of aluminium. They have been the laggards of the super-cycle.

On an annual average price basis, aluminium has risen 54% from 2004 to 2007. By comparison, tin has risen 70%, copper 148%, nickel 169%, lead 192% and zinc 208%. Indeed, aluminium is the most abundant metallic element in the world, which puts it at rather a disadvantage to begin with. Aluminium is produced by refining bauxite ore into alumina, and then smelting that alumina into aluminium.

While most of us recognise aluminium’s use in soft drink cans (and beer, if you are so inclined), the greatest consumer of global aluminium is the transport industry at 26%. Therein follows packaging at 20%, along with construction at 20%, and the electricity industry at 9%. All other uses make up the remaining 26%. In the case of the electricity industry, aluminium can be used for wiring in the place of copper, and thus has become a meaningful substitute given the run in the copper price. (And there is a certain irony here – read on.)

No prizes for guessing which country now consumes the greatest proportion of the world’s aluminium. But the reason the aluminium price has not kept pace with other base metals prices is that China has also been the world’s fastest growing producer of aluminium. In 2007 alone, China increased its aluminium output by an extraordinary 35.4%. But consumption grew by an even higher 37.7%. Demand growth across the globe increased by 10% in 2007, but still we ended up with a surplus of 360kt. Production is keeping up with consumption globally, and the balance of sensitivities is very much controlled by China.

In fact, a lot of the aluminium price movement since 2004 can be contributed to the fall in the US dollar. The aluminium price as measured in euros has only improved slightly in 2007 over the 2001 price.

So why would you bother investing in aluminium? Well – it looks like the playing field is now changing.

One of the problems with aluminium smelting is that the process requires substantial amounts of electricity. To give you some idea, aluminium leaving Australia’s shores has consumed about 10% of the country’s electricity production. But so far Australia, abundant in its own coal, has not run into major electricity supply problems. The same cannot be said, however, for China. China is currently undergoing severe snowstorms which have cut electricity supply in provinces across the country. From the aluminium industry’s point of view, either the snow has shut down smelters, or the snow has cut the electricity supply, or the electricity supply has shut down anyway because it can’t cope with the winter demand.

China’s snowstorms have thus contributed to a recent spike in the aluminium price, but the snow will eventually melt. This will not, however, alleviate the fact that China cannot generate enough electricity at present to power its runaway economy. What electricity it can generate is becoming ever more expensive as the price of coal and oil also rise (in the former case, probably by over 100% this year). The Chinese government has been forced to consider just where precious electricity should go first. As the world has a surplus of aluminium, officials don’t have to look hard to find one consumer they may wish to restrict.

And such problems are not confined to China. South Africa is another major metal and mineral producer, and it is also suffering from power shortages at present, with no immediate solution to a pressing problem.

Thus the scene is set for global aluminium supply to perhaps become more constrained. There is already evidence that producers and consumers believe this is the case, as the long-dated aluminium forward price has begun to rise dramatically. Aluminium traders have reported a willingness from consumers to lock in one to two-year supply at higher prices now, while the producers have become reluctant to deal. One only need to look at the rising global cost of energy to appreciate that either the price of aluminium will have to rise, or aluminium producers will have to shut down, thus pushing the aluminium price up anyway.

Analysts at GSJB Were are predicting that global aluminium consumption will rise by another 8.7% in 2008. While demand will contract in the US and Japan, and halve in Europe, it will grow by another 20% in China. Other developing markets will also kick in, with demand in the Former Soviet Union rising 7.5%, Eastern Europe 4.5%, and Asia (ex-China/Japan) 3.9%.

On the supply side, Weres sees global production growth of 9.1%, made up of yet another 22% increase from China against a mere 4% from everywhere else. Add that altogether, and Weres comes up with a surplus of 500t at the end of 2008. That’s bigger than 2007, so the analysts also expect the 2008 average price for aluminium to be lower than 2007’s US$1.20/lb.

Well that’s not very exciting.

But wait. What is exciting is that the analysts suggests Chinese consumption growth will begin to outpace production growth, and as such China will become a net importer of aluminium in 2009. By this time, a modest bounce in OECD demand is also expected (particularly if the US pulls itself back on its feet). The market will move into deficit, and aluminium prices will begin to push higher.

UBS, on the other hand, believes the rising costs of aluminium production will impact a lot faster than the Weres analysts are predicting. The UBS analysts have set a forecast average aluminium price of US$1.24/lb for 2008, which they suggest is some 20% above consensus. They fundamentally disagree with any concept that the market will weaken over the next two years.

But wait. Citigroup analysts foresee circumstances which could push the 2008 price all the way to US$1.70/lb.

There’s not a whole lot of point, however, in getting bogged down by the specific price forecasts from resource analysts at any particular stage. They will change as the year progresses, as surely as night follows day. GSJB Were is presently forecasting a 2008 price of US$0.99/lb. JP Morgan, which tends traditionally to be conservative on commodity price forecasts, this week increased its 2009 aluminium price, but to only US$1.084/lb. However, the fundamental story behind why the price of aluminium has more upside than downside in the medium term is a compelling one. And it’s not just a simple case of believing in the 20-year Chinese super-cycle paradigm.

China has increased its aluminium production five-fold since 1999, to reach one third of total global output in 2007. The rapid industrialisation of China has surprised even the Chinese government. With an abundance of cheap labour and an abundance of cheap credit, production facilities of all description have sprung up in China seemingly overnight. It has been a mad scramble, with competition fierce and rewards tightly balanced at the margin. With little in the way of regulation in existence at first to control China’s ballooning industrialisation, the government has also had to scramble to try to keep control.

China’s power generation industry has not been able to keep up. Environmental degradation has run rampant, and aside from chronic localised air pollution and a rapidly decreasing proportion of clean drinking water, China is making a significant contribution to global greenhouse gases. Addressing the environmental problem is one thing, but China has to deal with its scarce supply of energy at the same time. The aluminium industry is one of the heaviest users of power, and China is a net exporter into a global market which is in surplus. It’s not really rocket surgery.

Over the past four years the government has been trying to curtail the profligate aluminium industry through a series of taxes and tariffs. In fact, the export of “primary” aluminium has indeed declined steeply from 2005. However, exporters have managed to sneak around the rules by exporting “semi-manufactures” instead. This definitional loophole has now, however, been closed, with export duties imposed on “semis” only last month.

The recent snowstorms have clearly caused temporary shutdowns in production facilities. Weres analysts believe, however, that the storms only served to exacerbate an already growing problem. Power deficits began to re-emerge in China late in 2007 mainly due to coal shortages, which were in turn due to the closure of smaller, unsafe mines, and simple infrastructure bottlenecks. (Australia knows all about infrastructure problems.)

Add the storms, and about 10% of China’s aluminium smelting capacity has been laying idle lately. However, there remains a question of what percentage will actually be back up and running once the snow melts, given deeper systemic problems.

The other major factor is one of cost. (Another problem Australia is very familiar with.) CRU international has calculated that the average cost of Chinese aluminium production rose from US46.7c/lb in 2003 to US$70.6c/lb in 2006. The costs of power, raw materials and labour have all contributed to the increase, along with the steady revaluation of the renminbi. While clearly the cost of oil, coal, gas and even uranium have increased by multiples in recent years, Weres’ analysts don’t believe those increases have yet been fully reflected in electricity prices, particularly not long-term contracted electricity prices secured by serial consumers such as the aluminium industry.

Obviously such costs have risen further into 2008, which should be reason enough to expect the aluminium price to do likewise. However, Weres suspects high-cost smelters in China would be prepared to run at a loss, at least for a while, if the local authorities thought it was in their interest. That’s one reason why the analysts are still downbeat about the 2008 outlook, as opposed to 2009.

The UBS analysts make the same argument for aluminium price upside as do Weres’, but they suggest the global aluminium market will move into deficit faster than the Weres team is predicting.

Citigroup throws another factor into the debate – that of bauxite supply. Electricity is one thing, but you can’t make aluminium without bauxite.

Before we move to on that story however, Citi notes that the electricity problem has other contributors. For example, while the national Chinese government is attempting to address the electricity consumption problem by increasing tariffs on aluminium exports, provincial governments in the meantime have been applying preferential tariffs to local smelters. China is made up of a lot of competing provinces who attempt to maintain “face” by outdoing each other in the great industrial revolution. One way to do so is to produce more aluminium than the next province, and if a bit of power cost relief is needed, so be it.

But the national government is on to it, and it has been leaning on provincial governments to dismantle preferential systems as half of China’s provinces experience rolling electricity “brown-outs”. Four provinces have since removed preferential tariffs, Citi reports, resulting in up to a 50% increase in power cost. That has to hurt at the margin.

It’s not quite as bad as it sounds, as 40% of China’s aluminium smelters have “captive power”. If you want to build an aluminium smelter, best to build it on the side of a hill next to a raging torrent. That way you can supply your own hydro power and not be so reliant on the national grid. The only problem is, China has also experienced a drought.

Just can’t win, can they? Drought here, snowstorms there… Sounds familiar?

But back to bauxite. While China does produce its own bauxite, Citi reports that bauxite imports now account for half of all demand, and all of the demand growth. More than 70% of Chinese bauxite imports come from Indonesia.

But now that Indonesia is looking to become a good global citizen (post-Soeharto), the government has moved to close down unlicensed bauxite mines on the basis of environmental degradation. This is especially so on Bintan Island and in Riao Province, which both happen to be popular tourist destinations. Citi suggests China will struggle to source alternative supplies, particularly the right sort of bauxite. (We won’t get into a chemistry lesson, but apparently some bauxites are better suited than others).

Citi thus suggests the global bauxite market could be pushed into deep deficit. Hence the aluminium market should also be pushed into deficit. That is why Citi has pencilled in a price of US$1.70/lb.

It appears that analysts will argue over considerations of timing, but there is little doubt the ultimate forecast is consistent. In the next year or two, it is hard to see the aluminium price going anywhere much but up, even if there is a bit more of a stumble first.

It should also be now apparent as to why a Chinese aluminium producer has been looking to muscle in on the Rio action

So how to invest in aluminium producers in Australia? Well that brings us back to the top of this article, given the Big Two (perhaps soon to be one) are BHP and Rio. Investing in these two leviathans involves a myriad of competing factors. However, the stand-out pure-play in Australia is Alumina Ltd ((AWC)).

Analysts all agree that the short term earnings outlook for this serial underperformer is pretty grim. As an alumina/aluminium producer, Alumina Ltd is facing all the same cost problems being faced in China, the production growth outlook is pretty flat for 2008, and aluminium will remain in surplus globally, at least for a while. But Alumina, in joint venture with Alcoa, boasts an enviable portfolio of smelting assets that cannot be replaced at today’s prices. That’s why six out of ten brokers call the stock a Buy.

For more information on Alumina Ltd see “Alumina Ltd Is All About Assets, Not Earnings” (Australia; 01/02/08).

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