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Not a Good Time for Aluminum

Posted on: November 12, 2008 - Email Article - Printable Version

Darrell Reid

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There’s no doubt commodities stocks have suffered, but few industries have struggled like the aluminum metals and mining segment. The most glaring indicator of the difficulties in this industry was most recently displayed by Alcoa Inc.’s [AA: 11.86, -0.25 (-2.06%)] horrid earnings. There couldn’t have been a “better” way to start the S&P 500 earnings season than to report a 52% drop in net income. With that said, a lot of the death and destruction has been priced into this industry and many companies are trading at trough multiples. Don’t be fooled by these metrics, aluminum will not be turning around soon.

The Market

Aluminum has been a continuously consolidating market. As of 2006 six companies operated fourteen primary mines and five major smelters. In 2006, RUSAL and SUAL of Moscow along with Glencore International of Swtizerland merged to create United Company RUSAL, the world’s largest aluminum company with a primary capacity of approximately 4 million metric tons per year. State-controlled Aluminum Corporation of China (Chalco) acquired several smelters in 2006 in an effort to consolidate primary aluminum smelting capacity. In North America, Alcoa Inc. accounts for over 50% of all aluminum production. China, Canada, Russia and the United States account for nearly 60% of global production. At the end of 2007, total world production stood at 38 million metric tons, up from 33.7 million metric tons in 2006.

What Happened?

The culprit of aluminum’s demise is most certainly the downturn in consumer auto sales and other transportation vehicles. In the U.S, the main uses for aluminum were transportation (34%) and containers and packaging (20%) in 2007. Aluminum is the second most used metal in the manufacturing of passenger vehicles in North America, averaging 145kg per vehicle. Last time I checked, October sales plummeted for Toyota [TM: 65.62, -0.75 (-1.13%)], GM [GM: 3.71, +0.06 (+1.64%)], and Ford [F: 2.58, +0.12 (+4.88%)] by 23%, 45%, and 35% respectively. Auto sales growth in China will slow to a screeching halt in the second half of 2008 to single digits. China’s disappointing PMI data for October released a weak reading of 44.6 causing analysts abroad to lower GDP expectations from 8.8% to 7.2%.

Energy prices haven’t helped either. Aluminum has a stronger bond than many other metals and must be dissolved through an electrolysis process and then reduced to its pure form. Electricity accounts for 20% to 40% of the costs of aluminum production. Electricity is typically generated from the use of various fossil fuels. It is common to see aluminum smelters strategically placed close to cheap electricity locations, but with the rapid rise in energy prices over the past year it’s easy to see why companies are struggling to make a profit. Also, the industry is fighting the cost escalation of key inputs such as natural gas, caustic soda, and calcined coke which have risen 47%, 88%, and 110% respectively.

Aluminum prices have plummeted over 35% since peaking along with copper, zinc, and oil. However, aluminum’s fall has been particularly steep since the spot price is currently below the marginal cost of production. That’s right- the aluminum fundamentals couldn’t be worse. Alcoa estimated one-third of world production is unprofitable at this time.

What to look for in 2009

With that said, this is a market condition that is not sustainable. The immediate reaction worldwide is to either suspend new capital commitments or reduce operations at high-cost production sites. Inventory levels are 70% above 5-year averages, a clear indicator of a market surplus. Companies such as Century Alumnium [CENX: 11.91, +0.19 (+1.62%)] have already delayed major projects and by doing so have been able to maintain a positive free cash flow position to protect against the expensive financing environment we have today. It is going to take time for the entire industry to react in the same fashion as Century Aluminum. As for the supply/demand fundamentals going forward, there isn’t too much upside. The industry is not sustainable at the current spot price around $0.845 per pound, but according to analysts, aluminum prices will not stray too far from the cash cost of production which is approximately $1.00 per pound. China has rapidly increased production at a pace above consumption, so look for governmental assistance in order to keep that market afloat. Consumption is expected to slow to 4.2% from 6.1% in 2008 and 10.5% in 2007. Don’t be fooled by the notion that “it just can’t fall any further.” It definitely can, and in the case of aluminum it most likely will. Avoid aluminum at all costs, there is nothing positive or promising about an industry surplus.

-Darrell Reid

Disclosure: None

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