We were originally asked by the organizers of a recent aluminum conference to address the topic “Aluminum: can momentum be sustained?” However, the reality is that the previous upward momentum has stalled. Moreover, there is a significant amount of uncertainty as to where prices will go from current levels. So the question we should really be asking is “Where next for aluminum prices?”
Many have come to the conclusion that prices have topped. We disagree. We remain bullish on aluminum prices and expect a further price peak early next year.
There is no doubt in our minds that global economies are slowing. Leading indicators of the Organization for Economic Co-operation and Development have topped, and Chinese industrial production has eased. Nonetheless, there are three key reasons supporting our bullish view on aluminum: demand is still positive (even if growth rates are slowing, they remain above trend); production is constrained (alumina is tight and energy prices are rising, with probably no other metal as sensitive to power shortages); and investor appetite for commodities is large, but funds are under-exposed to metals.
Growth rates
Let’s first look at Western World demand before turning to China. The U.S. remains the main driver in this market and has given a significant boost to consumption. However, rising interest rates are now causing some concern, though they are rising only gradually and from a very low level. In our view, the Fed Fund rate is unlikely to return to a “neutral level” of between 3.5% and 5.5% until the end of next year. This will continue to provide a fillip for growth.
Second, higher interest rates are normally associated with economic expansion. And there’s normally a good positive relationship between interest rates and metals prices. Through the so-called “third-quarter soft patch,” the U.S. manufacturing sector has remained strong. And we believe new capital investments will continue to drive metal demand, even if consumer demand slows.
We don’t dispute the fact that aluminum demand has slowed. But central to our positive view is that we see this as temporary rather than the start of a new trend. Indeed, order data from the U.S. Aluminum Association have fallen from their peak. And
In line with this, car sales have been disappointing and production cuts have been announced for the fourth quarter. But the increased intensity of the use of aluminum in new car models coming into production is offsetting some of this. More importantly, the outlook for other segments of the transport sector is upbeat. About half of total aluminum consumption in the transport sector is for light trucks, and aluminum demand for trucks and trailers is strong.
Although much smaller, aerospace is another strong end-use sector. For example, Airbus just announced a hefty increase in output for next year. It is also interesting to note that the sharp improvement in the metals component in the latest U.S. durable goods orders was boosted specifically by aircraft orders.
Physical premiums also show a strong aluminum market. Spot premiums are on the rise in all major consuming regions in the Western World. This reflects robust demand and low availability. The U.S. is especially strong. European and Japanese demand improvements have clearly been slower. Macroeconomic signals in both Europe and Japan remain mixed. But in Japan, it seems, an economic recovery could be more sustainable this time around. Contract premiums for the fourth quarter have just settled at 9-year highs, above US$90 per tonne.
Consumers in Japan and Europe have also benefited from stronger local currencies. Currency moves will continue to be important for aluminum prices. We expect the Japanese yen, for example, to strengthen against the U.S. dollar over the next 12 months. And the combination of local currency strength and higher economic activity is a powerful one.
Regarding availability in the U.S., physical market tightness is also a function of the strike action at Alcoa’s operations in Canada. There is even a risk that forthcoming labour talks will worsen the situation. Roughly 700,000 tonnes of primary capacity could be exposed to this risk.
We should not be surprised by the large number of labour disputes. There is a clear relationship between aluminum prices and labour costs. Labour unions are keeping a close eye on rising aluminum prices and using this as a bargaining chip for sizable wage increases. This also exemplifies the trend of real production costs being pressured higher. Strike action has had a distinct impact on actual output, and North American production growth is slowing as a result.
Turning to Chinese demand, prospects there are, of course, increasingly important for aluminum prices. China has, for some time, been a major contributor to global aluminum demand growth. But demand has also slowed in China, as is evident in the sharp fall in Chinese car production this year. However, it is important to note the fact that this follows dramatic growth last year.
Indeed, China has rapidly become the world’s fourth-largest car-producing country, from having a relatively small production output. In the past two years alone, Chinese car production has risen from 2 million to 5 million. This has more than offset weakness in other major car-producing countries.
The construction sector contributes relatively more to aluminum consumption in China, compared with the Western World. In China, about 25% of total aluminum consumed goes into construction, compared with about 17% in the U.S. It is also the segment of demand that would be most at risk if credit tightening were to intensify in China.
However, recent macro data for fixed-asset investment and inflation, for example, suggest that monetary tightening measures earlier in the year have been effective. Bank lending and domestic credit growth are slowing at a healthy rate.
Significantly, the underlying trend in aluminum consumption remains strong. Aluminum consumption per capita is low compared with other developed Asian countries. Urbanization and rising living standards in China will ensure a higher rate of trend growth in aluminum consumption going forward. Assuming a moderate slowdown in the Chinese economy over the near term, we estimate China will overtake the U.S. as the world’s largest aluminum consumer next year.
We see annual growth rates in Chinese primary aluminum consumption slowing to a still healthy 10% per year over the next couple of years, down from about 15-20% over the past three years.
Supply constraints
The second key reason for why we are bullish on aluminum prices relates to supply. The lack of raw materials and rising prices of energy and alumina mean operating rates are slowing.
Good progress has been made in reducing oversupply in the Chinese market so far this year, driven by several developments which we believe are set to be sustained for some time.
The most significant development is that the Chinese government has specifically targeted over-investment in primary aluminum smelting, and the National Development and Reform Commission is now discussing a new policy to ensure developments in the aluminum industry are “healthy and sustainable.” An estimated 500,000 tonnes of polluting Soderberg capacity has already been shut so far this year, and theoretically the remainder of the 1.4 million tonnes of Soderberg capacity are required to be shut by year-end. In reality, however, some of this capacity will be upgraded to “pre-bake” technology, and the closure of another 500,000 tonnes through the second half of this year seems likely. Curtailments have helped reduce production growth in China to about 12% in August, from hefty average monthly growth of above 25% in the past three years.
The second development inhibiting production growth is China’s severe power shortages. Not only are rising energy prices affecting profitability; there is also a physical shortage. Because of the energy inten
sity of the metal, aluminum smelters have faced sharper power rate hikes than have some other industries. In China, energy costs typically account for about 45% of primary aluminum production cash costs, compared with about 16% in Canada, for example. China is already far up the cost curve compared with other major aluminum-producing nations.
Unfortunately for the smelting industry, Chinese power shortages and higher costs are not temporary phenomena but structural problems that are unlikely to be corrected until 2006. Worse, rising energy costs are not isolated to China, and not even unlikely to disappear to one segment of the energy industry. Prices of natural gas, coal and oil are all trending higher.
Far-forward structural feature prices in the futures energy markets have moved up sharply — in oil, from US$20-22 per barrel in the 1990s to around US$36 per barrel today. This signifies that market participants view high oil prices as a structural, not just a cyclical, feature. Many see higher energy prices as a threat to economic activity, but supply implications for an energy-intensive industry such as aluminum will be important. No other industrial metal is as sensitive to power shortages as aluminum.
The third factor slowing output, aside from official restrictions and rising energy prices, is China’s dependence on imported alumina. Low commodity prices in recent years have led to insufficient alumina capacity. This has sent alumina prices soaring, and we do not expect alumina shortages to ease until 2006 either.
Apart from Chinese production curtailments, the recent fall in spot alumina prices reflects drawdowns of domestic alumina inventories. But, in line with a rebound in freight rates, alumina prices have also picked up again, and are preclusively high for Chinese aluminum smelters to make money, unless primary aluminum prices also move higher.
Given these operating constraints, production rates at Chinese smelters are down sharply, from about 97% last year to 90% this year, and we expect them to fall further through 2005 and 2006 to a low of 85%.
The combination of slower Chinese production growth and strong domestic consumption has already had a distinct impact on exports to the Western World this year. The reduction of the export tax rebate from 15% to 8% at the beginning of this year has had a significant impact, given the already-low level of profitability. The pending removal of the existing tax rebate should further reduce exports. However, ahead of this, deliveries overseas have risen in recent months — in line with London Metal Exchange aluminum prices trading at a premium to aluminum prices at the Shanghai Futures Exchange.
The recent rebound in exports also means that the Chinese market has tightened recently. As a result, stocks on the Shanghai Futures Exchange have started to fall and domestic aluminum prices have recovered. Going forward, though it is unlikely that China will re-emerge as a net importer of primary aluminum on an annual basis, we see exports falling considerably through 2005 and 2006, compared with their peak in 2003.
Investment funds
If the current slowdown in demand is only temporary and, as we expect, constrained energy and alumina have a dampening impact on aluminum production, aluminum prices could receive a significant additional boost from fund buying. This is the third key reason for our bullishness on aluminum prices. Investor appetite for commodities is huge, but exposure to industrial metals is, at present, modest.
Aluminum open interest has fallen sharply to its lowest level since July 2003, when prices were 25% lower than current levels. This partly reflects long liquidation. Given the fact that fund length is modest, there is a good chance investor buying will be attracted to aluminum specifically on positive signals.
Aluminum is a market in deficit, with falling reported stocks and a positive exposure to China. To reiterate, probably no other industrial metal is as sensitive to rising energy prices. Furthermore, aluminum underperformed the rest of the base metals complex so far this year — and indeed, this cycle. The risk-reward ratio is therefore relatively more attractive for aluminum than for other base metals.
In what has been a major commodities bull market over the past year, the performance of aluminum has actually been rather modest in comparison. The broader base metals complex has seen gains of at least 50% since the beginning of the fourth quarter of 2003. Aluminum’s percentage rise has been just one third of that. And prices have largely been flat since the beginning of this year, whereas copper, by comparison, is almost 20% higher.
This is in line with previous commodity price cycles, and consumers and producers generally appreciate price stability as it helps prevent major price-driven shifts in consumption or production patterns. There are good reasons to explain the underperformance of aluminum. The aluminum market has been far less tight than some other base metals markets; a large production surplus was in existence as late as last year, and inventories have also remained high in comparison to other metals. This is being rectified, and we could be about to witness aluminum’s time to perform.
The 2005 outlook is positive for aluminum prices, assuming Western World demand does not slow sharply and that there is no abrupt slowdown in the Chinese economy. The environment for supply is price-supportive but unlikely to take prices higher without the drive from demand. A good example of this was the power-related shutdowns in the U.S. Pacific Northwest in 2001, which resulted in the loss of 11% of global smelting capacity. However, this was still not enough to take prices higher, as demand growth was as its slowest in 20 years, though it did help cushion the price fall.
Although slowing next year, growth rates are likely to be above trend as U.S. interest rates are set to remain below neutral. Higher demand and output constraints have already brought the global aluminum market into deficit, compared with a large surplus last year, and caused sizable inventory drawdowns. Even the combination of slowing demand and rising supply will result in a wider deficit next year.
We do not believe the cyclical peak in prices has yet been reached. Under a golden scenario (obviously depending on the perspective you take), prices could even go to US$2,000 per tonne, though that would require an upside surprise to demand and severe supply disruptions, possibly coupled with another move lower in the dollar.
More realistic perhaps is our base case scenario, in which we expect prices to reach a cyclical peak of US$1,850 per tonne during the first half of next year. In the current trend-less market, the involvement of investment funds is limited, but given aluminum’s underperformance so far in this commodity bull-run, and a backwardated market, funds would be keen to add long exposure on positive signals.
Through 2006 we expect prices to soften in line with easing market tightness but do not expect prices to fall back to previously low levels in coming years. This is in line with a strong underlying trend rate in global demand growth and upside pressure on input costs. As a result, we think far forward prices will remain supported at relatively higher levels, in line with the current trends in other commodity markets.
— The preceding is an edited transcript of the author’s presentation at the Metal Bulletin’s 19th Aluminum Conference in Oslo, Norway, in September. The opinions presented are the author’s and do not necessarily represent those of the Barclays group. For access to all of Barclays’ economic, foreign-exchange and fixed-income research, go to the web site at barclayscapital.com. Queries may be submitted to the author at ingrid.sternby@barcap.com
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