Alcoa Reveals Alumina Price Strength

Alcoa AA reported headline second-quarter income of $322 million, a 5% increase from the first quarter. Favorable from Alumina's AWC perspective is that alumina drove most of the gain for Alcoa, with headline segment income rising 31% to $186 million. Alcoa's alumina result has proved a reliable indicator of Alcoa World Alumina and Chemicals' profitability. If the pattern holds true to form, the strong second-quarter alumina result implies that our prior $210 million first-half AWAC profit forecast is probably a little underdone and should be closer to $300 million.

Higher second-quarter prices and volume were partially offset by increases in energy and raw-material costs and the weak U.S. dollar. Quarterly alumina production, revenue, and shipments were records. Compared with the first quarter, AWAC alumina production rose 3% to 4.1 million tonnes, almost 10% above the 3.8 million-tonne 2010 quarterly average. More important, pricing reflects the new and much more favorable spot market's gradual replacement of legacy contract sales.

Just over half of AWAC's alumina sales are to third parties. The realized second-quarter third-party alumina price increased 7% to $390 per tonne, but intersegment sales were struck at $410 per tonne spot, an 18% increase on the first quarter. The average second-quarter price increase of 11% to $400 per tonne was ahead of expectations. It highlights the potential for revenue enhancement as the remainder of the third-party contracts roll off at the rate of about 20% per year. Currently only around a fifth of third-party sales are subject to spot pricing. Could that climbing intersegment sale price finally spur a bid from Alcoa?

We estimate first-half unit operating costs rose 25% to just under $300 per tonne as fuel and caustic prices continue to pressure the industry. Higher capacity utilization as production increases is a partial offset, and new lower-cost Brazilian capacity also helps. But energy and caustic inflation is expected to persist regardless.

Interesting, then, is the Gillard government's proposed AUD 23 per tonne carbon tax. Alumina CEO John Bevan says that without full detail of the legislation it is not possible to determine if Australia's alumina and aluminum industries remain competitive. Much hinges on energy-intensive trade-exposed industry permit allocations not decaying before overseas competitors adopt comparable carbon pricing.

It's worth considering that around 17% of our Alumina valuation rides on the back of aluminum smelters (all Australian-based). Alumina refineries constitute the balance, of which around half by tonnage are Australian-based--slightly more by value--those refineries being some of the lowest cost. In all, about 70% of Alumina's value is subject to Australian legislation. The scheme proposes 94.5% free permit allocation applying to smelting and refining, declining at 1.3% annually with a 90% floor expected if 70% of relevant global competitors do not have comparable carbon constraints.

Working further in Alumina's favor is that Australian refineries are gas fired--gas being around half as carbon-intensive as coal. In 2010, Alumina says its 40% share of AWAC's Australian operations produced around 5 million tonnes of carbon dioxide equivalent. That might clip around 3% from Alumina's posttax profit if the 90% free permit floor holds. Given the uncertainty, the possibility a Liberal government may scrap it, the senselessness in sending state-of-the-art and comparatively low-emitting industries offshore to higher-polluting locales and the chance the tax might not be that material in any case, we include no discount for it in our Alumina valuation.

We have increased our fair value estimate for Alumina. Drivers include the higher-than-anticipated average alumina price. Higher operating costs are a partial offset. We see an improving industry dynamic, courtesy of the ongoing unlinking of alumina pricing from aluminum, and we retain our positive stance. This is a fundamental change structurally akin to the move to spot pricing for iron ore. We expect margins to widen, but not quite to the same extent.