Aluminum Market Showing Signs of Stress

Extravagant claims recently made by United Company Rusal, the world’s largest aluminum producer, in a Financial Times article reflect more hope than reality.

“More than 4.5m tons of global aluminum production will be idled [by the end of] 2012 due to the fact that global aluminum prices are, based on Rusal’s estimates, below the break-even point for the majority of aluminum producers,” the statement read.

That amounts to about a tenth of global aluminum demand this year, according to the FT, yet only a fraction – 125,000 tons – is coming from Rusal itself. Rusal is a comparatively low-cost producer, yet is flirting with posting a loss for this year; published figures are muddied by write-downs on shareholdings in Norilsk Nickel and a reduction in the value of its bauxite facilities in Guinea.

Nevertheless, the underlying numbers are pretty dire.

Alcoa also reported a net loss for the second quarter, even though most of the firm’s profits come from higher value-add semi-finished products.

So are Rusal’s predictions of widespread closures pie in the sky, or are the long-awaited capacity cutbacks finally starting to happen?

An intriguing article by Andy Home of Reuters analyzes the premiums paid for physical aluminum deliveries and, in the process, weighs up the relative contribution made by the stock financing community and the metal consuming community.

As this graph from Reuters illustrates, the Japanese physical aluminum premium has never represented much more than 6 percent of the metal price as measured by the LME:

But recently it has shot up to 11 percent in the third quarter and on the basis of spot prices currently being paid in Asia, is likely to hit 14 percent or more by the fourth quarter.

Nor is Japan alone, but all the physical premium markets – Asia, Europe and the North American Midwest premium are moving up and indeed are converging, suggesting they are all being driven by the same fundamental tussle between the investment community looking to tie up metal in long-term financing deals, and consumers looking to access metal for processing.

To gain a relative measure of the two, the article states that Japan buys about two million tons of aluminum a year, mostly on the spot market, making the country one of the single-biggest influences on the physical flow and pricing of the metal. This is why the Japanese quarterly premium has over time become a benchmark for physical premiums everywhere else in Asia.

Yet in one location alone, Vlissingen in the Netherlands, the flow of metal into and out of LME sheds for stock financing has already totaled 1.14 million tons this year. But if the market is in surplus, as analysts suggest, Reuters suggests there can be but two reasons why premiums are rising so fast and so far.

Either demands from the financial sector are increasing, or physical supply is contracting and has not shown up in a measurable way. The financial stock and finance model has been around for years and there is no evidence to suggest demand has recently increased, so could it be supply is finally becoming constrained?

Primary producers certainly have an incentive to sell as much metal at spot as they can, with a $250/ton premium being enough to lift some from loss to profit on each ton sold. Reuters suggests production outside of China has fallen by around 1.2 million tons annualized since the fourth quarter 2011, a more realistic figure than Rusal’s 4.5 million tons, and if correct could be enough to bring the market almost into balance. Last year’s surplus was put at 1.74 million tons by the WBMS, but consumption was rising faster than production.

Further evidence of stress can be seen in the LME forward curve. The strength of the forward curve underpins the whole primary metal stock financing business, although finance periods are typically 18 months+. As an example, the 3-month premium was recently $41/ton; today it is below $23/ton.

Everyone agrees it is untenable at current sub-$1,900/ton levels in the longer term — but are physical premiums rising to unprecedented levels and a flattening of the forward curve the first signs of a rise on the way?