Recent Stock market Outlook is Not Bright for Aluminum Producers

This past week stock market and commodity bulls alike pointed to a solid earnings report from the world's second-largest aluminum producerAlcoa as proof that the global economy is continuing to strengthen. Alcoa reported that its net income dropped 69 percent and revenues were flat at $6 billion as compared with the year prior, which was above expectations. More importantly, the company announced profits of $94 million for the first quarter of 2012 and forecast continuing demand growth (7%) this year.

However, if investors look beyond the headlines and actually dig a little deeper, they will find that the outlook is not so bright for the global aluminum industry.

These concerns were recently voiced by the chief executive of the world's sixth-biggest aluminum producer, diversified commodities companyBHP BillitonADR. Its CEO Marius Kloppers said simply, “I don't like aluminum” and told investors in February that the aluminum division of BHP would be run strictly as a cash generator. Mr. Kloppers went on say that the industry is suffering from a structural profitability downturn as opposed to a cyclical profitability downturn. He is free to say that since aluminum is such a small part of his company, unlike Alcoa.

At another large commodities company and aluminum producer,Rio Tinto PLCADR, its two top executives passed up their lucrative bonuses after the company was forced to write down $8.8 billion on its aluminum assets. Rio Tinto purchased Canada's Alcan in 2007 for $44 billion, burdening the company with a boatload of debt with which it is still struggling.

The cause for concern by Mr. Kloppers and the source of the problem for Rio Tinto is too much supply and rising costs for electricity. Excess supplies have led to a decade of challenging conditions and below par profitability for the industry. This is important to point out since commodities as a whole have enjoyed a stellar decade.

Years of excess aluminum production have led to a build up of inventory. This inventory is now estimated to be more than 12 million tons which is enough aluminum to build 180,000 Boeing 747s and who knows how many aluminum cans.

Much of the excess supply has come from China, which is the world's largest aluminum producer. One of its main producing companies is theAluminum Corporation of China, which is better known as Chalco. The hope for the industry is that Chinese producers like Chalco will reduce their output due to soaring energy costs. China has some of the highest cost smelters in the world.

Many in the industry predict that China will soon be forced to shut down much of their high-cost aluminum output and become a major importer of aluminum in order to meet strong domestic demand.

But that is probably wishful thinking by some members of the industry. Despite high costs and low prices, Chinese aluminum production hit a record of 53,000 tons a day in February, according to analysts at Barclays. In addition, China is going on a major expansion drive, with plans to build another 10 million tons of annual capacity – enough to meet 60% of Chinese demand – in the western part of China over the next three years.

Instead of waiting for a miracle from China, the global aluminum industry needs to cut capacity. Since June, only 3 percent of global capacity has been axed. Alcoa plans to cut another 530,000 tons of capacity and other producers are making other similar minor cuts. But these are far too small to eliminate the supply overhang and raise the price of aluminum much above the current $1.12 a pound. Keep in mind that Alcoa's costs to produce aluminum is $1.11 a pound. This paper-thin margin is endemic across the industry, making it suitable only for investors willing to take a gamble on the future course of events in China.