Rio Tinto charge underlines weak outlook for aluminum

Rio Tinto's latest write-down of its aluminium assets supports our view that weak pricing and net market surpluses are likely to continue for at least the next two years, pressuring producer profitability, Fitch Ratings says.

The charge of between $10bn and $11bn is not a surprise given the state of the aluminium market. We estimate that between 30% and 50% of producers are failing to break even as high stock levels keep official prices in check and cheap electricity becomes scarcer. Over 5m tonnes of aluminium is held in official LME warehouses and probably the same volume again in unofficial storage.

The low prices caused by this oversupply are partly offset by high premiums in some markets for the physical supply of metal, because as much as 60% to 70% of the stocks are tied up in financial transactions. These premiums could rise further in the near term, but producers would still be better off with a higher base price and lower, more stable premiums.

Production cuts that could reduce the surplus have not been as deep as expected, especially in China where political pressure and high local premiums have kept smelters operating. Aluminium exchange traded funds (ETFs) have also failed to grow as fast as some producers had expected, limiting the impact they can have on stock levels. We therefore expect that surpluses will persist for the next few years. Prices could still improve in this environment, but our conservative assumption is for LME prices to remain broadly flat at $2,100 per tonne in 2013, with subsequent years continuing in a low price, high premium environment.

For Rio Tinto itself, the write-down will not damage its credit rating because the charge is non-cash and because the company's real strength is in its iron ore business, which remains strong with record production levels announced in its latest quarterly production statement. Persistent low prices will put pressure on the earnings of all producers but are not likely to hurt ratings. Both Rio Tinto and BHP Billiton have the diversity to offset weakness in aluminium, while Aluminum Corporation of China's rating is driven by its state ownership and Alcoa's strong liquidity should be sufficient to offset industry weakness.