Catching the Wave

SPECULATIVE INVESTMENT. Throughout the past year, a number of scrap metal dealers have pointed to the growing role of investment houses in driving nonferrous pricing. While copper has attracted much investor interest, aluminum also is becoming popular with some financial groups.

According to a report by Davenport Equity Research, Richmond, Va., in addition to several traditional funds becoming involved in the aluminum market, other investment houses are taking long-term stakes in commodities as a way to diversify large portfolios.

The Davenport report notes that there is a fair amount of uncertainty as to whether this new investment vehicle will continue to play a major stake in the market after a price correction takes place.

Stewart Spector, president of The Spector Report, Hawlett, N.Y., says one of the growing trends for aluminum (and ultimately secondary aluminum) has been the growing presence of hedge funds, speculators and commodity traders. Already, investors have been playing a greater role in the volatile movement of a host of other metals, including copper. "Speculators have been increasing at a phenomenal rate," Spector says.

Although the expectations are that aluminum should continue in a moderately upward trajectory, a recent report by Alcoa doused the commodity with cold water.

In its quarterly report, after reporting strong profit growth, Alcoa also notes that it expects demand for aluminum to remain strong through next year. The bullish tone indicates that with a global economy still showing strength, demand should remain strong. However, in the much shorter window of the next quarter, Alcoa expects a slowdown in some end markets, accompanied by a decline in prices. While normally a decrease in prices would be cause for concern, for aluminum this is typical of the summer slowdown, when auto production cools down and housing starts also decline.

Although auto sales may cool down, the overall transportation sector should be a fairly healthy market for aluminum. As fuel efficiency is a growing concern for the transportation sector, demand for aluminum should grow. Even with the domestic auto industry’s problems, overall forecasts for the transportation sector, which includes aircrafts, trucks, etc., predict a strong boost throughout the next several quarters.

Starting with the demand for the finished products, it appears that buying should remain fairly strong. Leo Larkin, an analyst with Standard & Poor’s, says that global demand remains in balance. "There is no reason for prices to drop too far." Larkin adds that the price of aluminum wouldn’t have lagged so badly if China didn’t flood the market with material.

The Davenport report echoes these remarks, noting that while some economic bears feel that many of the commodities have reached bubble-like status and are destined to show sharp declines, "Physical demand in China could last another decade." According to Davenport, "We believe that the fundamental thesis of a supercycle is very much intact. Of course, there will be waves of supply addition generated by high prices and further recessions will reduce demand temporarily."

This situation reflects very similarly with a host of other metals that are enjoying healthy demand, which is keeping floor prices high.

At the same time, one of the benefits for aluminum relative to other metals is the product’s position in the consumer packaging business. This segment may be ubiquitous to consumers, but the entrenchment of aluminum in packaging, especially beverage containers, helps prevent a sharp drop in overall aluminum production when auto or housing starts soften.

A CAREFUL BALANCING ACT. Ferrous markets may have captured much of the ink during the past several years in light of the flurry of mergers and acquisitions. However, much of the world’s aluminum market already has consolidated, with one large exception. That one exception is China, which has a sizable amount of small aluminum smelters scattered throughout the country.

With so many smaller businesses, it is likely that many of the "mom and pop" operations will be closed, leaving much larger smelters operating.

While a great deal of uncertainty surrounds production levels for aluminum in China, there are several opinions about what will happen in China going forward.

Spector says that the speculation regarding consolidation among Chinese aluminum smelters has traction. The Chinese government, which has been attempting to close smaller production facilities for steel, also will likely attempt to reduce the total number of aluminum consumers and boost the most efficient facilities.

Several other analysts note that after torrid demand growth, the Chinese market is destined to slow down a bit, which could reduce the demand for aluminum. It seems inescapable that any commodity’s short- and long-term market potential won’t be affected by the Chinese market.

In a presentation, Alain Belda, chairman and CEO of Alcoa, based in Pittsburgh, noted: "China is tracking an established path in aluminum consumption per capita as it develops economically; per-capita consumption remains low by developed nation standards. While primary aluminum production in China has increased dramatically, the growth rate of primary output is now slowing. Going forward, we expect China to be a net exporter of aluminum semis, and China will revert to a balance between primary aluminum imports/exports in the next year or two."

The Davenport report forecasts that China’s aluminum consumption should grow by 18 percent this year, compared to around 3.4 percent for the United States and 2.6 percent for Western Europe.

While the growth expected for the rest of this year is robust, the report speculates that aluminum markets will likely soften next year because of a combination of slackening demand from China and a decline in usage in the truck market.

Another factor playing into the aluminum market is the potential for further production cuts in Europe in response to high power costs. Escalating power prices, according to Davenport, have emerged as the critical issue facing the aluminum industry.

Also, China has more power available, and because of a surplus of alumina, even more power will be available. "In fact, we have increased our 2006 estimate for Chinese production to 9.3 million metric tons, up from the previous estimate of 8.6 million metric tons," the Davenport report states. "With this increase, we estimate global production rising 5.6 percent to 33.6 million metric tons in 2006 and 4.1 percent to 35 million metric tons in 2007."

A key issue that will influence aluminum markets is the actual supply of the material presently on the market. With hedge funds, investment houses and various financial institutions playing a greater role in commodity trading, several analysts note that reported supply levels and actual supply levels come into question.

Larkin points out in a recent article that the aluminum surplus has been tightening, with the surplus shrinking from 738,000 metric tons in 2002 to half of that by 2004, with expected further reductions.

Adding to the overall uncertainty, several analysts note that aluminum stocks in China continue to be underreported, though many people say they feel there are large blocks in the country. Other regions of the world also undoubtedly carry more material on hand.

However, Spector notes that some of the fundamentals that would move material, notably supply and demand, are absent to a degree. Inventories at the London Metals Exchange have declined, though Spector feels that sizable lots of aluminum are sitting in warehouses.

Moving forward past the short term, Davenport Equity Research writes: "Our deficit forecast over the next few years are predicated on slower capacity growth and reasonable, though slightly below trend, growth in demand. We project capacity growth to average 3.1 percent per year over the next four years vs. 7.6 percent over the last four years."

The Davenport report continues, "We have great visibility on capacity growth, given a construction time of three years plus one to two years for feasibility and financing. The great capacity bulge in China experienced in recent years appears to be over with the government actively discouraging new projects."

One of the largest wild cards is the energy cost structure. Several years ago soaring energy costs in the Northwestern United States forced a number of aluminum pot lines to shut down. While traditionally, because of high energy costs, China has been one of the highest cost aluminum smelting countries, European smelters could replace Chinese smelters as the highest cost facilities in the world, according to Davenport.

Spector also agrees that Chinese aluminum producers operate at the high end of the cost curve, compared to other regions of the world.

LOOKING DOWNSTREAM? While there has been some discussion about some of the large upstream mining companies looking to possibly extend their businesses by acquiring one of the larger aluminum companies, several industry observers feel that the move doesn’t truly make sense.