Going Up

Global end user aluminum demand is contracting slightly. Global manufacturing activity (end user aluminum demand) in November contracted slightly for the third month in a row. The JP Morgan Global Manufacturing PMI (Purchasing Managers' Index) declined marginally to 49.6 from 49.9 in September on the back of worsening conditions in Europe and a slight contraction in China, Japan and Brazil. The new orders sub-index also deteriorated, down to 48.6 from 49.5 in October, implying contraction should continue in December.

Regional details showed that among the developed countries, the U.S. is clearly outperforming. The U.S. manufacturing sector grew at a slightly faster pace as the PMI increased to a five-month high of 52.7 from 50.8. In turn, the Japanese manufacturing sector slid back into contraction territory, and the euro zone faced the worst contraction in 28 months. Meanwhile, Chinese manufacturing activity contracted for the first time in 33 months as the PMI fell to 49 from 50.4. In the rest of the BRIC (Brazil, Russia, India, China) block, Russia accelerated, while India expanded at the slowest pace since April 2009. Brazil showed some improvement, though it contracted by its slowest pace in four months.

For 2012, our most objective tools suggest we will see more contraction in Europe, probably some modest slowdown in China, the U.S. will over-perform and the overall global economy will avoid recession.
 

Demand Defined
Other than in Europe, mill products demand is relatively healthy. Our best estimate is that after seasonal adjustments, global aluminum mill products shipments were unchanged month over month in October and stood 10 percent above one year ago, with the main support delivered by the auto sector. Probably the main takeaway is that U.S. auto production climbed in October to its highest level since March 2008, and vehicle sales rose to a 27-month high in November. In fact, mill products shipments remained fairly resilient, especially in North America, but also in China and Japan. Europe is undoubtedly the exception. In the case of the U.S., we have to point out that extrusions demand is holding on (helped in part by the auto sector) even when the housing sector remains depressed. There are reasons to expect at least a mild U.S. housing recovery in 2012, which should be translated into growing demand for extrusions and an increasingly tight billet market.

Demand for primary aluminum fell in October, stabilized in November, and was up a bit in December. Global apparent primary aluminum demand fell in October by a seasonally adjusted monthly rate of 10 percent to an annualized rate of 40.6 million tons, 1.9 percent above a year ago. Global apparent primary demand declined to its lowest level in eight months, driven by an 18 percent month-over-month drop in China, while falling in the rest of the world by 8.9 percent. Semi aluminum producers seem to have been especially wary to buy and preferred to rely on inventories as much as they could. This was strongly evident in China and Europe. Most recent evidence shows the LME (London Metal Exchange) thee-month-cash price narrowed considerably through the second half of November and has been tightening even further so far in December. This condition of a shrinking contango suggests a probable pickup in physical demand. Low prices could have been playing a role in stepping up spot demand. The three-month-cash contango narrowed up to six-month low levels of $4.50 per metric ton.

Physical demand in China also came back in the second half of November. The spread between three-month contract and spot domestic aluminum prices in China also narrowed steadily since the second half of November. It is clear that Chinese semi producers are still demanding less metal than what they actually need. There are ample re-stocking needs through the entire supply chain.

Fear levels as measured by the VIX (Volatility Index) in the U.S., Europe and China had come down in the last two months of 2011 to levels consistent with the idea that the first quarter of 2012 should experience a bounce in global demand that could be compounded by the fact that the first quarter is a strong seasonal quarter for spot demand.

On the other side of the market equation, poor profitability could close some capacity in the Western world in the first quarter of 2012. As expected, global primary aluminum production seems to have peaked in September. In October, a significant decline in China sent global output to a six-month low. Chinese aluminum output was sharply down in October on escalating power shortages and falling profitability. Practically all the monthly drop came from China, while the rest of the world as a whole was practically muted. It is difficult not to think that China's domestic output will come in below expectations in coming months on added cost pressures. Profitability issues due to ongoing low prices are also intensifying outside China and could lead to output cuts in the first quarter if the situation persists. In December, rest-of-the-world primary aluminum output average cash cost stood at $1,794 per metric ton (81 cents per pound) versus current prices of $2,065 per metric ton (94 cent per pound). At current LME prices, we estimate that 21 percent of non-China capacity is losing money on a cash cost basis (excluding income from premiums). Regionally speaking, 36 percent of this nonprofitable capacity is in Western Europe. The bottom line is that in the case that LME prices remain depressed or fall further and regional premiums continue to soften, it is reasonable to think Western Europe is the most vulnerable region to cut back more capacity. North America and Asia (excluding the Middle East) could follow. Overall, we continue to see escalating risks for global primary output.
 

Deficit Detail
In the meantime, it seems metal availability is increasing in Europe and the primary market is slightly less tight elsewhere. In the beginning of the second week of December, LME aluminum inventories at the Dutch port of Vlissingen accumulated a two-day buildup of 175,650 tons. Inventories stored at LME Vlissingen locations reached 888,800 tons. Moreover, inventories in Detroit saw a one-day increase of 98,400 tons, rising to 1.27 million tons. Total LME aluminum inventories reached fresh all-time highs of 4.81 million tons on the back of these inflows. It is important to note that market talk remains that massive inflows at Vlissingen and Detroit warehouses have been a result of material previously stored off-warrant in the same location now being registered into LME warrants. However, aluminum ingot premiums data indeed suggest that at least a portion of the buildup is actually explained by improving metal availability, especially in Europe.

Duty-paid spot primary aluminum premiums in Europe fell to 18-month lows of $150 to $180 per metric ton CIF (cost, insurance and freight), down from $180 to $200 per metric ton the previous month). Premiums in the U.S. and Japan have eased to their lowest levels in seven months, reaching 7.6 cents per pound in the U.S. ($167 per metric ton) and $112 to $115 per metric ton CIF in Japan. In turn, premiums in Brazil and China remain stable.

Our proprietary aluminum market balance indicator shows the global market continues to run at an underlying monthly deficit, though it is a fact that market conditions have loosened somewhat from September. Beyond short-term developments, our models suggest the primary aluminum market remains on the path of tightness, though it will register lower deficits than initially expected in 2011 and 2012. After 2012, the market is in route to register annual deficits of at least 1.5 million tons.
 

Pricing Particulars
By now, our models suggest more range trading for prices in the short term. It seems reasonable to say that the incoming data suggests prices should continue to consolidate mainly around current levels of $2,000 to $2,100 per metric ton (90 to 95 cents per pound). Although a quick visit below $2,000 per metric ton (90 cents per pound) cannot be ruled out yet. On one hand, a slightly less tight spot market in Europe, technical readings, current seasonal patterns and fund flows are currently delivered downward pressure to aluminum prices. On the other hand, it is a fact that a heavy short covering phase could arise anytime, as funds hold the largest aluminum short position ever and LME aluminum prices are increasingly undervalued with respect to secondary/scrap prices, China's aluminum domestic prices, aluminum production costs and global aluminum inventories. Additionally, market fear (VIX) has fallen to levels below 30, usually associated with bouncing demand and at least a slight bounce in prices. Mixed market signals are usually reflected in high price volatility in the midst of a range trading movement.

Looking forward, our models continue to indicate higher prices in 2012 to 2013. Industry fundamentals and economic cycle analysis support the view of an underlying upward trend in prices beyond the short term pause / correction phase. Our models suggest attractive demand growth supported by urbanization and industrialization in Asia, aluminum gaining market share in transportation, packaging and electronics, and pent-up demand in the US. The best long-term leading indicator we have suggests prices should experience an underlying upward trend for the next 36 months.

In the same line, our models point to higher ingot and billet premiums in the first quarter of 2012. Again, the exception should be Europe. Structurally speaking, global competition for material will intensify in the next few years. As we have said before, the Gulf Cooperation Council (GCC) in the Middle East will be the only region generating additional excess metal at the margin at least until 2015. In consequence, our models suggest we should see rising premiums across the board with special emphasis in the Americas, as those countries have the worst geographical position to attract metal.

Jorge Vazquez is founder and managing director of Harbor's Intelligence Aluminum Unit, which focuses on studying the global aluminum industry and providing industry intelligence, price outlook and risk management consulting to the entire supply chain around the globe. He can be contacted at jorgevs@askharbor.com.