Aluminum has been the least preferred metal among equity investors given its high inventory levels, dependence on energy prices, and excess-supply situation. Aluminum prices remain 25% below their prerecession peak at nearly $2,500 per metric ton while prices for copper and tin are at record highs. We believe the long-term fundamentals of aluminum are sound given its attractive properties, widespread usage, and consumption patterns for countries entering high-growth stages of economic development. However, we think aluminum prices could be challenged in the near term due to an oversupply problem unlikely to recede in the next couple of years.
Geography Plays a Key Role in Cost Structure
The largest costs in producing aluminum are its primary raw material alumina (which is essentially refined bauxite ore) and energy (as a significant amount of electricity is needed to run an aluminum smelter).
Bauxite deposits are most plentiful in Australia, Western Africa, and Brazil and ownership of these assets is concentrated among the largest aluminum producers. The need for bauxite and the limited supply relative to aluminum production capacity has caused a high degree of consolidation within the aluminum industry, with Alcoa (AA), Aluminum Corp. of China (ACH), United Co. Rusal, and Rio Tinto Alcan (RIO) producing the lion's share of global aluminum needs. The next stage of aluminum production is smelting, which is more economical in areas that have access to cheaper energy sources such as Russia, Scandinavia, and the Middle East. Soaring energy prices have caused aluminum-smelter construction to shift to these areas in recent years. The geographic discrepancy between bauxite sources and cheap electricity puts an emphasis on proximity to a port and economies of scale to spread the cost burden of operating in distant areas. Aluminum is priced in U.S. dollars so currency movements can have a significant impact on short-term profitability. Naturally, the aluminum companies with the lowest operating costs are those with the greatest bauxite supply and the largest percentage of aluminum capacity in geographies with plentiful electricity.
China Brings New Demand Sources, but Added Supply Creates a Dilemma for Pricing
Demand for aluminum has grown at a faster rate than the other base metals during the four decades prior to the financial crisis and our long-term demand outlook is strong. Infrastructure and automotive demand should drive aluminum consumption while penetration into new applications, particularly transportation, should support growth. Aluminum consumption in the U.S. primarily comes from transportation and packaging, but emerging-market demand is fueled by construction and equipment manufacturing. China is following the typical path of an emerging economy, with demand for aluminum rising dramatically after per capita income rose above $5,000. This growth likely will moderate after income exceeds $15,000 per capita, but this is still a few years away. China was the only major region to have positive aluminum consumption growth in 2009 but that changed in 2010 as developed countries started to recover.
While growth in China will inevitably slow in our view, other areas such as Russia, India, the Middle East, and Brazil are speeding up. Aluminum giant Alcoa has forecasted global-demand growth of around 6% per year through 2020, which would double current consumption levels. This could be a tad aggressive, in our view, but trying to forecast 10 years of consumption is nearly impossible in any cyclical industry. Aluminum producers' demand-growth forecasts for 2011 range from 8% to 12%. We think it will fall somewhere in the middle, which is just below 2010's growth rate and much stronger than we expect for steel and other base metals.
The supply side of the equation is more troubling. While China does not appear to be an attractive place to make aluminum due to its relative lack of both bauxite and cheap energy, the rise of aluminum demand in China during the last decade for cars, infrastructure, and machinery has also caused a rapid increase in smelter construction. Smelting capacity in China grew more than 20% per year for the last decade and China is now the largest producer and the largest consumer of aluminum. While China's capacity is only 23% of the world's total, around 40% of aluminum was produced in China in 2010 as most of the world's idled facilities are in the U.S., Europe, or other areas where producing aluminum is actually less costly than in China. This is worrying as it demonstrates the resistance toward curtailments by the marginal-cost producers when signs of oversupply turn up.
China's new capacity was economical when aluminum prices were strong, but prices plummeted in late 2008 to levels far below the cash costs of production for many Chinese smelters. Aluminum is a highly cyclical product due to its heavy usage in transportation and construction sectors and the severity of the recession caused an oversupply as consumption fell faster than output. The oversupply looks even greater if we take into account the growth in warehoused inventory at the London Metals Exchange, which surged to 4.6 million metric tons in 2009 compared to historical averages of less than one million metric tons. We believe much of this inventory is tied up in financing deals spurred by low interest rates, yet the stockpile has remained stubbornly high for the last two years, currently sitting at just over 4.5 million metric tons. Given the oversupply, aluminum prices have moved in line with the marginal cash cost of production. Chinese smelters who buy their electricity from the power grid (about half of them) likely have the highest cash costs in the world, which we estimate to be around $2,400 per metric ton. Over the long run, this should create a floor for aluminum prices in the absence of recession.
Elimination of Excess Supply is Necessary for Sustainable Price Improvement
We believe the estimated surplus of production relative to consumption was north of 1 million metric tons in 2010. Regardless of financing deals, we think LME inventories are an indication of the excess-supply situation globally. And the vast number of smelters that have opened while aluminum consumption was declining is troubling. Even if demand continues to climb at a strong pace, there still are numerous smelters that currently sit idle and we think it could take several years for the oversupply to dissipate. Most estimates are for a declining oversupply in 2011, but we think it could actually rise if tight monetary policy squeezes demand in China or power restrictions are lifted. Both of which are strong possibilities in our view. Power restrictions put in place by the Chinese government last fall cut aluminum production by 20% in some areas, but we view these output cuts as a temporary solution to reaching a national energy efficiency goal. Aluminum represents more than 5% of all power usage in China and many smelters were unprofitable, making aluminum an easy target for production restrictions. But these mandates are starting to lift, and we see few signs of any permanent output cuts in China. We think these curtailments were a primary driver of the aluminum price runup that began around the same time. This further supports our view that supply will be the primary determinant of aluminum pricing in the near term.
Still, primary aluminum production is limited by its key raw material, alumina, which is in much tighter supply due to limited bauxite sources. Therefore, we believe aluminum prices will be supported over the long run by greater demand, tight alumina availability, and rising production costs, namely energy prices. Inexpensive electricity and raw materials will be the key drivers of competitiveness and China does not have much of either. It makes economic sense for the marginal-cost producers in China to idle in 2011, and this would provide the most support for aluminum prices in the coming year.
The only other path we see to higher aluminum prices this year is the potential launch of a physically-backed aluminum exchange-traded fund, which would tie up about 3 million metric tons for the next several years. The success of precious-metal ETFs has prompted some investors to show interest in funds backed by physical base metals, and an aluminum ETF is in the planning stages for a launch later this spring. ETFs backed by nickel, copper, and tin were launched last December to mixed reviews. Clearly, the storage costs will be higher for aluminum due to the lower value of aluminum per ton--it costs a lot more to store $10 billion worth of aluminum than to store the same value in copper and significantly more than to store $10 billion in gold. So we are not convinced that aluminum ETFs are a hot enough commodity to positively impact aluminum prices.
Morningstar's Aluminum Coverage Universe
The pure-play aluminum producers under Morningstar's coverage are trading just below our fair value estimates. While we think the share prices are fairly valued, Alcoa has the most upside potential from better-than-expected aluminum prices in the coming year.
Alcoa | Narrow Moat | High Uncertainty | P/FV 0.97
Alcoa's stock price has moved up 60% since August 2010 when aluminum prices started to gain traction. However, we think the shares are fully valued even if aluminum prices fail to move another inch as sustainable cost reductions have become a greater catalyst for earnings improvement. The company's focus on developing primary aluminum production in areas of lower energy costs significantly will improve its position on the global cost curve by 2015. Further, Alcoa has already reached or surpassed prerecession margins at its downstream businesses and has guided to an additional $4 billion in revenue by 2013 for these segments. Finally, the company's abundance of alumina will become even more valuable if aluminum pricing continues its upward trend.
Aluminum Corp. of China (Chalco) | Narrow Moat | High Uncertainty | P/FV 0.95
China's largest aluminum producer shuttered 5%-10% of its capacity following power restrictions by local governments. The company has a better cost position than any major player in the region, but Chalco is not immune to the woes of a country with little electricity relative to its needs. Its strong position in alumina gives it an edge relative to its closest competitors, but the threat from outsiders such as Alcoa remains a risk, particularly as the Chinese government recognizes that it could be cheaper to import aluminum than make it. One thing is for sure, exports are not a viable option long term for Chinese smelters as this is in essence exporting energy, which makes little sense and we expect to see export limitations put in place by the Chinese government. Chalco is fully dependent on the continued growth of aluminum demand in China.
Century Aluminum | (CENX) | No Moat | High Uncertainty | P/FV 0.90
Century Aluminum is more exposed to swings in aluminum prices as most of its capacity is in higher-cost smelters in the U.S., much of which remains idled, and the company has no alumina assets. In fact, the company generates a significant portion of its revenue from tolling arrangements, whereby other aluminum producers provide alumina for Century to smelt into aluminum for a fee. The company's Icelandic facility has performed well and a second plant should become operational in 2012, but preserving viability in the U.S. will be an ongoing challenge.
Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.