The Outlook for Aluminum in 2013

As the most abundant metal in the earth, aluminum actually makes up about 8% of the weight of the planet's solid surface. The metal is known for its low density, ability to resist corrosion, and wide range of uses. It can be found in everything from soda cans to airplanes with an increasing number of industrial usages in between.

The metal was a hot commodity during the housing-led economic boom, but its price collapsed during the financial crisis, followed by the stock of those companies engaged in its production. While spot prices have risen since the dark days of the recession, those prices are still not as high as aluminum producers would like. As we look out over the next year there are several factors that will play a role in both the commodity's price and the profits of its producers.

Of supply, demand, and aluminum prices
According to Citi, aluminum has been experiencing a rise in both production and inventories, but demand has been high enough to keep prices stable. For 2013 the bank sees consumption growth of just 1.3% because of the slowdown in China and continued sovereign debt crisis in Europe. Citi sees average aluminum prices of $2,100 per tonne over the year.

Top North American aluminum producer, Alcoa (NYSE: AA  ) is seeing an even more bullish outlook. The company's most recent quarterly earnings report noted that demand was strong and outpacing the company's 10-year forecast while production was in balance with demand. The company sees global aluminum demand growing 7% in 2013 which is up from the 6% growth in 2012.

The company sees strong demand in the aerospace industry, as well as rising demand in the automotive space, as aluminum use is increasing over steel use in the production of vehicles. Additionally, the metal is also making inroads in replacing copper in a variety of applications, including HVAC, consumer electronics, and building facades. These diverse drivers of demand have a longer-term bullish effect on aluminum prices.

An industry in transition
Despite strong projected growth in demand, the industry's near-term profit outlook is still murky. The industry still hasn't fully recovered from the fallout of the financial crisis. Aluminum was a hot commodity before the dawn of the global financial crisis. At the peak of the commodity's boom, Alcoa attempted to acquire Canadian aluminum producer Alcan in an effort to create the world's largest aluminum producer.

In the end Alcoa was outbid by Rio Tinto (NYSE: RIO  ) which paid more than $38.1 billion for the company. That deal hasn't worked out too well for Rio Tinto as aluminum prices collapsed -- just this year the company wrote down $9 billion worth of its aluminum assets. For some perspective, that's nearly the entire current market cap of Alcoa.

Others in the industry are taking down capacity or canceling expansion projects. Already this year BHP Billiton (NYSE: BHP  ) has canceled plans to build an aluminum smelter in Africa. Meanwhile Alcoa and other industry participants have announced more than 1.3 million metric tons of production cutbacks.

Smaller players like Century Aluminum (NASDAQ: CENX  ) are finding it difficult to operate in this environment. The company announced that its Hawesville smelter in Kentucky is no longer viable because of the high costs of power under its current contract. The company recently terminated the power contract on the plant and is looking for alternatives in an effort to keep the plant open.

All this realignment, though, is a net positive for the future price of aluminum. Taking this excess capacity offline is important for increasing margins across the industry. Still, the industry at large can only do so much -- what happens in China is just as important for the commodity's price and the profits of its producers.

All eyes on China
It's a well-known fact that the growth rate of China's economy is slowing down. Although, according to Alcoa CEO Klaus Kleinfeld, China's not slowing down as much as is thought, and could grow as much as 8% over the next year. To combat this perceived weakness the Chinese government has announced a massive $150 billion infrastructure spending package. If the spending package does produce results, then it'll provide a boost to all types of commodity producers.

One more area to watch is the country's very fractured aluminum industry, aside from state sponsored Chinalco (NYSE: ACH  ) . A big problem is that 34% of the production capacity in China is operating at a loss. Industry consolidation and capacity reductions are the only way for producers in China to get production costs competitive enough to push up margins across the industry.

Hidden inventory
Because of a combination of low interest rates and an attractive forward contango in the aluminum price curve, a bulk of the spare aluminum inventory is just sitting in warehouses. What's happening is that banks are buying aluminum, warehousing it, and then selling it forward in the futures market. This is keeping inventory off the market as it's being used as a profit center instead of being used in end markets.

According to Alcoa, as much as 90% of the inventory that's traded simply moves around as financed inventory, instead of going to customers. As long as financing is cheap and the forward curve remains steep, it's unlikely that we'll see this inventory actually become marketable. This trend will keep volatility high for the foreseeable future.

Foolish bottom line
Over the next year the outlook for aluminum appears to be modest at best. Investors should expect a slight rise in aluminum prices as supply and demand stay in balance. The outlook over the longer term is much more bullish thanks to production cutbacks, continued growth in China, as well as aluminum's new place as the preferred metal for the automotive industry.

Materials industries are traditionally known for their high barriers to entry, and the aluminum industry is no exception. Representing 14.7% of 2011 global production in this highly consolidated industry, Alcoa is in prime position to take advantage of growth that some expect will lead to total industry revenue approaching $160 billion by 2017. Based on this prospective growth and several other company-specific factors, Alcoa is certainly worth a closer look. For a Foolish investment perspective on this global giant simply click here to get started.


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