China Might Not Spoil the Party for Aluminum Producers

With China cutting output, the outlook for aluminum producers has improved even more.

Mar 26, 2014 at 12:37PM

Aluminum prices tumbled in 2013 due to a supply glut in the first half of the year. The supply glut forced major aluminum producers to cut production, which ultimately resulted in a supply deficit at the end of 2013. This, coupled with strong demand from the aerospace and automobile industry, has improved the outlook for aluminum producers. Not surprisingly, shares of Alcoa (NYSE:AA) and Century Aluminum (NASDAQ:CENX) have risen sharply in the past year. However, the one major concern for aluminum producers was overcapacity in China, which had been increasing its production of aluminum in spite of a slowdown. But a recent report suggests that aluminum smelters in China are now cutting output, which has further improved the outlook for producers.

Strong demand from aerospace and automotive industries
Last year, aluminum prices were clobbered due to a supply glut, nosediving about 17% in 2013. However, Alcoa gained more than 25% in 2013 as demand from both the U.S. aerospace and automobile industries remained strong, even as the American aluminum giant slashed costs to bolster its bottom line. Alcoa's smaller rival, Century Aluminum, also gained more than 27% last year.

The strong performance has continued into this year as the demand from automobile industry and aircraft manufacturers is expected to remain strong during the first half of 2014. Automakers such as Ford and General Motors are expanding capacity at their existing plants in the U.S. and Canada due to the ongoing recovery in the U.S. auto sales.

Investors will be keen to know Alcoa's forecast for fiscal 2014 when the company reports its quarterly results on April 8. Alcoa results are often regarded as a bellwether for the overall economy given widespread usage of aluminum products in industries ranging from aerospace and automobile to defense and energy.

Supply rationing
Another significant factor that has helped in driving shares of aluminum producers higher is the supply rationing on aluminum.

After halting productions in 2013, major aluminum producers are expected to continue to cut down production in 2014 as well.

The world's largest aluminum producer, United Co. Rusal PLC slashed aluminum production by 8% to 3.9 million metric tons last year. This year, the Russian aluminum giant will continue to curtailing the output by 3.5 million metric tons.

According to Barclays Capital, production cuts are expected to create a supply deficit of 1.1 metric tons in 2014, up from a deficit of 726,000 metric tons in 2013.

While production cuts and reasonably stronger demand from the U.S. automobile and aerospace industry augurs well for aluminum producers, overcapacity in China's overcapacity has been a major concern for producers.

Chinese export fears
China had been expected to keep producing aluminum in 2014, notwithstanding weak domestic demand. As I have discussed in previous articles, China is rebalancing its economy from export and infrastructure spending to consumption, which has resulted in a slowdown. Although Beijing wanted its smelters to halt their production, regional governments had been reluctant to cut the output as they believed that any such decision could affect the labor market and hurt growth, according to ratings agency Fitch. Besides, domestic Chinese producers were reluctant to cut production at time when costs are running at very low levels (about $1,500/ ton) mainly due to subsidies.

In this backdrop, it was likely that China faced with oversupply would have looked to export, which was not a good scenario for aluminum producers. However, a recent report indicates that China is actually cutting output due to low prices.

Chinese smelters cut output
Reuters, citing industry sources, said in a recent report that Chinese aluminum smelters are expected to shut around 2 million tons of operating capacity in the next few months. The move comes as smelters look to limit their losses in the wake of weak prices and declining government support. Indeed, the Chinese government has been reducing its support to those industries where it feels there is overcapacity.

If indeed there is a production cut in China, it would further increase the supply deficit in the global aluminum market. Given the strong demand from industries such as aerospace and automobile, the outlook for aluminum producers has improved even more.

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Varun Chandan Arora has no position in any stocks mentioned. The Motley Fool recommends Ford and General Motors. The Motley Fool owns shares of Ford. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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