Aluminum: Investing Essentials

An investing primer on the aluminum industry.

Aug 7, 2014 at 12:00AM

Unlike some metals, aluminum's history doesn't go back thousands of years. While aluminum salts were used by the ancient Greeks and Romans to make dyes and help heal wounds, it wasn't really used until the 1800s when it was isolated and eventually produced to make useful items. 

What is the aluminum industry?

Aluminum is a chemical element and is actually the third most abundant element in the world behind only oxygen and silicon. In fact, it is so abundant that it makes up about 8% of the weight of the Earth's crust. But because it is so chemically reactive it's not found as a pure element in nature, but instead found combined with more than 270 different minerals. The top source of aluminum is an ore called bauxite.

Aluminium

A chunk of aluminum. Source: Wikipedia/Materialscientist

Because aluminum isn't found as a pure element the aluminum industry can't just dig it up and sell it to end users. As such, the foundation of the aluminum industry is bauxite mining. Deposits of bauxite are found in layers near the Earth's surface and an open-pit mine is used to extract the bauxite. From there it's processed into a fine white powder known as alumina. In order to transform alumina into aluminum it is exposed to intense heat and electricity through a process called aluminum smelting, which was originally developed by the company that would later become Alcoa (NYSE:AA)

The process taking bauxite and turning it into aluminum is a very capital intensive process as aluminum smelters are costly to build. Further, aluminum requires a lot of electricity, which is why many aluminum plants are located either near hydroelectric power plants or the aluminum producer builds its own power plant to keep operating costs down.

How big is the aluminum industry?

The aluminum industry adds $150 billion to the U.S. economy each year. That's about 1% of the country's GDP. In addition to that more than 155,000 workers are directly employed by the industry. Further, for every direct job in the industry another 3.3 jobs are created. Overall, it is estimated that 672,000 total jobs are affected by the production, processing and usage of aluminum in this country. These workers take home $29 billion in wages each year tricking down more of the benefits of the industry within the economy.

Worldwide more than 40 million tons of aluminum are produced each year. It's the second largest metals market in the world behind iron and steel. China produces nearly half of the world's aluminum and is followed by Russia, Canada, the U.S., and the United Arab Emirates.

How does the aluminum industry work?

The aluminum industry can be separated into three main segments: upstream, midstream and downstream. Upstream refers to the production of aluminum from bauxite mining to alumina refining to aluminum smelting. It is the commodity business of aluminum production and as such has higher exposure to the price of aluminum.

Aluminum Roll Tesla

Aluminum roll. Source: Tesla Motors Flickr page

Midstream refers to converting aluminum into manufacturing feedstock. For example, the rolled sheets of aluminum sold to auto manufacturers are made in the midstream segment. Finally, the downstream segment refers to engineered products and solutions. This segment refers to those companies that like Alcoa, for example, use aluminum alloys to make commercial vehicle wheels that are 47% lighter than steel and 18% lighter than average aluminum wheels or multi-material fastening systems for the aerospace and transportation industry. The midstream and downstream segments can also be referred to as value-add businesses as these segments add to raw aluminum and therefore receive higher prices than the base commodity. Because of this these segments tend to earn higher margins than downstream producers.

What drives the aluminum industry?

There are a number of end markets that aluminum is sold into including aerospace, automotive, packaging, and construction. But the industry that really drives the aluminum industry these days, especially the midstream and downstream segments, is the transportation sector. This sector is keenly focused on reducing fuel costs and one way to do that is to reduce weight. Because aluminum is 10%-40% lighter than steel, yet just as strong, it's the perfect metal for the chore as a 15% weight reduction can cut fuel usage by 7%-20%.

Because of this the automotive industry is a particularly compelling growth area for aluminum. Each year the auto industry uses more aluminum in each car and as the following slide notes its usage is expected to grow from 343 pounds currently in the average car to 550 pounds per car over the next decade.

Aluminum In Cars

Source: Alcoa Investor Presentation 

Major automakers like Ford (NYSE:F) and disruptors like Tesla (NASDAQ:TSLA) are focused on using aluminum to reduce the weight of vehicles to improve performance and safety. With CAFE standards doubling from 2011 to 2025, automakers really have no choice but to cut the weight of their vehicles in order to meet these new standards, and aluminum will be a big part of that solution for the industry.

Aluminum is also a very important metal for the aerospace industry. Its lightweight properties help lower the weight of aircraft, which saves airlines money on jet fuel. With jet fuel continuing to be a major cost for airlines it is forcing manufacturers to continue to find ways to reduce the weight of a commercial aircraft, which means it needs to continue replacing heavier components with those made by aluminum.

The growth of aluminum usage by the auto and aerospace industry will really drive the aluminum industry in the years ahead. Further, emerging markets like China will also play an important role in consuming the metal through increased demand for aluminum building products as well as beverage cans. Integrated aluminum producers should really benefit from this trend as the value-add segments will yield high margin growth. 

Matt DiLallo has the following options: long January 2016 $10 calls on Ford. The Motley Fool recommends Ford and Tesla Motors. The Motley Fool owns shares of Ford and Tesla Motors. 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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