Alcoa Inc (NYSE:AA), the largest U.S. aluminum producer, expects aluminum demand to outpace supply in 2014. If this happens, it would end a seven-year surplus in the aluminum market. The aluminum market has been in surplus since 2007, mainly because of large capacity increases in China and the Middle East. However, analysts expect Chinese production to grow at almost the same rate as demand in 2014. CRU Group, a market analysis firm, forecasts Chinese output to grow by 10% to slightly more than 26 million tons compared with demand of 25.8 million tons in 2014. 

While improving demand should help Alcoa post strong results, the company has also been taking self-help actions to create value for shareholders. Alcoa, which is often considered an economic barometer by investors, has been transforming itself into a value-added, technologically advanced manufacturing company providing innovative solutions for its customers and commanding a leading position in many of its key end markets.

While Alcoa, similar to its peer Constellium (NYSE:CSTM), continues to spend most of its growth capex on high-margin automotive and aerospace markets (downstream), in this article, I will focus on the company's upstream assets and the steps Alcoa is taking to drive down costs in the upstream Alumina and Primary Metals segments.

Adding low-cost capacity
Alcoa is cutting costs by restructuring its upstream segments through the rationalization of capacity by shutting down high-cost smelters and adding new low-cost capacity. Alcoa entered into a joint venture with the Saudi Arabian Mining Company, Ma'aden, in 2009 to build the largest and the lowest cost integrated facility in the in Middle East. The joint venture will be one of the lowest-cost facilities in the world, producing 1.8 million tons of alumina, 740,000 tons of aluminum, and 380,000 tons of rolled aluminum products. 

Shutting down high-cost facilities
Alcoa is not only adding new low-cost capacity; at the same time, it's also shutting down high-cost facilities. Over the past five years, the aluminum producer has permanently closed about 30% of its global aluminum (smelting) capacity. In addition, by the end of 2014, the company will take down its can sheet rolling capacity by 200,000 tons at its Point Henry rolling mills in Australia. 

Alcoa is not the only company cutting output. United Company Rusal, the world's largest aluminum producer, saw its output drop by 8% in 2013 and is planning to cut back by a similar amount this year. Other companies that have announced capacity cutbacks include Rio Tinto (NYSE:RIO) and Norsk Hydro (NASDAQOTH:NHYDY). These capacity shutdowns/curtailments combined with increasing demand should further provide support to prices.

Improving productivity
In addition to adding new low-cost capacity and shutting down high-cost facilities, Alcoa is also focused on improving productivity to drive down costs in the company's upstream business. After the 2008 financial crisis, the aluminum producer has implemented rigorous productivity enhancement measures and has achieved more than $6 billion of savings between 2009 and 2013. The company is planning additional cost savings of $850 million in 2014, of which $250 million was already achieved in the first quarter. 

Strong aluminum demand
Aluminum usage ex-China is expected to outpace production by 1.3 million-1.4 million tons this year. Aluminum producers outside China, including Alcoa, Rusal, Rio Tinto, Norsk Hydro, etc., have cut production by 3 million tons since 2012 and are expected to cut production further by 1.6 million tons in 2012. As the global aluminum demand continues to improve, and capacity cutbacks finally begin to bite, aluminum prices should improve later this year. Moreover, a strong demand outlook should further lend support to prices in 2015.

The supply and demand situation in China should also improve going forward, as producers in Asia's biggest economy are losing money at current prices, and output is set to decline as banks cut credit to companies making losses.

Record premiums
Aluminum premiums are also at record highs. According to United Company Rusal, the largest producer of aluminum, premiums paid to secure aluminum are expected to exceed $500 per ton as soon as the next quarter, as demand continues to improve and supply remains tight.

Buyers across the world are paying record premiums for supplies of aluminum, as stockpiles tracked by the London Metal Exchange (LME) remain low. "At least 75% of stockpiles in London Metal Exchange warehouses are tied into financing transactions and unavailable for immediate withdrawal," said Oleg Mukhamedshin, Deputy CEO of Rusal. 

Bottom line
While the improving demand for aluminum should help Alcoa post strong results, the company has also been taking self-help measures to create value for shareholders. The company has been transforming itself into a value-added technologically advanced manufacturing company providing innovative solutions for its customers and commanding a leading position in many of its key end markets. Alcoa is also cutting costs in its upstream operations and rationalizing capacity by shutting down high-cost smelters, which should further help the company improve its EBITDA margins.