Aluminum prices struck a 17-month high this week, finally crossing the $2,000 per ton mark. The aluminum market has benefited from a series of production cuts carried out by smelters globally, including Alcoa, Rusal, and Rio Tinto. Prices have also been boosted as inventories fell to a multi-month low. The improved outlook has boosted shares of Alcoa and Century Aluminum. More importantly, aluminum prices could remain strong as there is likely to be a supply deficit for a prolonged period of time.

Aluminum prices hit 17-month high
Alcoa and Century Aluminum shares have been among the top performers this year. Year to date, Alcoa shares have gained more than 62% while Century Aluminum is up more than 80%. The gains have been partly driven by the changing market environment, which has boosted aluminum prices.

The rally in aluminum prices has been sparked by growing conjecture that the aluminum market could face a huge supply deficit in the short- to mid-term as inventories at the warehouses overseen by the London Metal Exchange (LME) have fallen to a multi-month low.

Rusal, Alcoa, and Rio Tinto have been cutting production, as I noted in a previous article. These production cuts have allowed the market to become more fundamentally balanced, ending a glut accumulated over the years due to higher production and weakness in demand. The aluminum market recorded a deficit of 726,000 tons last year, and Alcoa now anticipates a wider-than-expected deficit of 930,000 tons this year.

While production cuts have helped the aluminum market, the latest rally has been driven by a decline in inventory levels at the LME. On Monday, the metal entered a bull market, crossing $2,000 per ton mark, or about 20% above its year-to-date closing low of $1,677. This low was recorded on Feb. 3 as inventories at LME-administered warehouses fell 9.4% year to date to below 5 million tons.

As of July 21, the stockpile tracked by LME was at 4.94 million tons, the lowest level since Sep. 12, 2012, according to data provided by Bloomberg. It's not just that the inventories have been shrinking, either; the waiting period to withdraw aluminum from LME-registered warehouses is also getting longer due to shrinking supplies. Since May 2014, the waiting time to withdraw aluminum from LME's biggest warehouse has stretched by 58 days.

Prices to remain strong
While a drop in inventories boosted aluminum prices this week, production cuts have been the major reason why prices have strengthened this year. According to data provided by Bloomberg, production cuts outside of China amounted to about 2.8 million tons each year since November 2011, helping to lift the price of the metal. The outlook for aluminum prices would depend on the output going forward.

In a report dated July 10, analysts at Bank of America Merrill Lynch in London ruled out smelters commencing production in the coming quarter even if prices recover. Bank of America expects the aluminum market to witness a deficit of 504,000 tons in 2015.

Shifting the focus to China, the world's biggest aluminum producer, it seems that output is likely to remain limited for an extended period of time, notwithstanding the recent ramping up of its smelting facilities. Grappling with high-cost smelting facilities and falling aluminum prices, China has had to shut down some of its old plants since 2013. This move helped in reducing the output. Wood Mackenzie estimates that shuttering of high-cost smelters reduced the supply by 3.2 million tons or 12% since January 2013.

However, China has started simultaneously building new low-cost facilities to ramp up the output in last twelve months. The country built new smelting facilities of about 3 million tons, with the majority of the projects taking place in its northwest province of Xinjiang. The ramping up process has been slow, however; it is expected to be at least the first half of 2015 before these new facilities are up and running.

Indonesia's ongoing bauxite export ban is also likely to cut off supplies of the raw material to China.

Given these scenarios, aluminum prices are likely to remain strong. This should further boost the outlook for Alcoa and other smelters.