Alcoa (NYSE:AA) is a leading producer of alumina, aluminum and products made from aluminum. The company’s results are closely eyed as it usually is the first Dow company to post earnings and because it gives investors a clue to the likely results of other industrial goods producers. Aluminum, being one of the most important industrial metals, is closely tracked and followed by analysts and investors alike. Although the Russian company UC Rusal is the biggest producer of aluminum by volume, its foreign listing makes Alcoa more important from an investor’s point of view.
Alcoa is a fully integrated producer of aluminum: it mines bauxite, refines it into alumina, makes primary aluminum and also produces midstream products like flat rolled sheets and downstream engineered products.
In this article, we take a closer look at Alcoa’s alumina business division. We will describe the cost structure of the business, the pricing mechanism for alumina, the reasons behind the poor performance of the division in 2012, and the future outlook. You can also see our most recent earnings note here: Alcoa Reports Q4 Profit As Long Term Demand Growth Is On Track
What Does The Alumina Division Do?
Alcoa’s alumina business involves processing bauxite and refining it to obtain alumina. It comprises of Alcoa’s worldwide refinery system and bauxite mining operations. A major portion of bauxite mined by Alcoa is used internally. However, Alcoa also sources bauxite from third-party sellers to meet its requirements.
The alumina obtained by refining is sold directly to internal and external aluminum smelter customers worldwide, or is sold to customers who process it into industrial chemical products. A portion of this segment’s third-party sales are completed through the use of agents, alumina traders, and distributors. Slightly more than half of Alcoa’s alumina production is sold under supply contracts to third parties worldwide while the remainder is used internally by the primary metals segment to produce aluminum. 
In 2012, Alcoa’s alumina division revenues were $3 billion from third-party sales while inter-segment sales accounted for $2.3 billion worth of sales. ((Q4 2012 Press Release, Alcoa))
Bauxite and caustic soda constitute nearly 50% of the production cost for alumina with bauxite’s share at approximately 30%. However, the precise breakdown shows large variations depending on the grade of bauxite used and proximity of the alumina refinery from the bauxite mine. Low grade bauxite needs more caustic soda for processing while transportation costs add to the overall cost of bauxite. 
The other cost components are electricity, natural gas, and fuel oil. Electricity costs are typically around 25% of total production costs for alumina.
Alumina has historically been priced as a percentage of the more liquid and transparent aluminum price quoted on the London Metal Exchange (LME). Contract terms have historically fluctuated in the range of 12-14% of the LME aluminum metal price. This ratio is typically arrived at through negotiations between alumina refiners and aluminum smelters, who are the customers. Spot prices have been much more volatile as the alumina spot market is a very thin market. For 2012, our calculations show that taking into consideration only third-party alumina sales, Alcoa’s average realized price for alumina was approximately 13.5% of the average realized price for aluminum.
Over the years, the aluminum industry has moved away from a vertically integrated model where producers had their own bauxite mines and alumina refineries. Many independent aluminum smelters have come up and they buy alumina in the spot market. In such a case, a fair price discovery can be better achieved through market mechanisms. 
Therefore, Alcoa has implemented a move to price alumina based on an index of spot alumina prices rather than as a percentage of the LME-based aluminum price. This change is expected to affect approximately 20% of annual contracts coming up for renewal each year. It will more fairly reflect the fundamentals of the alumina business in its own right, including the cost of raw materials and transportation.
Over time, we expect pricing to be driven by the demand-supply dynamic for alumina in its own right rather than being linked to aluminum. At the end of Q3 2012, Alcoa had expected around 40% of alumina third-party shipments to be linked to the alumina price index or spot price by the end of 2012. We are awaiting the company’s annual report to check if this assertion has borne out.
While several indices are used by industry players, Alcoa favors the use of the index developed by Platts. 
Financial Performance Of The Alumina Division And Outlook
In 2012, the alumina division reported after-tax operating income (ATOI) of $90 million compared to the previous year’s figure of $607 million. The division’s poor performance was attributed to a drastic fall in aluminum prices and rising input costs, particularly of caustic soda. The average realized price of aluminum fell from $2,636 per tonne in 2011 to $2,327 per tonne in 2012.
The price of caustic soda is not expected to come down in the foreseeable future, and the price outlook for aluminum is not looking up either. Aluminum has been trading at much lower prices than last year. Alcoa contends that aluminum prices on the LME are being driven by macroeconomic sentiment rather than industry fundamentals. ((Q4 2012 Earnings Presentation, Alcoa Website))
At this time, the macroeconomic sentiment for Europe is weak and a dramatic turnaround in the U.S. is not likely. The latter has yet to resolve its fiscal cliff and debt ceiling problems. The Chinese infrastructure push has yet to show a significant impact on the markets for aluminum and copper. In short, we don’t see much macroeconomic driven upside for aluminum prices going forward. This will keep margins and net profits down for the alumina division. 
We have a Trefis price estimate for Alcoa of $8 after the fourth quarter earnings results.Notes: