Alcoa (NYSE:AA) has announced that it will consider cutting about 11% of its smelting capacity, or 460,000 tonnes, over the next 15 months as it battles low prices for aluminum. According to a company news release, this step is being taken in response to a 33% drop in aluminum prices since 2011. The facilities where this exercise will be carried out have not been decided upon yet, but it will focus on its most expensive plants and those subject to the risk of rising energy or regulatory costs. The company operates smelters in the U.S., Canada, Brazil, Australia and Europe. 
As of now, Alcoa already has an idle smelting capacity of 568,000 tonnes, or 13% of the total. Cutting down further on capacity will cause its market share to decline. Over the years, the company has gradually shifted focus to the downstream part of the business i.e. making value-added aluminum products. The latest proposed reductions in smelting capacity will accelerate the process.
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Importance Of Aluminum Prices For Alcoa
Alcoa is organized into four business segments: Alumina, which mines bauxite and processes it into the precursor to aluminum; Primary Metals, which smelts aluminum; Flat-rolled Products, which makes sheets used in beverage cans as well as airplane wings and car parts; and Engineered Products and Solutions, which makes aerospace fasteners, turbine blades and truck wheels. While the Flat-rolled and Engineered Products and Solutions divisions produce value-added products and thus generate higher margins, a significant proportion of Alcoa’s earnings still come from the Alumina and Primary Metals divisions. This makes its earnings highly sensitive to aluminum prices.
Recent Aluminum Price Trends
Aluminum prices on the London Metal Exchange, which are used as a benchmark by the company to determine its own prices, have been dropping sharply since the end of February. Prices have dropped from $2,100/tonne at the beginning of the year to below $1,800/tonne and are still trending lower. 
The continuing European debt crisis, sluggish U.S. demand, and slowing Chinese growth contributed to the decline in aluminum demand and prices over the last few quarters. The Chinese economic growth rate in Q1 2013 was registered at 7.7%, which was much below expectations. The country’s Purchasing Managers’ Index (PMI) data for April was also below estimates because export orders fell due to tough external economic conditions. It is now believed that aluminum supply will outstrip demand by 1.2 million tonnes this year. 
One factor that might explain falling prices is the persistently high aluminum inventory relative to demand, which may be keeping a lid on London Metal Exchange (LME) prices for aluminum. Also, despite falling aluminum prices, Chinese production is expected to rise by 10% from 2012. This represents an absolute increase of 2.2 million tonnes. Thus, despite inventories being at a record high, market forces have failed to rationalize supply through shutdown of smelting capacity in China. This is primarily due to state intervention in the form of provision of subsidies or renegotiated power contracts to smelters. According to Oleg Derispaska, the CEO of the world’s largest aluminum producer Rusal, about 42% of the current production capacity could be cut at prevailing price levels. 
Where Will The Cuts Be Implemented?
The smelters where the cuts will be implemented are not known yet. Speculation is rife that the the most likely candidate is the Point Henry smelter in Australia, which has 190,000 tonnes of annual capacity. A number of Alcoa’s plants in the U.S., Australia and Europe are high-cost and based on old technology, resulting in cash costs higher than current prices in some cases. Its operations in Canada are its largest and also cost the least, hence it is being assumed that they will be immune to cuts. 
Alcoa says that it may not limit itself to shutting down capacity only in the smelting segment. It will consider a wide variety of alternative actions, ranging from discontinuing pot relining to full plant curtailments and/or permanent shutdowns. The alumina refining capacity will also be reviewed to reflect any curtailments in smelting capacity as well as prevailing market conditions.
While low prices may be one reason for Alcoa’s actions, it may also have been driven by rating agencies’ actions. While Standard & Poor’s lowered its outlook on Alcoa to negative from stable last week, Fitch Ratings also lowered its outlook on Alcoa earlier in April. This was despite Alcoa’s claims that it is making efforts to cut costs and streamline businesses. It has a stated goal of lowering its position on the world aluminum cost curve by 10% and the alumina cost curve by 7% by 2015.
We have a Trefis price estimate for Alcoa of $7.Notes:
- Alcoa to Review 460,000 Metric Tons of Smelting Capacity for Possible Curtailment, Alcoa Press Release [↩]
- LME Aluminum Price Graph, LME [↩]
- China factory growth eases, adds to recovery risk, Reuters [↩]
- Alcoa to Consider Cutting 11% of Capacity, WSJ [↩]
- Alcoa may curtail quarter of aluminum output as industry confronts low prices, Global Post [↩]