The Impact Of A Sustained Increase In Chinese Aluminum Production On Alcoa

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Aluminum prices have been fairly subdued this year. London Metal Exchange (LME) aluminum prices have averaged roughly $1,800 per ton so far this year, as compared to roughly $1,900 per ton in 2014. [1] Aluminum has diverse applications in industry. It is an important input in the packaging, aerospace, automotive, construction, commercial transportation, power generation, capital goods, and consumer durables industries. Thus, demand for aluminum is broadly correlated with industrial growth. Economic weakness in Europe and slowing Chinese growth have contributed to the weakness in aluminum demand, and consequently prices, over the last few quarters. [1] China, the world’s largest consumer of aluminum, is expected to witness a slowdown in GDP growth to 6.8% and 6.3% in 2015 and 2016 respectively, from 7.4% in 2014. [2]

On the supply side, production capacity has not been reduced corresponding to the weakness in demand over the last few quarters. Persistently high aluminum inventory levels relative to demand have kept LME aluminum prices depressed. This inventory was built up partially as a result of aluminum being tied up in financing deals, which were made possible due to low interest rates. [3] Despite inventories being at a record high, market forces failed to rationalize supply through the shutdown of smelting capacity. Though global aluminum majors like Alcoa and Rusal did make significant smelting capacity cuts, the same was not true of Chinese companies. This was primarily due to state intervention in the form of provision of subsidies or renegotiated power contracts to smelters, which serve as a disincentive to cut production. China accounts for around half of the world’s aluminum production, and the expansion in production by Chinese producers has more than made up for capacity cuts by global majors. [4] This oversupply situation is expected to keep aluminum prices depressed.

As a result of the fall in LME prices, regional aluminum prices in China are trading below the costs of production of a majority of Chinese domestic smelters. [5] However, Chinese aluminum producers were boosted by a recent decision of the Chinese government to provide tax breaks and subsidized power to domestic aluminum smelters. [6] This is likely to lead to an increase in Chinese production and could further worsen the gap between supply and demand, resulting in a drop in global aluminum prices. In this article, we will take a look at the impact of this scenario on Alcoa’s stock price.

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Impact of a Sustained Increase in Chinese Aluminum Production on Alcoa

Boosted by favorable government policy, China could add an additional 4.5 million tons in smelting capacity over the course of the year, or close to 10% of global aluminum production. [5] Though the shutdown of obsolete and high cost aluminum smelting capacity will reduce the net addition to production capacity, the closures of high-cost Chinese smelting capacity will be much less as compared to the fresh production capacity that comes online. Similarly, though the shutdown of high-cost smelting capacity from the rest of the world could lessen the impact of Chinese capacity additions, a net addition to global aluminum smelting capacity in 2015 is still the most likely scenario.

If China continues to supply subsidized power to its aluminum smelters, resulting in capacity additions at current rates, the global oversupply of aluminum is likely to persist. This would negatively impact LME aluminum prices. A fall in LME aluminum prices is likely to translate not only into lower realized aluminum prices for Alcoa, but also lower realized alumina prices, since a significant proportion of pricing contracts for Alcoa’s alumina sales are linked to LME aluminum prices. While modeling the high Chinese aluminum production scenario, we will assume that the company’s production plans and capital expenditure remain the same in this alternative scenario. Since we forecast capital expenditure as a percentage of EBITDA, in order to model this new scenario we have modified our forecasts in order to keep capital expenditure at the same absolute levels in the new scenario. If we factor in these assumptions on the various drivers impacted in our stock price model, our price estimate for Alcoa decreases by 15% from $14.35 to $12.20. Thus, there is significant potential for a downward revision in valuation in the case of a sustained increase in Chinese aluminum production.

See our complete analysis for this scenario

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Notes:
  1. LME Aluminum Prices, LME [] []
  2. World Economic Outlook January Update, IMF []
  3. Aluminum Price Premiums: Disconnect Between LME and Reality Continues, Metal Miner []
  4. Global aluminum production; the sound of one hand clapping, Reuters []
  5. Chinese aluminium smelters shut more capacity as prices dive, Reuters [] []
  6. China measures set to boost aluminium supply, Financial Times []