A glimmer of hope for Alcoa

Alcoa’s second quarter earnings issued overnight surprised on the upside and contained a glimmer of optimism for the long-beleaguered upstream segments of the aluminium industry.

The turnaround in the performance of Alcoa’s primary metals business, which produced a $US97 million profit in the second quarter compared to a $US32m loss a year earlier, has been driven by Alcoa’s own productivity measures but also an improvement in prices and in the industry’s supply/demand balance.

Alcoa’s cost-cutting, smelter closures and capacity reductions -- which will include the closure of its Point Henry smelter near Geelong next month -- have been echoed across the industry outside of China.

Since the financial crisis, Alcoa’s smelter closures have taken more than a million tonnes of metal out of the market, while reductions to the capacity of its continuing operations amount to about another 800,000 tonnes.

Russia’s Rusal, the world’s largest producer, recently said it was on track to reduce its production by about 8 per cent (or 333,000 tonnes) this year relative to its 2013 output.

The same story is occurring through the developed world part of the industry as it has been forced to adjust not just to lower developed world demand post-crisis, but the inexorable rise in China’s production. China accounts for about half the global industry’s supply and demand.

Within Alcoa’s presentation of its results was a slide showing its expectation of 2014 aluminium supply and demand.

It showed it expects China to produce about 24.65m tonnes of metal this year and the rest of the world about 26m tonnes, with China adding 1.7m tonnes and the rest of the world 465,000 tonnes.

China would, however, curtail almost 800,000 tonnes of capacity and the rest of the industry 155,000 tonnes, leaving China with a modest 105,000 tonne surplus of supply over demand but the rest of the world with a 1m tonne deficit.

In other words, the fundamentals for the sector are moving towards a deficit of supply, which ought to auger well for improved prices – which Alcoa is already experiencing. Alumina, while still suffering from a surplus of supply over demand, is seeing its surplus shrink.

Apart from the massive reductions in capacity that have occurred outside China, there are signs of a slowing in the rate of growth in China’s production and its composition.

China has been growing its newer, lower-cost and less carbon-intensive capacity even as about half of its output from older and dirtier smelters has been losing money on a cash basis.

The Chinese leadership’s crackdown on polluting industries and the pressure it has imposed on its banking system to improve the quality of their lending is forcing structural changes to the state-owned sectors whose economics are poor. This is seeing some of the uneconomic capacity being withdrawn and creating the prospect of a more rational and stable aluminium industry.

The prospect of improved fundamentals for the sector underpins Rio Tinto’s conviction and hope that in the longer term, its big position in aluminium -- which has cost it tens of billions of dollars, a chairman and perhaps a chief executive -- might eventually produce reasonable returns on its written down investments. It also helps it will help reduce its current near-total reliance on iron ore for its earnings.

It is unlikely to do what Alcoa has done in recent years and push as aggressively into downstream value-adding. Alcoa has expanded its exposure to high-value sectors like aerospace and automotive and started to diversify into manufacturing with non-aluminium lightweight metals.

The emergence of a more rational market for alumina and primary aluminium over the next couple of years would, however, be a major positive shift in the entire industry’s settings. Rusal and Rio would have a leveraged exposure to an improvement.