Alcoa’s results overnight should have brought a smile to the face of Rio Tinto’s Sam Walsh. Walsh has been increasingly confident about the outlook for Rio’s aluminium business and the performance of Alcoa’s primary metals business, its best since 2007, provides support for his optimism.
Aluminium was the sector that missed out on the commodities boom, experiencing nothing but trauma in the post-crisis period because China, representing about half the global production base, kept increasing output into an increasingly over-supplied market.
The response of the rest of the industry has been dramatic and perhaps provides a preview of what will occur across the rest of the resources sector over the next few years as the plunge in commodity prices forces high-cost volume from the markets.
Alcoa’s experience is mirrored across its sector. Since 2007 it has closed about 1.4 million tonnes of capacity and curtailed another 665,000 tonnes, taking out close to a third of its original capacity.
It has also focused relentlessly on improving the productivity of its operations. Across its range of operations it had $US1.2 billion of productivity gains in 2014 and is targeting another $US900 million this year.
With Rio and Rusal taking similar action and the growth rate in China’s production tapering off sharply, the supply/demand balance has moved from one of heavy oversupply to one where the market is roughly balanced.
Last year there was a shortfall of almost a million tonnes of metal relative to demand. This year, Alcoa sees a market marginally in deficit and, with inventories at their lowest levels since 2008, the fundamentals for the sector continue to improve.
Alcoa is forecasting 7 per cent growth in demand for its primary metal this year, which should help support the resurgence of its reshaped business.
The picture isn’t quite as positive in alumina, where there was a modest surplus of supply last year. Alcoa expects a more substantial one this year.
One thing Alcoa has in common with Rio, although in Rio’s case it is exaggerated, is an exposure to an Australian dollar cost base. A 1c movement in the Australian dollar’s value relative to the US dollar impacts Alcoa’s net income by $US11 million. The Australian dollar has fallen about US14c since the middle of last year, so the impacts are material.
While the fall in the value of the Australian dollar won’t compensate commodity producers for the plunge in US dollar-denominated commodity prices, it is helping to blunt the worst of the impact.
Walsh has been increasingly and more openly talking up the prospects for Rio’s aluminium business. Rio has a lot of scars -- about $US30 billion worth of them -- from its expansion in the sector with the ill-fated (and ill-timed and priced) acquisition of Alcan ahead of the crisis, but it has closed or reduced about a quarter of its pre-existing capacity and carved into its cost base.
The division generated about $US1.1bn of earnings before interest, tax, depreciation and amortisation in the first half of this year and Walsh’s plan to invest about $US1bn to expand the business, which includes the world’s leading bauxite business, underscores the increased confidence Rio has in its prospects.
Walsh, with Glencore’s Ivan Glasenberg stalking Rio, needs aluminium to contribute more to the group to reduce the near-total dependence Rio has had on its iron ore business for its earnings in recent years. Rio rejected a merger proposal from Glencore last year but expects Glasenberg to have another crack at it when London’s takeover rules allow it to make another move in April.
While the big and continuing increases in its iron ore production volumes (which have been strongly criticised by Glasenberg) will offset some of the impact of the dive in iron ore prices, they obviously won’t compensate Rio for the more than halving of the price.
Aluminium could help fill in the gap. The momentum that has appeared in Alcoa’s numbers this year and the optimistic outlook supported by the vastly-improved fundamentals of supply and demand suggests Walsh’s confidence in his business isn’t misplaced.