Rio Tinto sees the silver lining in aluminium

Two major themes emerging within China are set to shake up the aluminium industry, and hint at a much brighter outlook for Rio Tinto -- if the sector can better balance supply and demand.

There was a noticeable tinge of optimism in Rio Tinto’s post-results assessment of the longer term future of its ravaged aluminium division. That optimism might be starting to be borne out by events.

Aluminium was the metal that didn’t benefit from the commodities boom but still got belted by the commodities bust. In the pre-crisis environment demand was strong -- it grew at about 8 per cent a year thanks to surging demand from China -- but production growth was even stronger as smelting capacity in China and the Middle East kept expanding their output.

Not surprisingly, prices plummeted to about half their pre-crisis levels. This forced a traumatic restructuring of the global industry, except in China and the Middle East, where production continue to rise.

The recent announcement from Alcoa that it would shut its Point Henry smelter near Geelong is part of a Western world rationalisation of smelting capacity.

Alcoa has shut down or cut back production by more than 500,000 tonnes in the past year. The world’s largest producer, Rusal, reduced its capacity by 8 per cent last year and has said non-Chinese production will have to be cut by up to another 1.5 million tonnes this year.

The key problem that has destabilised the industry is that China’s industry, which now accounts for roughly half the world’s production, hasn’t behaved rationally.

While its newer and larger smelters have benefitted from lower energy costs, more hydro generation and greater proximity to bigger and more modern smelters, a large percentage of the industry has been prepared to maintain output while losing money.

That may be changing.

There are two major themes emerging within China.

The new leadership under President Xi Jinping appears to be committed to significant structural reform. This is most evident within China’s banking system but also within its state-owned enterprise sector, where there appears to be a drive underway to rationalise sub-economic activity and get rid of local government subsidies.

The two trains of economic reform are related and are occurring against the backdrop of a slowing of China’s economic growth rate. China’s banks are under pressure from their regulators and the economy to introduce far greater discipline in their lending. They are reportedly starting to deny credit to poor credit risks. That’s forcing change on industries with significant over-capacity, like the steel and cement industries -- as well as aluminium.

A Goldman Sachs analysis of the aluminium sector earlier this month said that China’s domestic aluminium prices have fallen by 10 per cent since the start of the year to their lowest levels in 16 years as low-cost smelting capacity in northern China continues to surge. However, high-cost grid-based capacity (up to 30 per cent of China’s production) elsewhere has continued production.

Goldman estimated at about half of China’s output -- about a quarter of global supply -- was losing money on a cash basis. It said it expected that smelter closures in China would result in 2014 being the last year of the surplus of the metal in global markets.

With the rationalisation of higher-cost production that has been occurring in the West and the prospect of an over-due purging of loss-making (and polluting) capacity in China, Rio’s belief that the industry might be close to bottoming out may be based more on economic logic than hope.

Rio, of course, has a major presence in the sector even after writing of tens of billions of dollars in the wake of its ill-timed and valued $US38 billion acquisition of Alcan on the eve of the financial crisis. Its aluminium division made a positive contribution to last year’s earnings of $557m, although that was a meagre return even on the savagely written-down value of the assets employed.

If the global sector does move into something approaching a supply-and-demand balance next year, the foundations of the industry and its outlook – and the outlook for Rio, which needs to reduce its near-complete reliance on iron ore -- would look more positive than they have for years.

Rusal has estimated the industry needs an aluminium price of at least $US2000 a tonne to break even. It has been hovering around $US1700 a tonne for the past few years. Goldman doesn’t see prices rising to $US2000 until 2016, but the fact that it can even canvass that prospect is indicative of the structural changes that have occurred to Western production and appear to be belatedly occurring in China’s industry.

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