Aluminum: Does a Physical ETF Make Sense?

Includes: JJU, KALU
by: Hard Assets Investor

By Julian Murdoch

Physically backed ETFs may currently be en vogue in the precious metals space, but for base metals, the playing field remains empty. Not one physically backed industrial metal ETF exists in the States yet—although rumors have swirled about their impending creation for years. Plus, last month we saw both J.P. Morgan and iShares file for physically backed copper funds. (We discussed the filings on a recent podcast.)

Now, just last week, Alcoa's CEO Klaus Kleinfeld told Bloomberg that he supported the creation of a physically backed aluminum ETF, too. But does a physically backed ETF make sense in the aluminum space?

To answer that question, first we must look at the metal's fundamentals.

Aluminum: A Roller Coaster Ride

For aluminum, the past five years have been a roller coaster:

5-Year AluminumClick to enlarge

(Click to enlarge)

Prices currently float around the $2,260/metric tonne level—still 10 percent down from earlier highs struck back in 2008, and mostly flat on the year.

At the same time, inventories have fallen nearly continuously since the 2008 peak, which, on the surface, sounds good for supply-side support for prices. Still, the market remains oversupplied when compared with the drastic inventory shortage that drove prices over $3,000/tonne back in 2008. Moreover, the inventory drawdown seems to have slowed lately:

Aluminum InventoriesClick to enlarge

(Click to enlarge)

Of course, global aluminum demand can be a tricky thing to parse, and nobody seems to agree on just how strong demand currently is.

On one hand, you have some producers remaining pessimistic on demand, including Kaiser Aluminum Corp's (NASDAQ:KALU) CEO Jack Hockema, who recently said, "The global demand is not that strong yet. The prices are ahead of the fundamentals."

But then you have China, the world's manufacturing behemoth, who estimated its total 2010 demand to be 16.8 million tons—a 22 percent increase from 2009. That's even with recent power curbs in China that have affected one-third of the country's aluminum production capacity. In certain provinces, the power curbs—which are part of the government's plan to reduce pollution and meet 2010 energy conservation requirements—have slowed or ceased coal-hungry aluminum production. Prices have since risen 17 percent.

Some companies, such as the world's leading aluminum producer Rusal, forecast that China's appetite for aluminum will only continue to grow, just more slowly. Rusal's CEO Oleg Deripaska told Bloomberg that consumption of aluminum in China will swell by 20 million to 22 million tons over the next three to four years. He also argues the same type of growth will occur in other parts of Asia, estimating that over the next seven to eight years, aluminum consumption will grow by 4 to 5 percent per annum.

Therefore, while the shorter-term market experiences relatively high inventory levels, demand prospects still look good in the medium to long term. But even still, is this the right environment for a physical ETF?

Metal vs. Paper

Investors find physically backed products appealing because, unlike futures or futures-based products, they can directly track spot prices (minus the fund's expense ratios, of course).

Secondly, by investing in a fund that directly owns the metal, the potentially crippling effects of contango can be avoided. Without futures, there's no need to bother with rolling contracts, or taking the hit to returns when the newly purchased contract costs more than the expiring one.

But is that a compelling enough reason? To see how much a physical ETF might have mattered this year, let's look at the iPath Aluminum ETF (NYSEARCA:JJU) versus the actual spot price:

Aluminum vs. Futures

This year, our hypothetical physical ETF would have outperformed by perhaps 7 percent, minus expenses. Not half bad.

Certainly aluminum producers are interested in a physically backed ETF, too, especially since it would offer a new source of demand for their product. According to Bloomberg, Daniel Brebner, an analyst with Deutsche Bank AG, estimated that if an industrial metal ETF captured just 2 percent of global demand (an estimate that is billed as "conservative"), that would translate to nearly 13 percent of the current exchange monitored inventory.

That could also affect prices. In the same article, David Thurtell, an analyst with Citigroup Inc., estimated that an ETF that held 1.4 million metric tons of aluminum could increase prices by $250 a tonne. Other analysts have put that number as high as $500/tonne.

So no wonder Kleinfeld sounded downright giddy about supplying metal for such a product. "We would be very open to it, very supportive of it," he told Bloomberg.

But one of the biggest negatives for any physically backed ETF is the storage costs associated with the metal. For gold, platinum and silver, those costs are relatively small, compared with these metals' overall value per ton. But when you start looking at industrial metals, the math changes.

Base metals require a lot of space per ton in storage, and the costs are not unsubstantial. For example, the cost of storing aluminum is currently about 39 cents per ton per day, or $147 per year per ton. That doesn't seem too bad, until you compare it with the price per ton—at Friday's prices, that $147 per year equals almost 8 percent of the price of aluminum—a cost that can eat into returns rather quickly.

Now, ways to keep down storage costs exist, and you can be sure that those involved will look for any shortcut. But even at half that price, the storage costs remain pretty steep, and not too far off from the difference in the futures market.

This isn't too surprising, as the whole point of futures markets is to capture precisely these kinds of costs, not just to be a lottery on the future.

What's more, end users of aluminum may not be as excited as the producers when it comes to the creation of a physically backed ETF. The prospect of cost increases, which will naturally need to be either absorbed by the manufacturer or passed onto the consumer, can't be tickling their fancy. But so far, though, no one has out and out complained. (At least not yet.)

While no company has filed for an aluminum ETF yet, that hasn't stopped anyone from acting like its launch is a forgone conclusion. Banks have snapped up warehouses and aluminum producers have discussed details on supplying the metal.

When a product does launch, prices are sure to climb for a bit, as investors play with their newest ETF toy. But the metal's fundamentals should reassert themselves fairly quickly. Unlike the precious metals, which are safe-haven stores of value, aluminum is ultimately a working metal, and one for which overall global supply/demand should remain key.

Disclosure: No position