Continuing Strength In Aluminum Prices To Benefit Alcoa

Aug.26.14 | About: Alcoa, Inc. (AA)

Summary

Aluminum prices have bounced back sharply this year as smelters outside China have cut production.

There is concern though that the rally might be stalled.

The rally is likely to continue due to three important factors, which include lower-than-expected Chinese surplus, U.S. housing market gaining momentum and problems in Brazil.

Aluminum prices will remain strong, which augurs well for Alcoa.

Due to the robust outlook and current price level, Alcoa shares are a bargain.

It has been a remarkable year for aluminum. The metal, which plunged about 17% last year due to feeble demand, has gained more than 15% this year as production cuts from the likes of Alcoa Inc. (NYSE:AA), Rusal and Rio Tinto (NYSE:RIO) have helped in bringing the market back to equilibrium. Aluminum prices have finally crossed the $2,000 mark this year. Recently, it rose to an 18-month high. However, lately, there have been some concerns over whether the rally will continue.

The metal retreated about half a percentage on the London Metal Exchange recently after worse-than-expected factory activities data emerged from China last Thursday. HSBC's preliminary Purchase Manager's Index (PMI) for August stood at 50.3, the weakest reading since May. Analysts polled by Reuters had expected a reading of 51.5 following a multi-month high reading of 51.7 in July.

Although a reading of above 50 signals expansion, a slide in the index also indicates that China is losing some momentum. The weaker-than-expected data comes at a time when Beijing is witnessing slump both in the industrial output and credit growth.

There are concerns that aluminum demand in China, which is the world's biggest consumer and producer of the metal, could fall due to a slowdown in the economy. Adding to this concern is the fact that unlike the West, China has been continuing to smelt aluminum. Production cuts carried by North American and European aluminum smelters allowed the market to turn into a deficit in 2013 following a period of supply glut, accumulated since 2011. However, market participants fear that a slowdown in factory activities in China and continued production could once again lead to an oversupplied market. That fear is obvious. China's unwrought aluminum output rose 7.9%, year-over-year for the first five months of the year to 9.59 million tons even as Western smelters continued to slash the production.

Speculation is rife that in this environment, Chinese smelters will look to export more of their unwrought aluminum in international markets to offset weakness in the domestic demand.

Indeed, back in July, encouraged by higher prices in overseas markets, China's aluminum shipments rose to a three-year high. Bloomberg, citing China's General Administration of Customs, reported that China shipped 380,000 metric tons of both raw and fabricated aluminum in July, a 23% rise on a year-over-year basis.

So, is the aluminum market entering a stage where we could see a price correction? And will the metal once again slip below $2000 per ton level?

In my opinion, it is unlikely due to three major reasons.

China's Surplus Will Not be as High as Originally Estimated

In order to offset lower aluminum prices, Chinese aluminum smelters have been cutting down the output since 2013 by closing high-cost smelting facilities. It is estimated that shuttering of these facilities reduced the annual supply by 2 million tons. However, China has also been building new low-cost smelting facilities in last twelve months. But much of this new added capacity has been sitting idle. While only 200,000-500,000 tons of output has hit the market in the first half, another 700,000-800,000 tons could come online in the second half of the year. Earlier in July, CNBC, citing Shanghai-based analyst Wang Chunhui reported that this year the surplus is now expected at below 500,000 tons, down from an earlier forecast for 1 million tons.

U.S. Housing Market Gaining Momentum

After falling for two months in a row, housing starts picked up sharply in July. According to the Commerce Department, housing-starts accelerated by 15.7% in July to a seasonally adjusted annual 1.09 million unit pace while economists' consensus estimate was for an increase by 969,000 unit-rate.

And this augurs well for the aluminum market given that the U.S. is the second largest consumer of the metal.

Aluminum Production in Brazil has Been Hit Hard

The South American country has been witnessing the worst ever drought in decades. As a result, Brazil's water reservoirs have been running dry. It is worth noting that hydroelectric generators account for about 70% of the nation's total electricity production. Due to acute water shortages, producing electricity has become very expensive. As power is the biggest cost component in refining aluminum (about 50%), producing aluminum is becoming uneconomical. Even though Brazil has the world's third-largest ore reserves, it is importing refined aluminum this year. According to Bloomberg, Brazil's aluminum production fell to its lowest level since 1996 in July. American aluminum giant Alcoa had to slash its output capacity by 147,000 tons in Brazil this year due to the challenging environment.

Not surprising then the aluminum market is heading for a deficit in 2014. Goldman Sachs estimates that the aluminum market will record a deficit of 579,000 tons in 2014 and 619,000 tons, next year.

What These Factors Mean For Alcoa?

These factors mean that aluminum prices will remain strong, which of augurs well for Alcoa. As I noted in an earlier article, Alcoa is benefiting from strong demand for its value added products. The concern for the company had been the upstream business. However, it has been restructuring the upstream business. In fact, in the second quarter of 2014, Alcoa beat Street expectations, thanks to the robust performance of its smelting business. Given the outlook for aluminum prices, the smelting business should continue to remain strong. This combined with the strong performance of the value added business means that Alcoa is set for robust growth in the coming quarters. Not surprisingly, Alcoa has gained more than 55% so far this year. However, despite the strong gains, the stock looks like a bargain at current price level and given the company's robust outlook.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.