SafakOguz/iStock via Getty Images

SafakOguz/iStock via Getty Images

For years (actually decades), China has been a low cost and fast growing producer of primary aluminum. As can be seen below, China accounted for c.70% of global supply growth from 2000-2007, c.100% from 2007-2014, 83% from 2014-2021. During this period of fast expansion, China prioritized having access to this raw material for rapid industrialization, hence the big producers were largely loss-making as China preferred to have stable access to the raw material and risked overproducing compared to underproducing.

Under this background, aluminum producers were largely unprofitable. Alcoa (AA) had $10bn more or less in revenue per year since 2013, but earnings were spotty. The CEO of Alcoa called China’s policy to restrict supply growth in aluminum a game changer in March 2021; however, this story has largely been put on the backburner given the recession fears.

The markets are underestimating the impact as we get close to China’s self-imposed production cap in aluminum. China imposed a 45 million ton/year aluminum production capacity ceiling several years back as part of a national policy to reduce overcapacity in energy intensive and polluting industry. Current capacity has increased to 44.3 million tons and is currently operating at a mind-boggling utilization rate of 92% in Jun-22, which means we have likely reached “peak production” in China under current policy.

The nickel short squeeze earlier this year was in part driven by the low nickel inventories at that point.

As many authors no doubt have pointed out, aluminum inventories are currently in an even more severe situation.

LME inventories below are significantly lower than the lowest level in many years. In fact, there are only roughly 290,000 tonnes in inventories which is dropping at around 100,000 tons a month despite the recessionary fears.

Inventories in China shown below (not counted in the LME inventories above) are at multi-year lows for July as well despite all the negative headwinds (expanded production this year and the COVID disruptions etc.).

China aluminum inventories (Chinese financial information provider WIND)

China aluminum inventories (Chinese financial information provider WIND)

Chinese aluminum producers’ gross margin per ton of aluminum (in local Chinese currency) is shown below and this has fallen back to a relatively low level within historical standards, which means the current price of aluminum has a margin of safety (and if Alcoa is being priced off current aluminum prices and profitability, then it has a margin of safety as well). Note that the below is an average -> the marginal Chinese producer would be near 0 gross profit at current prices.

Chinese aluminum producer per ton profit (Chinese financial information provider WIND)

Chinese aluminum producer per ton profit (Chinese financial information provider WIND)

Shown below is the global forecast demand for aluminum from just solar/wind (left axis in ten thousand tons), which is several million tons in the next few years (not sure where the extra supply will come from). Solar/wind demand are likely to be accelerated in the current environment where a premium is being put on energy security. China new solar installations is forecast to almost double in 2022 compared to last year.

Forecast aluminum demand from solar and wind (Chinese financial information provider WIND)

Forecast aluminum demand from solar and wind (Chinese financial information provider WIND)

It might seem sort of shaky to base an investment thesis so strongly on production quota policies in China, especially when policies change often. However, the production quota limits may be more enduring. In fact, running out of capacity expansion quotas, Chinese aluminum giants have taken to acquiring each other lately.

The production limits in China have no sign of changing anytime soon, whether the actual goal of the cap is to reduce carbon emissions and energy intensity as % of GDP (as coal is the primary energy for aluminum production in China and aluminum production is a big energy hog) or preventing oversupply and consistent losses. These caps were set for many industries and aluminum is just one of them. These caps would not be re-set easily as then every industry with a cap would want theirs adjusted as well.

As China has been one of the biggest producers of aluminum, once China no longer increases supply, aluminum could face shortages, particularly as demand for this commodity continues to grow.

Of course this cap is not set in stone, there are precedents for changing these caps. For example, coal production was capped at roughly 4.1 billion tonnes in 2021, but after coal prices tripled in Q3-FY21, this cap was loosened and production ramped up, sending coal prices back lower to historically comparable levels. However, it took about 5 months of surging coal prices for the coal production cap to be loosened. Coal also has a much larger impact on the economy (through electricity prices) than aluminum. So it seems likely the aluminum production cap is not going to be moved unless there is a persistent, enduring bull market in aluminum.

On the demand side, the main uses of aluminum are usually not that high a percentage of the final product’s value for demand to be materially dented by higher prices, at least in the short run. For example, passenger vehicles (i.e. your average car) use roughly ~200 kilograms of aluminum on average with EVs using a bit more. That is equivalent to about $500 at current prices, which is only a small fraction of a new car’s retail price. Even if aluminum prices increase by 30% or 50%, automakers might complain a bit but it’s not life or death.

The main short-term risks will be recessionary fears and high natural gas prices in Europe denting industrial demand. However, the medium- and long-term outlook is favorable.

Given the low inventories, demand growth, recovery in risk appetite from a Fed to be marginally less hawkish and solid Q2 corporate earnings and most importantly limited supply growth, it appears aluminum may be set for a short squeeze. A short squeeze will lead to a revaluation of Alcoa’s value as one of the largest primary aluminum producers.

This article was written by

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.