Aluminium defies laws of supply and demand

Aluminium appears at first glance to be defying gravity. Inventories of the metal languishing in London Metal Exchange’s warehouses hit an all-time high last week, five times above last year’s levels. But prices are rising in spite of the overhang and have gained 30 per cent since February. “The current situation is bizarre,” says Stephen Briggs, a base metals analyst at Royal bank of Scotland in London. Analysts expect aluminium inventories to smash through 5m tonnes by the third quarter, up from less than 1m tonnes from 2005 to 2008, as global demand lags behind supply even after large production cuts. Prices have continued to rise, reaching a five-month high last week of $1,701 a tonne, although they are well below July’s all-time high of $3,380. Aluminium is an important metal for the global economy. Its weight-to-strength ratio makes it widely used in the construction sector and to manufacture aircraft and trains. Those sectors have been badly hit in the economic downturn, cutting consumption. David Wilson, a base metals analyst at Société Générale in London, thinks the consequent levels of overhang in the market are so high that they will take a very long time to get rid of. “It is very unlikely that we will see a large enough recovery in underlying demand to clear the supply, even if there are signs of increased appetite in China,” says Mr Wilson. Analysts argue that aluminium has belied its bearish fundamental picture in part owing to renewed enthusiasm for commodities as a recovery play, with investors buying such assets indiscriminately via baskets of metals, grains and oil. Gayle Berry, a base metals analysts at Barclays Capital in London, says base metals are benefiting from an increase in investor risk appetite, including from hedge funds, across the market. Curiously, prices are rallying partly because investors had calculated that the fundamentals for the aluminium market would become extremely negative. Investors have placed large bets on lower prices – taking out short positions in which they sell an aluminium contract first – and gambling that aluminium supply would outpace demand as the aircraft and construction industries suffered. At the first sign of prices picking up, those investors rushed to the exit, closing their positions by buying back the contract, thereby pushing prices higher still. “People have been bearish for a long time and taken out very large short positions,” Ms Berry says. “That creates the risk of sudden and very sharp short covering rallies.” Fears of lower production are also supporting prices. Companies from Russia’s Rusal, the world’s largest producer, to Alcoa, the largest US producer, have cut supplies, prompting some analysts to forecast a decline in global production of 5 per cent this year, the biggest annual drop since the 15 per cent drop of 1982. The cuts in production have tightened some markets. In Japan some buyers have had to pay higher prices to secure aluminium supplies for the first time in a year. Conversely, as commodity prices continue to rally on hopes that a China-fuelled economic recovery will rekindle global demand, aluminium smelters are beginning to resume production, threatening to push even greater amounts of supply into the market. Traders believe that China, the world’s largest producer and consumer of refined aluminium, could restart much supply capacity if prices surged above $2,000. The supply picture is further complicated by physical traders who, having been unable to shift their supply at what they considered an acceptable price early this year, parked some of the surplus into long-term storage deals at LME warehouses. These were funded by the price difference between depressed spot prices and higher long-dated contracts, which made it more attractive to hold on to supplies at the time, and means some metal cannot immediately be released into the market. Mr Briggs argues that the stocks will not be released for some time, “meaning that the amount of supply accessible on the spot market is smaller than LME inventory figures would suggest”. While such technical factors may provide short-term support, few people are convinced that aluminium prices will remain strong over the mid-term if demand does not recover significantly.