METALS INSIDER: Aluminium - beware the amplifier effect

-- Andy Home is a Reuters columnist. The opinions expressed are his own. -- By Andy Home LONDON, Jan 13 (Reuters) - Aluminium is in a curious state of simultaneous feast and famine. LME warehouse stocks are still close to all-time record highs but cancelled warrants in the system are rising fast. There are 245,000 tonnes of metal earmarked for physical delivery in the cancelled category. That represents around 5.3 percent of total LME-registered tonnage. It's the highest the ratio has been since October 2007. This graphic shows the steep rise in the ratio over the last few months: http://graphics.thomsonreuters.com/0110/CMD_ALWT0110.gif Bulls are greeting this development as a sign of returning demand and to some extent it is but the impact is being amplified by supply-side developments. AMERICAN FAMINE By far the largest regional component of this demand for LME-stored metal is the U.S. The next graphic shows the distribution of deliveries out of the LME warehouse system since July of last year and the current distribution of cancelled tonnage (as of close of business Monday). http://graphics.thomsonreuters.com/0110/LME_ALSCT0110.gif It is U.S. consumers who are evidently feeling the pinch, a point reinforced by rising physical premiums in the Midwest of the country. Part of the dynamic in the U.S. is bullish. Consumer stocks have been cut to the bone and inventory levels through the supply chain are skeletal. This means that any improvement in order flow, even a marginal one, quickly translates to demand for extra metal. The speed with which that demand is impacting the LME system, however, is largely down to supply anomalies. U.S. producers are maintaining steep production cuts initiated during the closing months of 2008. North American production is still some 20 percent off its mid-2008 peak, according to figures from the International Aluminium Institute. That means there is little domestic supply-side elasticity to respond to the current demand pick-up. The situation has been compounded by two further supply-side developments, one specific to the Americas and one global. Venezuela has slashed aluminium production by around 15,600 tonnes per month in response to a domestic power crisis that shows no signs of ending any time soon. This has removed a significant slice of localised supply until further notice. CHINESE FEAST Meanwhile, RUSAL, the world's largest supplier of the light metal, is directing more of its sales eastwards. The company signed late last year a long-term deal to supply 20,000 tonnes per month to Chinese conglomerate NORINCO. The deal was due to kick in at the start of 2010 and will run until 2016, in effect removing another quarter of a million tonnes from the Western market each year. Quite why NORINCO, which has extensive interests but is best known as an arms exporter, has chosen to commit to imported metal is an interesting question. Chinese demand is undoubtedly rising faster than anywhere else at the moment. Alcoa , in slides accompanying its Q4 2009 analysts call, projects Chinese demand will rise by 18 percent this year, vastly outperforming any other major country or region. However, Chinese production is also rising at a super-heated pace. November's run rate of 16.15 million tonnes was a record high. It is a moot point as to whether even China can absorb all this metal and the snapshot December trade figures out earlier this week showed a continuing decline in net imports. It's difficult to tell from the preliminary figures but the country's unwrought aluminium trade looked to be broadly balanced last month with exports rising quite sharply. The full trade report out later this month will also throw some light on whether a trend of rising exports of semi-fabricated products is continuing. This is a key part of China's trade dynamic since exports of such products carry a lower tax penalty than primary refined metal. THE NEW CONSUMER RUSAL is also a reminder that aluminium consumers are competing for metal with a different type of consumer, namely the investor community. Financing of LME stock, which leads to large amounts of metal being "locked up", has been a much-discussed feature of the aluminium market for some time. But it's worth remembering that the same straightforward strategy can be used to finance off-market stocks. That is what happened last year with Swiss trade house Glencore snapping up well over a million tonnes of RUSAL metal to store off-market. Inevitably this has served to tighten up the global physical market as Japanese term buyers found to their cost in their negotiations for Q3 2009 shipments. The complete absence of offers from RUSAL led to a 30-percent jump in premiums to $74-75 per tonne over LME cash. As long as the contango on the LME forward curve allows the financing trade to be profitable, it will continue. Improving credit conditions mean that bankers no longer insist on the metal being collateralised against LME warrants, as was the case during the worst of the fallout from the 2008 credit crunch, which is when and why LME stocks ballooned. THE AMPLIFIER EFFECT Be wary, therefore, of the apparent strength of demand for LME aluminium and its implications for the great recovery debate. Demand signals are being amplified by continuing production cutbacks, the diversion of global metal flows and the rebuild of off-market inventories. Demand is recovering but not at the pace suggested by LME stock developments. That's why producers such as Alcoa are still keeping potlines idled. It's also why the U.S. producer, hardly a traditional bear voice in the market, was still palpably downbeat in its assessment of the market in its Q4 earnings call. Check slides 28, 29 and 30 in its presentation, available at the following internet address: http://www.alcoa.com/global/en/investment/pdfs/Alcoa_4Q09_Earnings_Presentation.pdf Three key sectors (aerospace, industrial gas turbines and construction) are expected to deteriorate further. One (beverage cans) is expected to be flat. Only two (automotive and truck/trailer) are expected to improve. North American demand is forecast to grow by only 5 percent this year after contracting by 15 percent last year (with Europe lagging even that modest rebound). Alcoa's conclusion? A forecast the global market will register a 1.2 million tonne surplus this year. Whether consumers ever get to see that surplus, however, is an altogether different question, as those in the U.S. are discovering right now. (Graphics by Scott Barber) ((andy.home@thomsonreuters.com))