METALS INSIDER: Squeeze on aluminium? Alcoa explains how

-- Andy Home is a Reuters columnist. The opinions expressed are his own. For more Metals Insider columns, top Reuters metals stories and third party content, please visit the free Base Metals Community website at (www.metalsinsider.com) -- By Andy Home LONDON, July 10 (Reuters) - A squeeze any time soon on the aluminium market seems a far-fetched idea. LME stocks, after all, are at record highs, equivalent to around 45 days' worth of global consumption, according to U.S. producer Alcoa's Q2 results conference call. Demand is still bombed-out in just about every key end-use sector. Alcoa is forecasting a seven percent decline in global consumption this year. The only product sector not expected to see a decline in usage is beverage cans, and even here consumption is likely to be flat. Then there is the lurking suspicion that the light metal has accumulated structural surplus production capacity, particularly in China. How then is this particular market going to be squeezed? Well, Alcoa Chief Executive Officer Klaus Kleinfeld gave a pretty good summary of how it's going to happen. Not that he used the word "squeeze" at any stage of his presentation to analysts. Kleinfeld was merely explaining how Alcoa views the market right now, which is more positively than most analysts. But in doing so, he pinpointed the below-surface market dynamics, which could see an end of de-stocking in the aluminium market swiftly transmitted to LME stocks and, by extension, to LME prices. SUPPLY CHAIN DEPLETED The most important dynamic is the near total depletion of the aluminium supply chain thanks to the massive de-stocking that has taken place since the credit crunch went nuclear in the third quarter of 2008. That wholesale de-stocking is one of the reasons LME stocks are so high. They have ballooned as off-market inventory has been delivered onto LME warrant to lock in financing terms that don't drain industry's credit lines. However, the flip side to this phenomenon has been a sharp run-down in producer inventories of primary aluminium. Producer stocks, as reported monthly by the International Aluminium Institute (IAI), have fallen every month so far this year. As of the end of May they were down by 267,000 tonnes on the start of the year and at 1.409 million tonnes were at multi-year lows. The same applies to the aluminium products supply chain. Total producer inventories reported by the IAI, which include product stocks, are also at multi-year lows. So too are stocks of product held by U.S. service centers. According to Alcoa, these have slumped by over 50 percent from their peak in October 2006. End-user sectors such as automotive are also completely de-stocked but, critically, this may be about to change. Kleinfeld noted that both Ford and Toyota have recently signalled they will increase production of certain brands, primarily because their own inventories have fallen too low. Alcoa is expecting U.S. automotive production to be 1 million units higher in the second half of this year than the first. Considering the implosion of the sector in the early months of 2009, this would amount not so much to a recovery as to a readjustment from ultra-low levels. But even a marginal pick-up in metal consumption is going to flow very fast along a threadbare supply chain. PRODUCTION AND SCRAP CURTAILED Producers, however, will have limited ability to react swiftly to this call on metal. Most, including Alcoa, have recently taken down significant amounts of capacity in response to price weakness and are currently focused on cost-cutting. Some curtailments are still being implemented. Closing an aluminium potline is a lengthy process. So is restarting one. Western producers are unlikely to commit to restarts until they see full recovery in end-user demand, not what might be a "blip" in the end-user stocking cycle. Chinese producers may be quicker to react, and some already have judging by that country's rising production, but that metal will stay in China until there is another tectonic shift in the LME-Shanghai arbitrage in favour of exports. The lack of supply elasticity in the Western world is further compounded by the scarcity of scrap metal, resulting from the general slowdown in economic activity. Alcoa, which is a major buyer of scrap, said it has seen scrap prices, as expressed as a percentage of the LME primary metal price, rise across the board in recent months. The increase has ranged from a 4 percentage point rise in food containers to a 13 percentage point rise in painted siding. WHAT YOU SEE? Production cutbacks, a tightening scrap market and a depleted supply chain mean any improvement in demand for metal units will have to be satisfied, at least in part, by LME stocks. And that's where the real fun starts. Would-be buyers will find that what you see on the LME is not necessarily what you get. In addition to the usual logistical considerations of where LME metal is actually located, there is the problem of how much LME-registered metal is locked into term financing/warehousing deals. Exactly how much no one knows and Kleinfeld declined to give an estimate. But a significant part of LME inventory, maybe even a majority part, is simply not available for immediate sale and delivery. It's only the marginal "free" tonnage that has to be squeezed to generate a sharp rise in price and/or technical tightness across the nearby spreads. WHAT YOU DON'T SEE? There is another dimension to this that Kleinfeld didn't touch on. The effect on the LME of the switch from de-stocking to re-stocking can be amplified if metal is simultaneously withheld from the exchange. It is a badly-kept secret in the aluminium market that Russian giant UC Rusal will sell a large amount of metal to Swiss trade house Glencore under a term agreement. That metal will not hit the LME system and it's already noticeable that the rise in LME inventories has lost a lot of momentum. Last month's 157,600-tonne increase was the smallest monthly build since October last year. So far this month LME aluminium stocks have actually fallen by a net 1,225 tonnes. Also noticeable is the increase in cancelled tonnage to over 100,000 tonnes since the start of June. As of Thursday (reported Friday morning) cancelled tonnage stood at 122,325 tonnes. The game, in other words, has already started. The game doesn't alter aluminium's underlying problems. An end to de-stocking is not the same as consumer-driven demand recovery. Production cutbacks may simply be masking structural excess capacity. Visible inventory is still at historically super-high prices. But that visible inventory is not what it seems to be either. There are not 4.4 million tonnes of "ready-to-go" LME metal in the event of a pick-up in metal demand, however fleeting it may be. Quite how much is "ready-to-go" remains to be seen. It may take a squeeze to find out the answer