METALS INSIDER: Aluminium - learning to live with oversupply

LONDON, Sept 23 (Reuters) - The aluminium market has had something of a spring in its step in recent weeks. There are increasing signs that the de-stocking cycle is drawing to a close and that the physical market is tightening as a result. LME stocks are still enormous but seem to be topping out, albeit partly thanks to a revival in off-market stock-holding. Physical premiums are on the up, as evidenced most dramatically by the jump in Q4 Japanese premiums to $115 per tonne over LME cash, their highest level in 14 years. On the LME, three-month prices have retreated from their late July-early August surge above $2,000 per tonne, but only as far as $1,900. However, look below the surface and the light metal's structural oversupply problems are taking visible shape. Global production growth is accelerating, first and foremost in China but also elsewhere in Asia. The immediate question is whether the market is ready for the supply-side surge that is building momentum with each passing month. In the medium term the issue is how aluminium is going to live with the overcapacity that resulted from the last price cycle. PRESENT DANGER Global output of primary aluminium was running at an annualised rate of 36.58 million tonnes in August, according to figures from the International Aluminium Institute (IAI) and the China Nonferrous Metals Industry Association (CNIA). It was the highest production rate since November last year and global output last month was just 7.5 percent below that in May 2008, when production rates outside of China peaked. (The Chinese peak came one month later in June 2008). As the following chart shows, it is China that is the main driver of the current output surge. http://graphics.thomsonreuters.com/099/UK_ALMCNC0909.gif Chinese producers were the first to cut production as prices plummeted over the third quarter of last year and they have been the first to restart. Output in the country has increased for the last five months and at 13.58 million tonnes annualised in August is closing in on the historical peak production rates of 14 million tonnes plus seen in Q2 2008. It may be only a matter of time before the country's output hits fresh all-time highs. As well as the momentum of further restarts, there is no shortage of new capacity due to be reactivated. Analysts at Macquarie Bank estimate that another 1 million tonnes of capacity is due to fire up by the end of the year due to improved profitability at smelters. The country's output of manufactured products is running at a robust rate --8 percent growth in the first eight months of 2009-- but there are already signs of nascent oversupply in the local market. Stocks of metal registered with the Shanghai Futures Exchange are currently at a record all-time high of 229,027 tonnes. And that's just what we can see. Remember that the government stockpile manager, the State Reserves Bureau is holding another 590,000 tonnes, which it bought in the first part of this year. Industry, aided and abetted by state government finance schemes, may be holding as much again. However, from a global perspective Chinese oversupply can be quarantined as long as it doesn't start to seep out of the country. The government holds the key to how this dynamic will play out. It has so far stood its ground in the face of industry requests to reduce the 15 percent export duty on primary aluminium and the country remains a net importer. Some slack has been given to exporters of aluminium products and lobbying for a full rebate of the VAT on exports is continuing [ID:nHKG283405], making this the export category to watch in the coming months' trade figures. Last month's products exports were 130,000 tonnes, exactly matching July's 2009 highs, but still well short of the near 200,000-tonne per month rates seen during much of 2009. A change of tax treatment, though, would potentially open the flood-gates, wreaking havoc in Western markets, which are significantly behind China in the recovery cycle. FUTURE DANGER The latest production figures also point to a more deep-rooted future problem for the aluminium market, which is one of structural oversupply. Look back at the chart above and note that non-China production increased for the first time since October last year. The next chart, replicating the regional breakdown used by the IAI, shows exactly where the production boost is taking place. http://graphics.thomsonreuters.com/099/UK_ALMPRD0909.gif While producer discipline is quite clear to see in sharply lower output rates in North America, Western and Eastern Europe, it is now being negated by the growth of production in (non-China) Asia. This reflects both the lack of capacity cuts by big regional producers such as ALBA and DUBAL in the Persian Gulf and the ramp-up of new capacity both there and in India. Sohar Aluminium's new smelter in Oman reached first-stage capacity of 350,000 tonnes per year in the second quarter. Meanwhile, the 585,000-tonne per year Qatalum smelter in Qatar is due to begin commissioning by the end of this year. In India national aluminium production rose by 16.5 percent in the first eight months of 2009 thanks to the commissioning of Vedanta's Jharsuguda smelter in Orissa. The first 250,000-tonne per year phase is now online. A second, similar-sized stage is due to come online early next year. Waiting in the wings is the even bigger Jharsuguda II project with capacity of 1.25 million tonnes. First-stage commissioning is also scheduled for early next year. Factor in the amount of idled capacity that could be restarted and you start to see why analysts are concerned that the world has simply built too many smelters relative to likely demand, however strong any restocking cycle outside of China. That is not to say that prices cannot rise further. Aluminium's close production-price linkage with energy costs mean that there is always upside as long as you believe there is upside in energy prices. However, a sustained push beyond $2,000 will lead to smelter reactivations outside of China. This represents a powerful cap on prices. If prices are to recover further, demand will have to be firing on full cylinders and even then it will require an unprecedented degree of supply-side discipline from non-Chinese producers to support them. In other words, Western producers may have to keep in place production cuts for a far longer period than seen in any previous price cycle.