METALS INSIDER-Aluminium supply normalises - will demand?

-- 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, Nov 25 (Reuters) - Global aluminium production ran at an annualised rate of 38.4 million tonnes in October 2009, according to the latest figures from the International Aluminium Institute. It was the highest operating rate since September 2008, meaning that the massive cutbacks initiated over the end of last year have now been negated. Indeed, in the case of China, the world's largest producer, national output is once again hitting fresh all-time records. Chinese aluminium production fell by an annualised 3.7 million tonnes between September 2008 and March 2009. Since then, however, it has surged by almost 5.0 million tonnes to 15.2 million tonnes annualised, as shown in the following graphic: http://graphics.thomsonreuters.com/119/CMD_MTHPRDCHG251109.gif MORE TO COME? Chinese production looks set to continue rising, due both to reactivation of idled capacity and new plants coming on stream. State research house Antaike estimates that operating capacity in the country is running at around 16.6 million tonnes this month, meaning further upside potential from October's run rate. Production outside of China is now also creeping higher but at 23.1 million tonnes annualised Western World output is still 2.6 million tonnes off the peak production levels seen in April and May 2008. That's largely down to continued producer restraint in North America and in Western Europe. Production in the former is down by 22 percent and the latter by 25 percent from those Q2 2008 highs. This graphic shows October operating rates by region relative to May 2008, which was a peak global production month: http://graphics.thomsonreuters.com/119/CMD_YRLPRDCHG251109.gif Western European production looks set to slide further in the short term, since Alcoa has just announced the curtailment of both its Italian smelters, with combined capacity of 194,000 tonnes per year, after the European Commission ordered the company to pay back what it alleges were state subsidies. Alcoa , though, has plenty of spare idled capacity in the U.S. which it could reactivate in compensation. Nor is there much doubt that Western World production is going to continue edging higher. New capacity in non-China parts of Asia already means that regional production is accelerating. And more is due to come in the next few months. Norway's Norsk Hydro confirmed earlier this month that its joint venture smelter in Qatar is still on track to begin firing up in December or January. The plant will add 585,000 tonnes to regional and global capacity once fully on line. Meanwhile, Indian production has already grown by over 16 percent this year thanks to the start up of the new Jharsuguda plant in the state of Orissa. The first phase with capacity of 250,000 tonnes per year is already up and running. A similar-sized second stage is scheduled for commissioning in the first quarter of 2010. CAN DEMAND KEEP PACE? The big question for the aluminium market is whether demand has recovered sufficiently to compensate for rising supply. Outside of China, the proposition looks dubious. Japanese shipments of aluminium products, for example, have bottomed out over the middle of this year but were still 18 percent below year-earlier levels in September. The situation is only slightly better in North America. Demand for mill products in August was 14.2 percent below year-earlier levels in August, according to the latest report from the Aluminum Association. New orders in September were still 9.4 percent off the pace of year-earlier levels, which suggests that demand is only slowly filling the gap opened up by the Great Decline of 2008. That leaves the world dependent on China continuing to power aluminium demand growth. Resurgent automotive and construction sectors are big positives behind the country's 12 percent rise in products output in the first 10 months of this year. This growth rate has been steadily accelerating and with investment pouring into both key end-use sectors, there is no reason to expect it to stop doing so. However, it is now well understood that the country is sitting on big stocks, only the surface of which is visible in the form of metal registered with the Shanghai Futures Exchange. It's also worth noting that the country's net trade in aluminium (primary metal and alloy) has moved back to neutral after a period of strong imports. See the following graphic for the breakdown: http://graphics.thomsonreuters.com/119/CN_ALTRD1109.gif The export tax on primary metal should keep a lid on metal exports in the coming period, but there is a danger that they will simply be displaced into exports of products, particularly those that enjoy tax relief. Product exports over the last two reported months (September and October) reached the highest level so far this year and this category of China's net trade is worth keeping a close eye on going forwards. In short, it seems highly unlikely that the world has recovered sufficiently from the 2008 manufacturing contraction to absorb all of the new and restarted production capacity. For now the surplus is largely quarantined in China but for how long is an open question. HIGHER PRICES POSSIBLE? None of which, however, means that aluminium prices cannot hold the gains they have made in recent months. Although seemingly plagued by high stocks, systemic oversupply and excess capacity, prices are unlikely to decouple from the cross-commodities rally currently underway, particularly given aluminium's heavy weighting in the big commodity indices. Rather, the poor fundamental dynamics of the light metal will continue to act as a restraining influence, which is why aluminium continues to under-perform relative to most of the other LME metals. Moreover, there is a fundamental prop beneath the market. Aluminium's production cost curve is creeping steadily higher, reflecting the price of the all-important electricity needed to produce the light metal. This issue, a regular feature of the bull market before September 2008, is once again raising its head. China has just hiked power tariffs for non-residential users by 5.4 percent, which will affect those smelters which do not have captive power sources and those that have not negotiated tariffs directly with power companies. A rising cost curve remains the most positive price driver for aluminium. Just don't get too excited. There's a lot of spare capacity out there ready to jump on any spike in price. (Graphics by Scott Barber, editing by Anthony Barker)