Structural Change Just the Trick for AWAC

Thursday, Jun 17, 2010
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Alcoa World Alumina and Chemicals is predominantly about alumina refining. It has two aluminum smelters in Victoria, but these account for a minority 15% of group earnings before interest and tax. It's the eight refineries with total 17 million tonnes annual alumina capacity that drive earnings. They account for around one fourth of global supply.


Traditionally, alumina has been price-linked to aluminum, more recently at around 15% of the aluminum price. But this contradicts the low correlation between aluminum prices and alumina input costs. Current pricing does not reflect alumina industry fundamentals, but this looks likely to change.


Excluding the cost of alumina, aluminum cost is all about energy. Aluminum, for all intents and purposes, might best be described as solidified electricity. While also energy intensive, the alumina stage is as much about key inputs bauxite, caustic, other raw materials, and freight. The mismatch was demonstrated starkly in 2008, when caustic prices rose to triple 2002 levels yet the aluminum price, and alumina by definition, comparatively floundered. AWAC's margins were erased.


AWAC's prices comprise a mix of variably dated lagging contracts and some spot. Alumina Ltd. AWC , AWAC's 40% owner, asserts that alumina pricing is already in a transition phase, with contract pricing to move toward spot over a period of several years as link-based contracts roll off. The prolific growth in Chinese refining capacity accelerated this process. One third of China's bauxite needs are imported. Bauxite importers are the most marginal producers, and being at the top of the cost curve, they influence spot and contract pricing. Over the past year, spot has averaged 17% above composite pricing. The spot market is a growing force.


All else equal, we estimate that a 17% rise in achieved alumina prices toward spot could nearly double forecast AWC earnings. We don't assume this, but if the experience of the iron ore miners is anything to go by, there could be a lot of good news ahead. Perhaps AWC, a company at the mercy of mining-like volatile unit costs, will at long last get to enjoy miner-like prices. AWC?s value-add aspect could limit the negative impact of the Rudd government's proposed resource super profits tax, an added positive. AWC might still have to contend with carbon taxing at some stage, though this has obviously been pushed out with the government's back-down on go-it-alone carbon pricing.


We retain our positive view, although risk is higher than for BHP Billiton BHP or Rio Tinto RTP . AWAC sits favorably at the 25th percentile on the cost curve. Primary aluminum demand will continue to grow. The fact that aluminum is largely a manufacturing process should matter less to AWC as time goes by. More favorably, the company should be thought of increasingly as a mining investment, achieving margins closer to that sector's, regardless of sluggish aluminum pricing.

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