Friday, May 12, 2006


Despite High Prices, Global Aluminum Industry Faces Rising Energy, Input, Capital Costs.

Publication date: 01-Mar-06

Although the price of aluminum has recently shot up to more than $1.11 per pound--a level not seen since 1989—because of rising demand and constrained supply, it may not be high enough. That price may not offset soaring energy and input costs and escalating capital spending levels associated with large-scale capital projects aimed at transitioning production to regions with lower-cost energy. As a result, debt levels may rise, and the credit quality of primary aluminum companies could remain under pressure over the next few years.

Aluminum's Favorable Pricing Outlook
The price of aluminum has nearly doubled since Jan. 1, 2003 (see Chart 1), as a result of strong demand from China, low London Metal Exchange (LME) inventories, potential production capacity closures in Europe and North America, and the expectation of slowing Chinese exports. Investment demand from hedge funds that have shown greater interest in commodities has also driven some of the recent improvement.

The pricing outlook remains favorable for the intermediate term, as the market is expected to remain in a deficit. Global demand is currently estimated at 30 million metric tons and is estimated to grow 5% annually, to 47 million metric tons, by 2015. Supply is expected to be constrained because of the forced closure of some capacity in the U.S. and Europe, an estimated 1 million metric tons of capacity is at risk of closure, and an insufficient amount of new smelting capacity slated to start production before 2007 to replace closed capacity. Improving prices are also consistent with the expectation that primary aluminum exports from China will decrease as a result of government pursuit of this goal to reduce "exports" of power. Also, improved economic conditions in Russia and China should ultimately result in increased internal consumption and lower exports. However, Standard & Poor's Ratings Services expects the price of aluminum to decline again in the intermediate term as new capacity ramps up or if major economies slow.

China Pushes Demand And Prices
China's industrial growth has been the primary reason for the surge in demand and prices of most metals over the past couple of years and aluminum is no exception. Despite a heavy reliance on spot markets for raw materials and unreliable power supply, Chinese primary aluminum production has sustained rapid growth, increasing to more than 8 million metric tons a year in 2005 from less than 2 million in 1995.
The main reason for China's continued growth is governmental support. However, the Chinese government has taken several steps to curtail the aluminum industry's growth and its exports, including restricting approval criteria for new projects. The policy requires that new projects be self-sufficient in power supply and also encourages industry consolidation to a few large companies with highly efficient operations that meet restrictive pollution criteria. The Chinese government has also implemented measures to lower exports of primary aluminum, such as replacing its 8% export rebate on aluminum with a 5% export tariff. It appears that the government's efforts to rein in exports are working. Exports slowed in the second half of 2005 following the policy changes and the yuan revaluation. We now expect China to export about 1.2 million metric tons of primary aluminum in 2005, down from 1.6 million metric tons in 2004. If China sustains this trend, it would be bullish for a world aluminum market that needs Chinese exports to compensate for regional deficits elsewhere (most notably in Asia, North America, and Europe).

Several other developments in China bode well for the price of aluminum. A number of aluminum smelters there are banding together to reduce production, in an effort to pressure their power and raw materials suppliers to lower or hold the line on skyrocketing prices. Also, Chinese government officials have been talking about raising export taxes on primary aluminum. This, too, would be good for prices, because it would reduce the outflow of aluminum from China to the West. One senior official from China's nonferrous metals industry association stated that China's primary aluminum consumption was expected to reach about 7 million metric tons in 2005, up 17% from 2004 and to continue growing to 8.3 million in 2006 and exceed 11 million by 2010.

Cost Pressures Persist
As Chart 2 illustrates, the 2005 margins of the industry's two largest participants—Alcan Inc. (BBB+/Stable/A-2) and Alcoa Inc. (A-/Negative/A-2)—have not benefited from higher LME aluminum prices because of cost pressures, while the margins of other companies have not widened as much as the increase in LME aluminum price would suggest. Margins should improve in 2006 because of recent spikes in the price of aluminum. Although key raw materials inputs like bauxite, alumina, and caustic soda are priced globally and cost swings are unavoidable irrespective of location, costs related to power, labor, gas, and environment are persistently high in the key primary production areas of North America, Western Europe, and China. Aluminum smelters are among the most energy-intensive industries, with electrical power typically the largest cost component in primary aluminum production. Alumina is typically the second-highest cost component. Their rankings depend on a company's geographic location and how it purchases its power/alumina requirements, i.e. whether it is done on the spot market or under long-term contracts and what the pricing terms are—whether it is indexed to LME or subject to fuel surcharges or a fixed price. Long-term supply agreements have insulated many aluminum producers in North America and Europe from rising power costs. However, many agreements expire in the intermediate term, which will likely force some producers to cease or cut some of their production in these areas given that power costs have risen to varying degrees in many areas because of rising demand and feedstock costs, namely for coal and natural gas.
In response to these pressures, producers are shifting production to regions with lower power costs such as hydroelectric capacity in the hope of procuring access to stable, long-term, low-cost power. Indeed, U.S. primary aluminum production has declined to about 2.5 million Mt, down about 31% since 2000. Domestic production is likely to continue its decline given the high cost of power, which will be the primary determinant of a smelter's viability.

The supply of alumina has been tight the last couple of years, driven by strong demand (especially from China) and moderating supply growth due to limited previous investment in new capacity, numerous production problems at refineries and delays in ramping up new capacity. China is currently a large net importer of alumina, importing 50% or 6.8 metric tons of its production needs in 2004, which translates into 70-80% of world spot alumina. As a result, alumina spot prices are now near US$600 per metric ton, compared to a US$150 per ton average in 2001-2003. China will continue to remain a net importer of alumina but the percentage of imports is expected to decrease as the country is expanding its alumina production capacity. With some additional capacity coming on-line, the price of alumina is expected to moderate in 2006 but stay well above this prior level since increasing requirements for growing aluminum production levels will keep supply tight.

Growing Supply Of Primary Aluminum
Globally, there are plans for large new smelters--some as large as 600,000 metric tons to be built in areas with low-cost power, including Iceland, Dubai, South Africa, and Russia. Today Iceland, which benefits from low cost geothermal and hydroelectric power, has just 270 kilotons of primary aluminum production at two plants, Alcan and Century's Nordural facility. By the end of the decade the primary aluminum production from Iceland is expected to grow to 787 kilotons. Alcoa is building a large 344,000-metric-ton greenfield aluminum plant, scheduled to start in 2007. Century is currently expanding its Nordural plant to 220,000 metric tons from 90,000 metric tons set to start production in early 2006. Market leaders Alcoa and Alcan are considering several other large expansions in other low cost regions, totaling in the $billions over the next few years.

Other Expected Capacity Expansions
Unrated Rusal Holding Ltd.--the third-largest aluminum producer globally with US$5.4 billion in revenues and 2.7 million metric tons of primary aluminum production--has aggressive plans to grow to the largest and most profitable aluminum producer by 2013 with approximately 5 million metric tons per year of primary production and about 8 million metric tons per year of alumina. Current smelter projects include construction of Khakas Aluminum Smelter with capacity of 350 kilotons per year, two greenfield smelters in Irkutsk and Krasnoyarsk regions of Russia and a new smelter in Tajikstan. In total, the company expects 2 million metric tons of additional capacity by 2010 in Russia. Rusal is also currently in the process of signing a memorandum of understanding with RAO Unified Energy Systems of Russia to construct a $4 billion aluminum smelter and power plant in Boguchanskaya.

Vedanta Resources PLC (BB/Negative/--), a U.K.-based company with primary operations in India, which expects to produce 140,000 metric tons of aluminum in 2005, plans to invest $3 billion to increase its output to 900,000 metric tons over the next three years. Vedanta's board recently approved a $2 billion Greenfield project in Orissa, India, that includes a 500,000-metric-ton aluminum smelter and thermal power plant, which is expected to start up in 2010.

Substantial Capital Spending, Negative Cash Flows Likely
The proposed shift in companies' production profiles will necessitate large capital expenditures over the next five years, with the capital cost of a number of individual projects totaling in the billions of dollars for some large-scale projects, some of which include the construction or sponsorship of power-generation capacity. As Chart 3 illustrates, however, the combination of increasing costs and substantial capital spending is resulting in sharp declines in free cash flow and could increase the industry's total debt over the next several years if the price of aluminum falls from current levels.

Overview of Aluminum Companies
Low-cost Alcan Inc.
Alcan Inc. benefits from a leading market position in primary aluminum and downstream businesses, low-cost operations, and excellent revenue and geographic diversity. Alcan is a low-cost primary aluminum producer, with about 70% of its smelting capacity in the bottom two quartiles of cash costs globally.
Alcan's relatively high proportion of internally generated power and almost 90% self-sufficiency in alumina help shield it from rising input costs, while its high degree of downstream integration stabilizes earnings through the aluminum price cycle. Nevertheless, the appreciation of the Canadian and Australian dollars and the euro in the past few years as well as increasing power costs in Western Europe continue to erode the company's margins. The company is planning several major projects to improve its cost position and combat margin pressure, which will weigh heavily on its free cash generation over the next few years. Counterbalancing Alcan's strong business profile is a financial profile that is weak for the rating and that we expect to persist as the company increases its capital expenditures to expand its upstream bauxite and alumina capacity. We expect Alcan's investment in its upstream operations to defend its industry-leading cost position in the next several years, thereby contributing to enhanced profitability by 2007.

Big and broad Alcoa
Pittsburgh, Pa.-based Alcoa Inc.'s credit quality reflects the company's very strong business position as the largest integrated aluminum producer in the world, with broad product, business, and geographic diversity, and efficient alumina operations. Alcoa's very strong business position is supported by its market dominance in the upstream aluminum market with good end-market and operating diversification. While Alcoa's alumina operations are very low-cost, the company is taking necessary steps to improve its cost position at its primary aluminum operations, which is somewhat higher than many of its peers. This is primarily because approximately 40% of its smelting capacity is in the U.S., where operating costs are substantially higher than in other locations. Also, lower production; rising energy, input, and health-care costs; currency fluctuations; weakness in some downstream markets; and aluminum price volatility have previously pressured Alcoa's margins.

Given inflationary pressures and growth prospects in the alumina markets, Alcoa is implementing necessary strategic initiatives at its upstream operations that should allow it to maintain its competitive business position over the longer term. However, significant increases in capital expenditures, cost pressures, and volatile prices over the next few years could impede a timely return of financial performance and metrics to levels indicative of the current rating and lead to a downgrade.

High-cost Century Aluminum
Century Aluminum Co. (BB-/Stable/--) has a relatively high-cost position versus its peers and limited product diversity. With a capacity of about 615,000 metric tons per year (metric tons per year) of aluminum, Monterey, Calif.-based Century is a distant third in the production of primary aluminum in North America, after market leaders Alcoa and Alcan. Century has exposure to escalating power costs at its domestic operations. As it stands, about 85% of the company's primary aluminum capacity is currently in the U.S. and is significantly exposed to rising energy and alumina input costs. The company has three smelters in the U.S. and one in Iceland.

To counter cost pressures, Century is more than doubling the capacity of its Nordural smelter in Iceland to 220,000 metric tons per year from 90,000, which should reduce its higher-cost U.S. output to about 65% of its total capacity. The company scheduled the beginning of production for February 2006, and the smelter should be at full capacity by late 2006. The company's power costs and most of its alumina costs in Iceland are well insulated from the spikes occurring elsewhere, with its power rates indexed to LME aluminum prices through 2019 and most of its production under an alumina tolling contract for which it receives a margin for smelting.

To date, higher average aluminum prices have helped to offset rising costs and debt levels associated with its Nordural expansion. Century's credit metrics will weaken somewhat in the next two quarters, as we expect it to need to borrow additional funds to complete the Nordural expansion, but it should improve once it completes expansion and the new capacity ramps up and enhances its free cash flow.


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