Aluminum - don’t be too optimistic

China’s aluminum price at 14000-14500 yuan/t is a result of shutting illegal production, notwithstanding weak demand. Many research institutions also predict further rises; some even predict that aluminum prices will continue to rise and break through 17000 yuan/t. But I think that although policy side of cleaning up illegal production can be expected, yet the new capacity additions should not be ignored. We should not be overly optimistic about the metal price.

1.There is no doubt that cleaning up the illegal production capacity has achieved some effect, but the practical reduction of output remains uncertain。

The Chinese government has issued 13 policy documents since it began to regulate and control the electrolytic aluminum in 2012. The general tone of the 13 documents is to defuse overcapacity and control new increments. But electrolytic aluminum built capacity still increased from 30,000 KT to 44,000 KT in that 5 years. It is obviously that the previous regulatory policy did not get the expected effect. Contradiction between central policy and local economic development has intensified. This time, the regulations convinced the market of the strong determination of the central authorities, especially after the illegal capacity reduction of Xinjiang Jiarun, East Hope, China Hongqiao, and Shandong Xinfa. The market has no doubt about the implementation of this policy.

Over capacity cutting has also achieved a series of effects. But according to our statistics, the capacity of illegal production this time is 4000 KT, compared with industry spontaneous reduction of 4000 KT in 2015. The 2015 reduction was because aluminum enterprises were not optimistic about the aluminum prices in future, while this reduction is occurring despite high prices and a buoyant outlook. It means if the central authorities don’t maintain a high level of supervision and control, the affected smelters will look to offset the orders as quickly as possible. Beijing does not have a good track record at supervision and control at a local level, and local governments are not keen to lose tax revenue or sources of jobs.

2.Under weak demand conditions, the current price of electrolytic aluminum is inflated; aluminum factory profits is already high

Domestic spot market inventory has reached 1.26 million tons, and has grown consecutively for 5 weeks. Consumption is in industry off-season. A large number of small domestic downstream processing factories are shut down because of the environmental protection supervision. The contradiction between supply and demand has become increasingly prominent. But because of the illegal capacity shutdowns, the aluminum price rose instead of falling. Smelters are now running with a cash cost profitability on average of around 10000 yuan/t, with some smelters making as much as 3000 yuan/t.

3. The “illegal capacity” policy aims to streamline the industry’s development, not to spurt prices.

In the coal and steel sector, the supply side reductions led to an improvement in industry realised profits, but prices soared faced with repeated regulation. On July 17th, the NDRC held a conference to further arrange coal supply guarantee work.The conference mentioned that the expected net growth of the effective capacity this year is around 200 million tons, to curb soaring coal prices. For electrolytic aluminum supply-side reforms, we believe that the purpose is still to clean up illegal capacity and standardise the industry, so the central authorities will want to suppress prices soaring. Strongly-rising prices are not conducive to the production and business activities of enterprises. In addition, illegal electrolytic aluminum production capacity is extremely advanced in technology and energy consumption. As a result, after their work is finished, we believe shut-down production capacity will re-enter the market after getting compliance sign-off.

4. Do not ignore new production while staring at over-capacity reduction

According to our statistics, the net increase in production capacity of China’s electrolytic aluminum is 2.14 million tons, even after the illegal capacity closures. In addition, after a number of projects such as Mongolia Huayun, CHALO Huarun, Mongolia Chuangyuan and so on put into production in the second half of year, there will be millions of tons of new incremental capacity. Even taking into account the illegal capacity and Winter Heating Season cuts, there will be still 1 million tons of net increase production in the next 5 months. In addition, we can not rule out that the NDRC will modify some of the rules, or that some capacity forced to cut might get an exemption.

Overall, although Chinese cleaning up illegal production achieved certain effects, yet the progress is still slow. The current rise of aluminum price is only based on expectations of full adherence to the policy. There is no substantive improvement in the demand side, so we should not be too optimistic. Do not ignore new production while staring at over-capacity reduction. Aluminum price between 14500-15000 yuan/ton is very high. If all the illegal production capacity is shut down, the price may have the power to chase up to 15000-15500 yuan/ton, but if that happens we will be looking at a substantial fall. But we are looking at a fall even at the current price levels.