Liancheng - now you don’t see it, now you do

Ian Walker from Fastmarkets asked me last night what I thought of the Chalco announcement that they would close their Liancheng smelter in Gansu province. I told him I thought the announcement read like a sales pitch.

It turns out I was right, but the sales pitch wasn’t the one I was thinking of. I had thought that the language was very diplomatic and that perhaps they were trying to assuage the Gansu government’s concerns that the closure would cost VAT revenue, jobs, bank loans and GDP growth. But no. Today we discover that the Gansu government has caved in and decided to pay a subsidy to Chalco to keep the plant open.

The Liancheng smelter will now operate at slightly under half its total capacity, at about 250,000t.

This is no ordinary subsidy either. From what we understand, the subsidy on electricity costs will bring Liancheng down to RMB0.25 per KwH for their power. Considering they were paying about RMB0.37/KwH before, that’s a reduction of over 30%. On a cash cost basis, it takes Liancheng down to about RMB11,450 per tonne of aluminium produced, and delivers a saving of around US$245 per tonne.

It simple terms, it brings Liancheng to breakeven based on today’s Shanghai price (RMB11,700).

Is this a good move by the Gansu government? If you are a worker in Gansu province, or a holder of Chalco shares, the answer is probably yes. Beyond those two groups, it’s hard to find anyone who gains by this.

The last thing China needs right now is for supply to be locked in. Inherently supply is less elastic than demand. Demand has fallen roughly in line with the slowing economy, but supply keeps on coming, and now here is another piece of the supply picture that is locked in by the subsidy.

The last thing the rest of the aluminium world needs is for China to lock in supply. The LME price is down partly because Chinese metal has been leaking into international markets, and that’s been happening because China makes too much metal. Where the global aluminium community has been getting some leadership from the likes of Alcoa and Rusal, now Chalco takes the opposite end of the leadership spectrum. Not that the Chinese care too much about what happens outside China.

For companies to make a reasonable return for shareholders and so that they can keep employing their people, the market price needs to return to an equilibrium point. High cost smelters have to close in order to achieve this, and some of the highest cost most inefficient smelters are in China. Yet here we have yet another government subsidy coming in and disrupting the natural market forces.

The other thing that the backflip on the Chalco Liancheng announcement does, is that it will make all of us wary of the next wave of announcements. We saw this behaviour in 2014, and in 2013. No sooner did smelters announce they were closing than their local governments stepped in and paid subsidies. We will want to see the mothballs and the locked gates next time.