By Thomas Streater
It is likely the aluminum industry may be enjoying a collective
sense of schadenfreude as the misfortune that has befallen energy
companies offers an opportunity to lower the cost of producing the
lightweight metal afforded the nickname "solid electricity".
Aluminum production is a highly energy intensive process,
meaning the ability to source low cost power is a key determinant
in sorting who sits where on the industry cost curve. That cost
curve has been reshaped over recent years as many of the world's
biggest producers have shut down unprofitable smelters and
refineries in an industry infamous for overcapacity. Aluminum
prices scratched out a 3% rise in 2014, even though prices fell
late in the year.
The better than expected fourth quarter earnings from U.S.-based
Alcoa highlights the improvement in the industry's fundamentals. It
was the upstream part of the business, or those operations involved
in the mining of bauxite and its refining into alumina, that
starred in the quarterly earnings that exceeded analyst
expectations by 20%. Alcoa noted in its results the important
contribution made not only by productivity gains but also the
benefits of lower energy costs, especially in fuel oil.
The fall in the costs of energy like oil, gas and coal is
broadly positive for the aluminum industry, including Asia-based
producers like Aluminum Corporation of China (2600.HK) and India's
Hindalco Industries (500440.BY). However, investors seeking to play
the rally in aluminum stocks need to do their homework in checking
what type of electricity generation is used by individual companies
to power their smelters as it will determine profit margins.
Alcoa is largely powered by oil and gas, while Norway's Norsk
Hydro (NHY.OS), as the name suggests, gets its electricity from
hydroelectric power. Hong Kong-listed Russian producer Rusal
(0486.HK), which Barron's Asia recommended in November, is also
largely powered by hydro. Aluminum Corporation of China, better
known as Chalco, sources most of its power from coal-fired
generation. However, lower coal prices are likely to be only slowly
reflected in Chalco's margins as China's government reduces
electricity tariff only very gradually.
Aluminum, which has been friendless in the analyst community for
several long years, has drawn renewed interest over the past couple
of years amid the moves to cut capacity. Bernstein Research analyst
Vanessa Lau recently raised her earnings estimates for Alcoa, Norsk
Hydro, and Rusal after raising her aluminum price forecasts and on
stronger than expected earnings. Norsk Hydro and Rusal are both
benefitting from the tailwind of weakness in the Norwegian krone
and Russian ruble, respectively.
Lau has an outperform rating on the three stocks, as well as on
Hindalco and U.S.-listed Constellium (CSTM).
Falling coal prices are worth watching for their impact on
Hindalco, a stock Lau thinks is cheap given its trades at 0.8 times
book value. Lau told Barron's Asia the stock, which has fallen to
INR144 a share from a July high of INR198 a share, has been
affected by uncertainty around the Indian government's coal
allocation policy. Hindalco has sourced its coal from open-cut
mines, where the cost of mining is cheaper than underground
collieries. However, if Hindalco is not awarded additional coal
allocations then it will be forced to spend more to buy coal in the
market. But the slump in global prices of coal due to a significant
increase in supply, should allow Hindalco to produce the
lightweight metal at a competitive cost.
India's aluminum industry could also be bolstered by the reform
agenda of Prime Minister Narendra Modi. His focus on revitalizing
India's manufacturing industries, highlighted by his 'Make in
India' slogan, could lead to the easing of regulatory bottlenecks.
Hindalco has ramped up investment in greenfield projects, or new
developments. Separately, Hindalco should benefit from its
ownership of U.S.-based Novelis, which is benefiting from demand
for aluminum used in car manufacturing.
Aluminum prices should be supported by solid demand for the
lightweight metal. Alcoa has forecast 7% global demand growth in
2015, with a return to a balanced market after a supply deficit
last year. The company also noted that physical premiums - the
extra cost in regional hubs over the London Metal Exchange's
benchmark prices to access metal quickly - remain high. Lau, who
forecasts a 560,000 metric ton deficit in 2015, notes that even as
inventory levels have fallen over the last year, the high physical
premiums indicate supply is being easily absorbed by demand from
industrial users such as manufacturers. This stands in stark
contrast to the carnage witnessed in the energy markets, where
additional supply has been greeted by prices falling to multi-year
lows.
After a review of the industry, Barron's Asia remains bullish on
the shares of Hong Kong-listed Rusal, the world's largest aluminum
producer, while Hindalco is a stock that should be placed on
investor's watch lists given its appealing valuations.
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Email: thomas.streater@barrons.com
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