Alcoa Inc., China Alumina Smelters and Spot Buying: What Are the Risks?

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When you are barely breaking even (or worse, losing money), every cent of your cost structure becomes vital – so news that Chinese aluminum smelters are looking at moving from annual contracts to spot or short-term supply contracts for their alumina should come as no surprise. (Alcoa Inc. called for a move to spot or short-term prices earlier this year.)

The move will change the dynamic of smelter pricing by raising the smelters’ risk profile and potentially adding additional volatility into the pricing structure.

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A Reuters article explains that although China produces nearly half the world’s aluminum, it manages to produce nearly enough alumina to meet its current aluminum production needs; but more smelting capacity is expected to come online next year, making some smelters and traders keen to secure imports.

The article reports global sellers had last month offered China buyers 2014 alumina shipments at ratios of 17.5-17.8% of LME aluminum prices, FOB load port. Offers were raised to 17.8-18.5% in the past week for Australia and India origins due to uncertainty over the outlook for supply, but few takers at that level have emerged.

Two sources said some deals had been agreed at 17.8%, compared to 16.1-16.3% in 2013. A rate of 17.8% of the current LME aluminum price of $1,710 would work out at $304 per ton of alumina, FOB. While that was well below spot prices of about $326 last week, some buyers are apparently betting that spot prices will fall.

Hence, two short-term risks remain to spot prices.

Short-term risk No. 1: Indonesia has a planned ban on bauxite ore exports next year, and while no one expects it to be comprehensively enforced, a partial ban could restrict supply and support spot prices. Indonesia this year supplied about 70% of China’s bauxite imports.

Short-term risk No. 2: Rio Tinto plc has announced the closure of its Gove alumina refinery after sustained losses. The 2-million-ton-per-year facility, currently producing just 1.6 million tons, is scheduled to start running down in early 2014. Bauxite produced at the same location will continue to be produced, though, and has held at about 5.8 million tons per year for the last couple of years.

Buying alumina at a percentage of the LME aluminum price gave smelters a natural hedge to their price risk, but moving to reliance on spot supplies will mean smelters would have to forward-cover purchases, something they are not keen on doing because of the strong forward curve to the aluminum price, making the spot-to-three-month spread approaching $50/ton.

How this move to spot pricing works out for smelters remains to be seen, but the move is being supported by alumina suppliers keen to disconnect themselves from an ever-falling refined metal price.

Although Alcoa has called for a move to spot or short-term prices earlier this year, other alumina producers have made similar noises. Whether the move proves beneficial for smelters – only time will tell.

Read more from Stuart Burns.

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