Commodities

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

See this chart? This is what happiness looks like for an aluminum producer:

Good Times
World primary aluminum demand, trailing 12 months
Source: Bloomberg

But now look at this chart: This is the one that takes all the happiness away.

Foiled
Aluminum, LME rolling 3-month forward price
Source: Bloomberg

It is the cruelest of fates for the smelting crowd that aluminum boasts high growth in demand -- roughly 6 percent a year, compounded, over the past decade -- and yet its price is now actually lower than where it was back in 2005, when aluminum iPhones and Ford F-150 trucks weren't even dreamt of. No wonder Alcoa is trying to get away from the stuff -- sort of.

Yet the old Aluminum Company of America isn't quite there just yet.

Alcoa kicked off earnings season Monday evening by beating estimates. Not that this means a great deal in isolation: Alcoa's earnings are noisy with exceptional gains and losses at the best of times.

Now, with the company enduring the not-so-super bit of the commodity supercycle, it is the company's upcoming split that really matters. Back in September, Alcoa announced plans to separate into an upstream business mining, refining, and smelting alumina and aluminum and a downstream unit turning aluminum, along with other lightweight metals, into turbine blades, vehicle wheels and other useful things. The latter business is dubbed -- usefully, if somewhat insensitively for its sibling -- "Value-Add Co."

Splitting Alcoa is the right thing to do. The competitive edge in making aluminum rests largely on access to cheap energy, labor and capital. Like so much else in the commodity and manufacturing sectors, basic production and consumption of aluminum has shifted eastward -- Alcoa now has only one working smelter in the U.S., having announced more cutbacks last week. It makes far more sense to focus on securing long-term contracts to supply the likes of General Electric with higher-value engineered products rather than basic metal.

The wrinkle for Alcoa investors is that, even if the company's strategic path is the right one, it meanwhile must negotiate a 2016 that is shaping up to be as unpredictable and potentially dreadful for commodities as 2015 was. Alcoa's stock has given back all the gains it made after announcing its plans, and more.

Winter of Discontent
Alcoa's stock has given back the gains made on news of plans to split the company
Source: Bloomberg

Part of the problem is the lack of detail so far. For example, investors await clarity on capital structure. Alcoa carries about $7.2 billion of net debt, as well as legacy pensions. How these obligations get divided up between the two entities is crucial to their valuation. Value-Add Co. will ideally be an investment-grade business with room to grow. But that will depend in part on the upstream business -- which still accounted for half of Alcoa's adjusted Ebitda last year -- having stable cash flow, in order to shoulder a sizable chunk of debt.

Alloyed
Adjusted Ebitda for Alcoa's two businesses
Source: Alcoa

Reinforcing this uncertainty is the shadow hanging over any company in the business of metals: China.

China's role as both arch-consumer and producer of aluminum explains the metal's paradox of enviable demand and miserable pricing. China consumes half the world's aluminum. But, as with many other manufactured and industrial goods, the country has also gone overboard on building supply, as this analysis last month from Macquarie illustrates:

The fundamental story in aluminum remains around Chinese production. China has added over 16mt [million tonnes] of capacity since 2010, and about 14mt of production. For the global market, the good news is that this rate is slowing – China will only add half this volume over the coming 5 years. The challenge is that this rate is still well in advance of domestic consumption, particularly with scrap set to play a more important role in supply.

In its presentation on Monday evening, Alcoa projected China to add or restart another 3.4 million tonnes of aluminum production this year but also to close or curtail 2.4 million tonnes. Based on the company's expectations for demand, that should leave China with a surplus of less than 900,000 tonnes -- which in this market is as good as balanced. Meanwhile, net curtailments elsewhere, including Alcoa's own, should leave the global market overall in deficit, the company projects.

Yet to say that China's capacity commitments are negotiable would be an understatement. Low prices should have led to large closures already, but there clearly are more than just raw economics at play in these decisions -- just look at the Alcoa plant saved at the eleventh hour in November, courtesy of taxpayers in New York state.

There have been encouraging trends in terms of net closures of Chinese capacity in the second half of 2015, according to data from Paul Adkins, co-founder of AZ China, a Beijing-based metals consulting and research firm. The problem, as the chart below shows, is that for much of the past three years, capacity exits have often been reversed or outweighed by restarts in any given quarter, with new additions coming on top. Investors must hope the trend of the past six months or so holds.

Start Me Up
China's aluminum production capacity has until recently kept rising higher, even amid shutdowns
Source: AZ China

In splitting itself, Alcoa will attempt to separate its fate from an aluminum market weighed down by Chinese capacity. It is in the home stretch, but getting there still means covering a lot of rough ground this year.

Correction: Alcoa has named Roy Harvey to serve as CEO of its upstream business. An earlier version of this piece incorrectly said it had not picked a CEO yet.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in San Francisco at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net