Commodities

David Fickling is a Bloomberg Gadfly columnist covering commodities, as well as industrial and consumer companies. He has been a reporter for Bloomberg News, Dow Jones, the Wall Street Journal, the Financial Times and the Guardian.

If you learned of a product that was about to see a ninefold surge in demand over 15 years, you'd be crazy not to start making it, right?

Wrong.

If you were in the commodity business, you'd first want to check what was about to happen to supply.

Too Much of a Good Thing
China's aluminum production has grown fast. Its capacity to make metal has grown even faster
Source: World Bureau of Metal Statistics, U.S. Geological Survey, Bloomberg Intelligence
Note: FY16 production forecast generated by deflating FY15 figures at pace of decline from January through July 2016. FY16 capacity forecast by Bloomberg Intelligence.

Take Chinese aluminum. Consumption rose from 3.4 million metric tons in 2000 to 31 million tons last year -- but production capacity increased almost 14-fold, to 36 million tons. As a result, LME-traded aluminum forwards now cost about $1,650 a ton, almost exactly the same price as you'd have paid at the dawn of the millennium.

That supply-side problem explains why aluminum prices have consistently failed to fulfil the promise that fueled deals like Rio Tinto's $38 billion 2007 takeover of Alcan.

Dead Calm
Performance of industrial base metals, rebased
Source: Bloomberg
Note: Dec. 31, 1999=100.

"Oversupply pressure may mount again in the second half of the year," Chalco, China's second-biggest producer of the metal, said while announcing a 25 percent year-on-year sales drop in first-half results Thursday evening. "The market situation is still not optimistic."

Why does China keep producing this stuff? Well, much as a church in a medieval village provided social welfare, a community center, a marketplace, and basic population statistics, on top of its central religious role, Chinese aluminum producers do more than just churn out metal.

If it's connected to the grid, a smelter's vast electricity needs can provide the baseload power demand to electrify under-served areas of the country. If it's using its own power supply, the same electricity needs can keep miners in work digging up coal to fire the furnaces. Either way, building and maintaining aluminum plants is a great way for Chinese municipalities to provide jobs and drive economic growth.

That dynamic hasn't changed just because the country's industrial boom has come off the boil. Xinjiang province alone plans to add 4.3 million tons of annual smelting capacity by 2020, according to AME Group, a consultancy -- equivalent to about 12 percent of China's current output. Inner Mongolia will add 2.5 million tons over the same period, plus another 2 million tons by the end of 2017 from coastal Shandong province.

In total, the supply being added in Xinjiang alone will exceed all the current aluminum smelting in Europe and the former Soviet Union, according to AME -- and since the plants will use newer technology and be tied to captive coal mines, they'll produce cheaper metal, too.

That's bad news for Chalco, whose Ebitda margins already trailed rivals China Hongqiao and Henan Zhongfu Industry last year, according to Bloomberg Intelligence analyst Yi Zhu.

That should be enough to thwart the dreams of those hoping the decline of LME inventories to an eight-year low this year will spark a stronger price recovery for aluminum.

Meltdown
LME on-warrant primary aluminum inventories have fallen to their lowest level since 2008
Source: Bloomberg

While China's promised cuts to its steel industry may turn out to be less than meets the eye, aluminum output actually has been declining so far this year, even as new smelters spark up -- down 574,000 tons to 17.8 million tons in the seven months through July.

If those production levels don't accelerate over the coming months, a rough-and-ready measure of capacity utilization in the Chinese industry will drop from around 88 percent in 2015 to 77 percent this year, the lowest level since 2010. You'd have to be a wild optimist to think prices can rise in such a glutted environment.

Aluminum's chronic oversupply isn't going away. It's just gearing up for another cycle.

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

To contact the author of this story:
David Fickling in Sydney at dfickling@bloomberg.net

To contact the editor responsible for this story:
Paul Sillitoe at psillitoe@bloomberg.net