“If the aluminium price falls sharply then producers may have a problem,” says SGIC's base metals analyst Stephen Briggs. “Looking at the cost base, energy is most important to the aluminium industry, and energy prices are still rising. Smelters don't use oil, but oil prices influence worldwide power costs, and aluminium is the market that is most exposed.”

Producers have highlighted the problem. The world's largest producer, Alcoa, for instance, recently confirmed (in announcing its quarterly results) that times are hard despite high aluminium prices because of high energy and raw materials costs. These rose more than expected in 2005, to $747 million.

Recent research from Brook Hunt suggests that aluminium cash costs rose by a further 11 per cent in 2005.

“Production costs are at an all-time high and they are likely to remain so for many years to come,” notes James F. King, economic adviser to the industrial metals and raw materials industries.

Power prices have already forced smelters to close, particularly in North America and Western Europe, and much is said about a migration to areas where power is cheaper. Some question the validity of these claims, however.

“The whole cost curve has moved up and got steeper, too,” notes Briggs. “There is now a bigger difference between the lowest and highest cost producers. Europe has always been a high-cost location for aluminium production. If you are a Middle East producer using captive natural gas, the costs will rise less sharply.”

King notes: “Migration has happened over a long time, to Australia in the 1980s and Canada in the 1990s, and now the Middle East, where there was cheaper oil and gas. But oil and gas prices are no longer low. There is a lot of talk about it, but little actual decision-making.”

Furthermore, power is not the only consideration. Alumina prices are also at an historically high level. However, expanding alumina capacity is likely to ease this situation in the coming years.

“Alumina is a constraint now, but from late 2006 there will be more alumina capacity, as it comes online quicker than mines for other metals. The lead time is much shorter,” says Briggs.

Should aluminium prices fall, however, some producers could be hit, and it would most likely be the smaller ones.

“Integrated companies that produce alumina would not suffer so much, so the likes of Alcan and Alcoa would be cushioned,” says King. “But it would be the independents who feel the breeze. China and Western Europe face high domestic power prices, so some could be in a bad way if prices fell.”

Though aluminium is the most adversely affected by high prices, it is not the only market where costs are rising. Construction and labour costs are rising in many markets, including copper, and equipment shortages are also a concern for new projects.

For these markets, however, there is a silver lining, in that high production costs in themselves are likely to keep prices high, even if the markets turn.

Alcoa, in its results statement, was positive about demand for 2006, with aluminium demand growing in many end-user markets, and copper, for example, is still driven by China's growth.

UBS analyst Robin Bhar believes there is a low probability that prices will fall. “If costs rise, smelters close and supply drops, so prices would rise. However, it is not clear-cut. Aluminium is a unique market right now, and we have not seen the like since the industrialisation of Japan and Taiwan in the 1970s,” says Bhar.

“The majors will do scenario planning and capture the rises in costs, but they probably see that a price drop won't happen,” Bhar believes. “If production costs rise there are constraints on production, so why would prices fall?”

Industry adviser King agrees. “If costs of production are very high, then prices won't fall, unless there is a collapse in consumption. But then prices falling and costs remaining high is not feasible, as production would fall and so would expenditure on power and raw materials.”

Though a price fall would put pressure on markets where production costs are rising, the very factors that cause concern are likely to insulate most producers from potential damage.

Jim Banks
LME eRingsider
Edition 4, Spring 2006