New York, 21 April 2010

With the upending of a decades-long practice of setting iron ore prices in annual contracts this year, the time looks right for alumina refiners to angle for changes to the way the raw material for aluminum gets priced. China's huge appetite for raw materials has helped cause a shift in pricing of key commodities, including alumina, and aluminum giant Alcoa is being forced to bow to that reality, as Brazil's Vale and other big mining companies did this year selling iron ore to steel makers.

"We believe it is time for the industry to develop a pricing methodology that is reflective of alumina fundamentals, and that the most realistic approach in the near-term is the creation of a price index that takes into consideration nearby fixed-price transactions," Alcoa president of Materials Management Timothy Reyes told a recent conference.

Global miner BHP Billiton was out in front pushing for changes of all raw material contracts to take advantage of rising prices in the spot market, analysts said. As market prices for base metals shot higher this year, miners and alumina producers had more to gain from a switch to shorter-term contracts or to a spot-based pricing system than aluminum smelters, with greater costs and lower margins.

Until recently, Alcoa, the world's largest alumina producer at 18 million tonnes annually, resisted the change, keeping in place the pricing method it created 20-years ago to set alumina as a percentage of London Metal Exchange aluminum.

"For the last 5 to 7 years, it's been obvious that Alcoa was getting a worse price than the Chinese. Spot prices are just much higher," said one metals analyst in New York. On Alcoa's quarterly conference call last week, CEO Klaus Kleinfeld announced two changes to its alumina contracts.

First, he said, Alcoa set its prices upwards of 15 percent of the LME aluminum price, well above the 12 to 13 percent long-time average. For 20 years, alumina's percentage of LME aluminum has ranged from 11 to 17 percent, with 14 percent or more considered high.

Second, Kleinfeld said, "We have gone away from longer-term contracts to more shorter-term contractual obligations." Analysts speculated that by shorter-term Alcoa's CEO meant quarterly, as opposed to the traditional annual and, in some cases, multi-year contracts. About 95 percent of global alumina business gets settled through contracts, with the rest carried out on the spot market.

"Alumina is pretty much a developed market with long-term relationships and contracts that last for years. The price has traditionally been set annually. Volume agreements can get set for years at a time," said Wayne Atwell, managing director and metals analyst at investment bank Casimir Capital in New York.

Alumina is an intermediate product made from bauxite ore. It takes four tonnes of bauxite to make two tonnes of alumina, which gets whittled down to one tonne of aluminum. Alcoa remains the largest alumina producer in the world and receives larger margins in its raw material segment than in its aluminum business, which barely breaks even at current prices.

Under the LME percentage system, Atwell and others contend, Alcoa has been cutting itself out of potential profits because of its dominant market share and lower costs. Some analysts speculate higher alumina prices would increase Alcoa's already-high smelter costs and may be a reason the aluminum giant has been slow to change its pricing mechanism.

Some analysts speculate a spot-based alumina price could mean $100 a tonne of unrealized gains for the company. Others said the LME percentage would run 20 percent or more if spot where the basis.

A spot-based pricing mechanism would force more smelters to close down when aluminum prices fall, said Charles Bradford, steel and metals analyst at Affiliated Research Group in New York. Bradford added, however, that there is always a trade-off between long-term contracts that help with planning and short-term contracts that allow more control over margins.

Another veteran metals analyst pointed out that alumina lends itself to contractual agreements because it cannot be stored for long and needs the commitment of a contract to assure it will be received upon delivery. "You can't just shove alumina in a warehouse. It requires proper storage and it has to be used. There is a link between the needs of the taker of the alumina and the provider."

He and others called Alcoa's recent quest to cash in on the rise in spot prices, "a cake and eat it situation." There are isolated examples of index-type pricing already, representing only about 5 percent of total alumina sales.

Currently, India's National Aluminum (Nalco) tenders are seen as the benchmark for spot alumina in Asia, though analysts said China, the world's largest producer and consumer of aluminum, dominates spot alumina deals.

In China, Chalco, its largest producer of both aluminum and the raw material, sets the alumina price on a regular basis relative to spot. To feed its massive smelter capacity, China's spot alumina tends to garner higher prices.

China is still a net importer of alumina, despite its expected 27 million tonnes of output in 2010. Western world producers' projected output is 51 million tonnes. Global alumina demand is seen at about 78 million tonnes in 2010, with about 32 million tonnes consumed in China, according to Alcoa.

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