London, 21 June 2011

Rising Chinese power prices and the well-flagged potential for power rationing over the summer peak demand season have injected some bullish impetus into the aluminium market recently. After all, aluminium smelters are some of the most intensive industrial users of electricity and are an obvious target if Beijing orders households to be prioritized over industry in the event of a summer power crunch.

Moreover, parts of the Chinese smelter sector sit at the top end of the aluminium production cost curve, leaving them vulnerable to further increases in the price of the single most important cost input in the smelting process. However, the latest production figures from the China Non ferrous Metals Industry Association (CNMIA), as carried on the website of the International Aluminium Institute (IAI), show Chinese production cranking up yet another gear in May.

Daily average production in China hit a fresh all-time record high of 49,700 tonnes per day, equivalent to an annualised 18.14 million tonnes, up from 48,400 tonnes in April. The monthly jump in Chinese production more than offset a slight decline in the rest of the world and pushed global output also up to a fresh high of 43.66 million tonnes annualised.

The Chinese smelter sector has lifted run rates by an annualised 3.47 million tonnes so far this year and more may be to come. Local industry officials have suggested that Chinese production of the light metal may carry on rising through June and July with an estimated 1.5 million tonnes of new annual capacity slated to come on stream.

STILL IN DEFICIT?

Superficially at least, China needs all this extra production to meet its own fast-rising consumption of aluminium. China's output of semi-manufactured products, first-stage demand for the light metal, has been running at super-fast growth rates, up 33 percent in the first five months of this year.

Visible stocks of aluminium in China, namely those registered with the Shanghai Futures Exchange ( SHFE), have been steadily declining. They slid another 15,827 tonnes to 292,808 tonnes last week. That is widely thought to be the tip of the iceberg with off market stocks falling harder. Details are necessarily sketchy but researchers at Macquarie Bank, to cite just one example among many, estimate that stocks have fallen by around 150,000 tonnes since the start of the year and, in terms of weeks of consumption, are now slightly lower than their pre-crisis levels.

Macquarie's view is that "looking ahead, we find it hard to model anything other than a balanced to small deficit market in China in aluminium in 2H11". That is probably consensus thinking among the analyst community right now. The production-side risks to that assessment currently look neutral with the potential impact of a new wave of capacity start-ups offset by the potential for power rationing some time over the summer months.

OR STILL IN SURPLUS?

The problem with calculating an aluminium metal balance within China, though, is that by definition it ignores what is happening further downstream. China hasn't been a major exporter of primary aluminium since the end of 2006, when a 15-percent duty on exports was introduced.

It has, however, been a consistent and growing exporter of aluminium semis. Exports of "product", or at least that which China's customs is prepared to classify as product, surged by 56 percent to 2.18 million tonnes last year. And product exports have continued booming this year, up another 38 percent to 880,000 tonnes in the first four months of 2011.

This disconnect between China's trade in primary metal and in products is a direct result of government policy. Beijing has urged aluminium producers to move away from "commodity" metal production to greater value-added products output.

It has incentivized them to do so by allowing tax rebates on exports of selected products, in sharp contrast to the heavy duty on primary metal exports. This means that part of China's internal consumption of aluminium is merely to produce products for export. Based on official figures for the Jan-April 2011 period, exports of product accounted for 11 percent of total products output.

China bulls can argue that ratio is small enough not to detract from the broader strength of consumption within China. But were it not for the artificial incentive to export product, the implication is that latent oversupply of aluminium would be more evident in the primary metal market than the products sector.

TOO BIG TO FAIL

The issue of aluminium export rebates is back on the official agenda in China with local expectations growing that Beijing may be poised to slice four percentage points off the 13-percent rebate on exports of profile.

It's questionable how much a difference this will make to the bigger picture, particularly since the rebate on aluminium plate, the most active semi-finished product export, is expected to remain unchanged.

Beijing may wish to instill some order and consolidation into its notoriously fractured and unruly aluminium smelter sector, but it will not want to do anything other than tweak the rebate dial. The sector is now huge and a key employer and tax-payer in several provinces. It is too big to fail en masse. Rather, central government policy seems to be one of selective pruning.

It seems unlikely therefore we'll see any seismic change any time soon in the country's aluminium trade patterns. And that means that while the Chinese primary aluminium market may be in or close to deficit, the broader sector remains in surplus.

In that context and with Chinese manufacturing growth slowing, higher aluminium production will most likely only lead to higher product exports.

Ends --