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Metal Fatigue by Cheryl Strauss Einhorn Barron's, May 20, 2002

Aluminum remains weak, but could rise later

Anemic near-term demand for industrial commodities may be masking a longer-term bull story.

During the long slide in prices, commodity companies have reduced production capacity through mergers and bankruptcies. Commodity consumers have run down inventories. Speculators, meanwhile, have shunned basic materials in favor of sexier vehicles. In response, brokerage firms have withdrawn from the commodities business after the sharpest slump in industrial activity since the 'Seventies.v Despite the surge in the U.S. economy in the first quarter and four straight monthly increases in industrial production, demand for basic materials remains lackluster.

The story of the aluminum market fits this pattern well. Aluminum is an industrial commodity used in everything from making soda cans to automobiles.

Last year, as the economy slumped and electricity prices soared, producers shuttered smelters. In North America alone, primary aluminum production fell to an annual rate of 5.14 million metric tons from a peak of 6.26 million tons in January 2000, according to Goldman Sachs.

Yet, despite this 18% decline in annual output, and with much of that capacity remaining shuttered, the metal is unchanged from where it traded at the end of 2001 -- $1,360 per metric ton in London, below the cost of production for many aluminum makers.

And the cutbacks continue. Thursday, Alcan, the world's second-largest aluminum maker, said it will close its Ontario wire-making plant in July because of weak demand. The same day, Pechiney , the world's fourth-largest aluminum company, said it may scrap plans for a possible $1.7 billion smelter in Australia.

The metals business also has seen consolidation through mergers, such as those between Alcoa and Reynolds Metals and Phelps Dodge and Cyprus Amex Minerals.

But those moves have adversely affected trading volumes as well. Companies such as Merrill Lynch, Lehman Brothers and Mitsui have cut back their commodities-trading businesses, says Fred Demler, mineral economist analyst at Man Financial in New York.

"While companies like Alcoa and Reynolds used to each hedge in the market, now they can just cross with one another and it doesn't have to go down to the trading floor," Demler explains.

Volumes on the London Metal Exchange show the change in activity. LME volume for futures and options fell 10.5% last year. So far this year, there are some signs that trading may be stabilizing. Almost 20 million contracts traded through the first quarter of this year at the LME, nearly unchanged from a year earlier.

But the depressed conditions provide the precursors for recovery by bringing supply back into balance with demand.

"We're going to go from a surplus to a deficit," predicts Demler. He figures aluminum prices will drift downward in the near term, perhaps to $1,320 a metric ton. Then, by year end, he expects the market to rebound and retest its high for this year, near $1,450 a ton.

Goldman Sachs' commodities research team agrees that a bull market will begin once demand reemerges. "The focus in the metals markets has begun to shift from still weak fundamentals to the prospects for improvement in overall economic conditions," according to an outlook piece by Colin Fenton, the firm's senior economist in its global commodities research division. "Although we share concerns about the speed and quality of the recovery, the underlying production and inventory fundamentals of the metals markets are in far better shape than normal for this point in the cycle."

Specifically, Fenton notes investment in the last cycle fell far below cyclical norms. Very few new projects are in progress and there is "reason to believe that significant rationalization of current production will add to the structural deficit."

As a result, "net, even against a slower-than-normal recovery, the metals markets should reach balance sooner than normal and work off inventory overhangs faster than normal with supply restarts and new capacity only moderating -- not preventing -- upward price appreciation. Aluminum," he concludes, "is best positioned and is likely to recover even against very modest economic growth."