January 7, 2012 / 6:53 PM / 6 years ago

Analysis: Aluminum traders to producers: Cut like it's 1994

NEW YORK (Reuters) - To find a precedent for the deep, lasting output cuts that aluminum producers must make to put a floor under prices, traders are looking a lot further back than the last recession.

Three years ago, with the global economy convulsing in the throes of a serious recession, smelters worldwide started cutting back production -- temporarily. As prices quickly rebounded, nearly doubling within a year, those companies were just as quick to fire up their furnaces again.

With the overhang of high inventories and a 28-percent drop in prices since May last year, they’re responding again, with Pittsburgh-based Alcoa announcing on Thursday plans to shut down 12 percent of its capacity, some of it permanently.

But traders may not be so readily appeased as three years ago. Many say that much deeper, longer-lasting cuts -- more akin to the post-Soviet government pact of the mid-1990s -- will be required in order to rebalance a market.

“We believe that disciplined action by the industry is required to reduce the overhang that exists,” analysts at Dahlman Rose & Co said on Friday.

They said Alcoa’s action would be a wake-up call, with further cuts likely to come from relatively higher-cost producers in China, which represents some 40 percent of global capacity.

Alcoa’s action appeared to mark a step in the right direction. Some 291,000 tons of annual capacity that it had idled in 2009 will now be shuttered completely, removing the threat of a quick restart that could sink the market once again. It will also curtail another 240,000 tons of annual capacity in production at undisclosed locations. The closures equate to just over 1 percent of the 46-million-tonne per year market.

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Capacity: link.reuters.com/gaq85s

Production: link.reuters.com/haq85s

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London Metal Exchange aluminum prices rose only $10 to $2,039 per ton on Friday, signaling that much more would be required to revive a market that’s fallen by more than a quarter since last May.

One particularly frustrated trader said cuts need to be greater than in 2009 when at the height of the global economic crisis global output fell by just over 2 million tons to 37 million tons, according to Reuters data.

Market conditions have deteriorated in the last six months, particularly in Europe where demand has ground to a halt due to the debt crisis in the Euro zone, and concerns have mounted about weakening Chinese consumption.

In November, Alcoa announced it would perform unplanned maintenance on some flat-rolled facilities in North America and Europe due to a dramatic reduction in orders.

“The only good news will be if it prompts others to follow suit a bit like 1994,” said a dealer at a ring-dealing member of the LME.

So far there appears little rush. Norwegian producer Norsk Hydro (NHY.OL) told Reuters on Friday it was prepared to lower output if prices remain low, [nL6E8C52FE], but other major producers including Rusal, Rio Tinto Alcan and BHP Billiton declined to comment.

Rusal and Rio Tinto Alcan both operate smelters using lower-cost hydro electric power-Rusal in Siberia and Rio Tinto in Canada-which means they can withstand the lower prices for longer.

SUSTAINED

This time around, cuts may need to be deeper and more sustained than in 2008, for several reasons.

The speed of aluminum’s recovery in 2009 took the market by surprise - from the depths of $1,300 per ton in early 2009, prices surged over 80 percent in value within a year to $2,400 per ton largely on stronger-than-expected demand from China.

But supply also responded and by 2010, global output had already risen to a new high of 40.7 million tons, driven by China’s investment in its own smelters and by forecasts of long-term demand growth.

“The price recovery was too quick for anyone to take long-term action. Back in 2010, it looked like we need more metal for Asia,” said a senior executive at a large consumer.

Low interest rates have also played a role in creating the massive inventory that overhangs the market, with almost 5 million tons in LME warehouses and a similar tonnage estimated by traders to be sitting in off-warrant storage -- enough to cover global demand for three months.

    Incentives by warehouses to lure metal into their storage have given traders a reason to dump unwanted metal, lock it up in financing deals and earn money on the spread -- giving producers less of a reason to slash output.

    “The market was oversupplied even in 2008. The industry was still creating inventory but just at a slower rate,” said a European trader frustrated at the size of the LME stocks, particularly in Detroit and Vlissingen.

    PAINFUL MEMORIES

    Memories of 2008 are still painful, but those with longer careers also remember the turmoil of the early-1990s when the former Soviet Union flooded the market with material following the collapse of the Berlin Wall.

    By 1993, that surge had annihilated prices to close to $1,000 per ton and the industry, dominated at the time by Europe and Canada, was on its knees.

    In an unprecedented move, the governments of the European Union, the United States, Russia, Norway, Australia and Canada, all of which are leading producers, hammered out a voluntary agreement known as the “Memorandum of Understanding” in early 1994 to try and revitalize their countries’ manufacturing sectors.

    The governments came to an understanding that capacity by their countries would be reduced. Russia agreed as much as 500,000 tons, with the cutbacks that year totaling some 1.2 million tons, according to the U.S. Geological Survey. That equated to about 6 percent of total global output.

    The result of the deal transformed the fortunes of the global industry in an astonishingly short period of time.

    “Producers colluded through the arms of their governments,” said the senior executive, who worked for Alcan at the time remembering the deal. “The price was $1,072 in November 1993 and peaked at $1,295 in January 1995.”

    Such an audacious move may not be possible in 2012 given anti-trust laws and the dominance of China in the aluminum industry, but some say the industry could learn lessons from the principals behind the MoU of an industry-wide move.

    But with Liberum Capital estimating that almost a third of global primary smelting capacity is loss making at $2,000 per ton, additional industry smelter closures look likely.

    “Once you start to see producers bleed you know you’re coming close to fundamental support,” said Andrew Keen, Global Head of Metals and Mining Equity Research at HSBC. “People don’t produce for free. I would imagine a lot of producers are navel-gazing at the moment to see if they should turn off or not.”

    Writing by Josephine Mason; Editing by Bob Burgdorfer

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