Decoding the Bullish Argument for Alcoa Heading into 2017

Higher metal prices

Donald Trump’s win in the presidential election helped fuel a rally in aluminum prices, like most other commodities. Although aluminum pared some of its recent gains, it’s still trading above the $1,700 per metric ton price level. Among other factors, higher input costs are supporting aluminum prices. Alumina prices have shown strength over the last few months. Two key factors drove alumina’s price action. First, alumina seems headed for a supply deficit this year following Chinese curtailments. Second, higher coal prices are supporting alumina prices. The global aluminum cost curve shifted upward due to higher coal and alumina prices. Higher raw material prices could continue to support aluminum prices.

Bauxite sales

Bauxite could be another growth driver for Alcoa. Until now, most of the bauxite that Alcoa used to mine was consumed in its captive alumina operations. In fiscal 2015, Alcoa generated revenue of only $71 million from third-party bauxite sales. However, it has been aggressively pursuing bauxite sales over the last few quarters. It signed contracts valued at ~$600 million for 2016 and 2017.

US investors have few options to play the aluminum industry (NHYDY) (RIO). Solely based on being a pure-play integrated aluminum producer and the lack of quality assets in this space, Alcoa could command a scarcity premium. Alcoa’s leverage ratios look comfortable compared to some of the other companies in the space (CENX).

China’s restarts

One of the factors supporting higher aluminum prices has been less-than-expected smelter restarts in China. According to Rusal, there has been a net increase of only 0.90 million metric tons in China’s smelting capacity between July 2015 and August 2016. The company sees limited additional restarts since aluminum’s cost of production rose due to higher alumina and coal prices. Notably, higher coal prices also raised the production costs for Chinese alumina refiners that rely on imports.

Coal prices

In a bid to control pollution and curtail its excess industrial capacity, China reduced the hours for workers in its coal sector. However, the country subsequently relaxed the mining day norm to control skyrocketing prices. Higher coal output in China could help bring down the country’s reliance on imports. It would be negative for seaborne prices. Any fall in seaborne coal prices could impact alumina and aluminum prices.

Chinese supply

With massive existing overcapacity and the incorporation of fresh smelting capacity (ACH), Chinese supply could be a serious headwind for Alcoa and aluminum prices. Higher Chinese aluminum production could spoil the party that companies such as Alcoa and Century Aluminum (CENX) are currently enjoying. Overproduction in China fuels the country’s aluminum exports. It worked to the detriment of aluminum prices over the past few years.

Higher raw material prices and positive markets sentiments supported aluminum prices. However, Chinese overcapacity is hanging over aluminum markets.