Just after the crisis in 2008, we had seen the Aluminum stocks at the LME warehouses soar from a 1 Million ton level to 4 Million tons in a spate of months, and while this was happening, the Aluminum prices moved from a completely no support level to medium level where the marginal costs matched the prices. For a brief moment the industry survived the first shocks of the crisis due to a strong intervention from the banks, otherwise the Siberian Smelters would have had the biggest impact. There were some murmurings of banks trying to support a financial product, but wisdom saw that by so doing the industry could continue to produce in absence of immediate demand as the car markets collapsed, the housing fell off the cliff, as credit markets virtually
stopped lending.

When this was happening, the private sector and the domestic households were going through a deleveraging process like never before, but the banks were sitting on many under-performing assets with no collateral. The question of collateral led many to move to commodities like Aluminum, which could serve as a strong alternative, as like any other immovable asset class, for example housing. Miles of warehouses around Rotterdam served as the alternative to housing in Europe; the party began.

What happened in Aluminum was somewhat unique as no other metal could provide such a fillip, so quickly, as there were abundant production opportunities on one hand, and stocking in warehouses had no other hazard, given that the interest rates were near zero. I was pleasantly reminded of a photograph taken of an Alcoa plant in the late 80s, where piles of Aluminum stocks were signs of prosperity, which later turned the other way when cash became the means for running the business and wisdom transformed those shining warehouses of stocks to better productive use. The times again changed and stocks returned as the symbols of shining prosperity, or so it seemed.

There was a short phase of Aluminum where the market saw a rally when prices moved higher than the median marginal cost, but the rally did not last; the LME official warehouses stocked more than 5 million tons and the other warehouses all over the world added another 5 million tons, which
together is 50% of the world primary output in the form of ingots, no small number.

Conventional economic models would predict that with such a picture of stocks, the prices must be moving in sync with the fundamentals of demand and supply and would settle at levels that are close to the marginal cost, and so it did. But there were two other important events that made the
picture slightly more distorted.

The first was what was happening silently in China, and this time just the other way. The movement of capital stock to fixed assets in China started in a big way around the late nineties when China produced just about close to 1 Million ton of Aluminum output. Aluminum was seen by the leadership as a means of furthering employment as the downstream industry together with the upstream could merge with the energy industry to create an intertwined entity that depended on each other through a process of shared prosperity, while the economy needed infrastructure to be moved to high gear as urbanization caught on. In just one decade China added 15 million tons of capacity in Aluminum and the pace of investment only started to slow after the crisis struck, but it took just a little bit more time to react and this was good enough for the prices to be impacted further.

The second was what was happening in the same decade in the Middle East, where stranded source of energy in form of natural gas could be converted into the shiny white metal and transported across continents, which was just another way of transporting energy itself. The economics made perfect sense as long as the inputs like bauxite or alumina could be organized, which was never a problem. Middle East added just under 4 million tons.

The world had 19 million tons of capacity added in just these two concentrated places, which was more than 50% of the world’s output, which means in a decade the progress of Aluminum was quadrupled, a growth rate that had no underlying demand support, as being supremely recyclable, the applications where the maximum growth was happening were exactly the places where the metal could be recycled almost infinitely. To top it all the old scrap was coming back into the market.

Let me now draw attention to the producers, who by their estimation of a wrong demand scenario assumed a supply shortage that never existed. I have actually sieved through Alcoa quarterly reports, where Alcoa had never mentioned a supply surplus scenario, while the prices always
indicated just the opposite. This apparent lack of management will to accept the reality that market surplus cannot be tamed through a guidance that fails to stymie the tide of investments.

There were two other factors that further aggravated the price stickiness and the first one is the program of QE itself, which brought in more capital and less buyers and in a phase where meaningful investment avenues were far and few, Aluminum provided the perfect ground for fixed asset investment to continue. The Chinese central bank advances moved into States Reserves Bureau that in turn kept on buying Aluminum stocks, this was the alternative arrangement to monetary easing where we have a state sponsored buyer, who takes the brunt of the market surpluses and through that process ensures economic activities to be furthered.

The second factor of course was the underlying demand in the auto industry and the electrification program hitting a wall; the first one is a global phenomena, the second is purely a Chinese one, but the two together takes off more than 20% of the global demand for metal.

There are some minor set-backs as well, the most potent one is the failure of reforms in India when the core sector fell off the cliff, while coal, the major raw material needed for the country’s progress was locked in Mines which had no way of being either explored or mined due to lack of political will from the government.

In these times of change the Aluminum producers suffered the most, with stocks of Chalco dropping by a whopping 80%  from its peak value, Alcoa 75% from its peak value and Rusal by 60%. These are massive drops by any standard and are a pointer that the worst is not yet over. One would have expected a rebalancing of strategy and business models but we have seen more of the same, announcements of plant closure, which never happen as per the schedule, while fresh bouts of investments are announced sighting a market deficit, which also never materializes.

Is this an information asymmetry problem we are dealing with or a distortion created when the market clearing mechanism is failing to work?

18th November 2012

Investigating Market Distortion And The New Business Models In The Times Of Qe

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