Metals & Mining (Attractive): Aluminum pricing - the bull and the bear of it - Kotak

Aluminum pricing-the bull and the bear of it. Supply side reforms in China markets remain the most important factor in setting an aluminum pricing trajectory. Given the large deficit outside China, prices can either (1) rally on meaningful capacity closures later this year or (2) pull back in case of disappointment as current firm prices are factoring in some closure expectations. Irrespective of the near term outcome, we expect more disciplined supply growth over CY2018-19E owing to environmental concerns in China and pressure on it from trading partners. Maintain ADD on VEDL, HNDL.

Supply side reforms in China production key determinant for aluminum pricing outlook The overcapacity and surplus aluminum production in China (resulting in large exports) continues to be the most important factor affecting global aluminum prices. The world ex-China markets remain in deficit due to the lack of new investments and closure of inefficient high cost smelters. Given the large deficit outside China, supply side reforms in China have the potential to start a strong rally in aluminum prices. On the contrary, if reforms are not effective, it may lead to a pull-back in prices given China production as of now is rising and prices have rallied on hopes of capacity cuts mostly led by money managers increasing their long bets on aluminum.

- Four phases of supply side reforms in China-Supply side reforms in China will be in four phases (1) self-examination by companies whose period was over by May 15, 2017, (2) verification by local government by June 30, 2017, (3) inspection (at random) by September 15, 2017, and (4) rectification or closures by October 15, 2017.

- The ongoing 'inspection' phase. Verification reports from local governments will be submitted by June 30, 2017 to Central authorities. Various inspections carried out in Xinjiang, Inner Mongolia and Shandong (main aluminum producing regions in China) are yet to cause any significant production impact as of now though there have been a few closures such as (1) 20,000 tpa operational capacity at Xinjiang Jiarun, (2) 50,000 tpa operational capacity at Jinlian in Inner Mongolia, (3) a possible production cut in Xinjiang East Hope, besides (4) Hongqiao group's curtailment of 250,000 tpa of outdated capacity.

A recent media report indicates that Xingjiang Jiarun may also cut the second phase of 250,000 tpa of capacity this week. Also, some of the newly built capacities have been put under the violation list such as Shandong Xinfa's 1.1 mtpa smelter as it is yet to obtain approvals from Central authorities. This essentially means that new projects are susceptible to supply side reforms on stricter government stance requiring these capacities to obtain 'capacity quota'.

- All is not done-'Skepticism' around reform effectiveness remains. China, earlier in 2016 successfully implemented the coal supply side reforms as it reduced the number of working days in mines to 276 from 330 days, and this led to significant drop in coal production thereby aiding prices. Aluminum markets have remained optimistic on China curtailing aluminum production too, given the strong precedent of coal reforms. However, there have some slippages in the progress such as-Changji government in Xinjiang removed earlier directive for closure of 2 mtpa illegal capacity from its website recently.

Irrespective of outcome of reforms later in the year, expect more discipline in aluminum supplies If there is disappointment in China supply side reforms later in the year (to be only known by October 2017), aluminum prices may pull back given prices have risen on hopes of supply cuts. However, irrespective of the near-term outcome, we expect more disciplined supply growth over CY2018-19E in aluminum owing to environmental concerns in China and pressure from trading partners, given its large low cost exports. The World ex-China deficit will continue to increase as supply fails to catch up with demand. Indian aluminum stocks (HNDL, VEDL) have high sensitivity to changes in aluminum prices. We maintain ADD on VEDL and HNDL.

Production cuts in China set for winter heating period

The production shutdown policy during winter heating period has been approved by the Ministry of Environment Protection, National Development and Reforms Commission, Ministry of Finance, Ministry of Energy and other provincial governments in China. The policy directs aluminum smelters and alumina refineries in 28 cities to close 30% of their capacity over the winter heating period; carbon anode plants have been instructed to close ~50% of their capacity in the region-this policy will likely run from November 01, 2017 to March 15, 2018.

- China supply side reform on new capacities. China government is looking to curb production at projects that did not receive approvals. The government in Xinjiang released a document on supply side reform on April 14, 2017 and ordered construction to stop at three smelters in Xinjiang undergoing expansion with capacity of 2 mtpa. However, later in June, these notifications were removed from the website of the state government.

- Trade pressures on China. China aluminum production is also subject to increasing scrutiny from importing countries, especially in the west. US authorities are investigating whether aluminum imports pose a threat to self-sufficiency-if US will not be able to secure enough domestic aluminum to meet its needs, it is a matter of concern. Based on these findings, the government has the ability to ban aluminum imports entirely or impose any amount of tariff.

Other relevant news on China supply side reforms

- Shandong province. The provincial government had announced on May 31 2017 that new alumina and aluminum capacity must be strictly controlled in Shandong. If a new smelting project is deemed to be necessary, it must offset by (closure of) same amount of existing capacity.

A 1.1 mtpa Shandong Xinfa smelter is listed as illegal after environmental inspection. The plant has neither gained approval from MIIT or MEP nor does the power plant meet environmental standards.

- Guangdong. The province is about to start environmental inspections which will end in February 2018. These inspections will cover nine cities.

Source : Equity Bulls

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