Metals & Mining - Attractive - Aluminum-fundamentals improving, valuations attractive - Kotak

Aluminum-fundamentals improving, valuations attractive. The persistent supply deficit outside China has led to a sharp fall in World ex-China aluminum inventories (-30% in the last one year)-these inventories are likely to fall to 70 days by CY2018-end and below 60 days in CY2019. We believe aluminum pricing outlook can see large structural improvement in the next two years led by supply side reforms in China and widening deficit outside China. The stock valuations, however, post recent correction are baking in very low aluminum returns. We maintain BUY on HNDL and VEDL.

Aluminum prices fall due to liquidation of long positions; large China capacity in losses

LME aluminum prices corrected by 9% since February 2018 largely due to long CTAs (commodity trade advisors) liquidating their positions (for long/short positions in LME aluminum). The sell-off was accentuated by (1) concerns over an escalating trade war post import tariffs imposed by USA, and (2) fall in China SHFE aluminum prices due to rising China inventories and expectation of additional supplies from production restarts post winter heating period (i.e. post March 15). We highlight that at SHFE prices of CNY13,800/ton, close to 20% of China's aluminum smelting capacity is loss making (per CRU). The low or negative operating margins will slow down the pace of restarts of idled aluminum smelters in China.

Demand-supply balance-improving as world ex-China inventories fall sharply

Aluminum inventories outside China have declined sharply since start of CY2017 due to a persistent deficit. The World ex-China markets were in deficit of 333,000 tons for January - February 2018-the deficit is increasing (CY2017:1.87 mn tons) due to years of under-investment in new capacities given poor project returns. This has led to a large drawdown in reported/unreported stocks outside China. The World ex-China inventories have declined by close to 30% since January 2017 to 7.2 mn tons-the inventory days have fallen to 85 days from 113 days in the start of CY2017. Given the persistent deficit, the inventory days outside China will decline to 70 days by end of CY2018 and will quickly fall below 60 days in CY2019; inventory of 60 days is considered as a market equilibrium levels.

China markets-we expect aluminum surplus to eventually fall from supply-side reforms

Aluminum prices would have been much higher if Chinese aluminum markets were more balanced than the large surplus it reports today (and of course exports). Post the first plenary meeting of the 13th National People's Congress in China, the head of NDRC (National Development and Reform Commission) said that policies for steel and coal offer a good example of supply side reform for aluminum-NDRC oversees supply-side reforms in China. It said outdated, loss-making capacities will be closed for development of more efficient production. This likely means supply growth will only be led by approved capacity (hence regulated). NDRC also emphasized greener economic growth-this may point that winter closures will be repeated.

We expect strong improvement in outlook in next two years; stocks discounting low returns

Post the supply-side reforms, China has been more measured in approving new smelting capacities with emphasis on environmental sustainability. The aluminum capacity growth in China will significantly slowdown post 2018 and expect additional capacity of (1) 3.3 mtpa in 2018, (2) only 1.3 mtpa in 2019, and (3) much less than 1 mtpa in 2020. Given the strong demand growth in China, this will likely reduce surplus in Chinese aluminum markets.

We highlight that CMP of non-ferrous stocks is baking in low returns from aluminum operations. Aluminum has the best demand outlook among base metals and can see structural pricing improvement on lower Chinese supply growth and widening ex-China deficit. We maintain a positive view on HNDL (BUY, TP: Rs315), VEDL (BUY, TP :Rs445) and NACL (ADD).

China aluminum markets-we expect supply growth to moderate

As part of supply side reforms, China closed 3.03 mtpa of illegal aluminum capacity in mid-CY2017. Also, 2 mtpa of new capacity had no chance of ramp-up-Hongqiao had 1.5 mtpa of such new capacity. Due to China supply side policy, the capacity growth in China will significantly slow down post 2018. The new capacity growth is expected at (1) 3.3 mtpa in 2018, (2) 1.3 mtpa in 2019 and (3) less than 1 mtpa from 2020. We believe the lower production growth from China can have a meaningful impact on global aluminum markets.

Also, the repetition of winter cuts can also aid in reducing Chinese market surplus.

The provincial Henan government has already announced plans to repeat winter cuts next winter. The Central government is yet to decide on a new policy. If the Central government decides to repeat winter cuts, there can be province-wide closures and new provinces could also be included in the list.

Source : Equity Bulls

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