COLUMN-Falling LME aluminium price confounds the theorists: Andy Home

(Andy Home is a Reuters columnist. The opinions expressed are his own)

By Andy Home

LONDON, June 3 (Reuters) - Aluminium premiums are in meltdown the world over.

The London Metal Exchange (LME) price of the light metal has followed them lower over recent weeks with the benchmark three-month price now hovering just above one-year lows around the $1,750-per tonne level.

This is not how things were supposed to play out.

The accepted wisdom was that if premiums fell, the LME basis price would rise in compensation, keeping the "all-in" price unchanged.

The "all-in" price, however, has sunk from December highs of $2,500 per tonne to just $1,900 per tonne.

It's possible the speed of the collapse in premiums has temporarily destabilised the relationship between premiums and LME price and some sort of time-lagged correction will take place.

However, the alternative possibility is that the falling "all-in" price is actually telling us something important about the overall state of the global aluminium market.

Namely that it is oversupplied (again) and that the price may have to fall further if supply and demand are to be rebalanced.

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Graphic on "all-in" aluminium price:

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STELLAR DEMAND GROWTH, BUT FASTER PRODUCTION GROWTH

Global (Shenzhen: 300465.SZ - news) aluminium usage grew by 9.00 percent last year and is likely to grow by another 6.50 percent this year, according to U.S. producer Alcoa (NYSE: AA - news) 's Q1 financials presentation.

Such a super-strong growth rate makes aluminium a stand-out from just about every other industrial metal and reflects transformational shifts in the automotive sector with the light metal grabbing usage share from steel.

The only problem for producers such as Alcoa is the fact that global production is now growing even faster, running at 10.3 percent in April and at a cumulative 6.8 percent over the first four months of the year, according to the International Aluminium Institute.

The main driver of that growth, as it has been for many months, is China.

Annualised production in China has risen by almost two million tonnes to 31.5 million since the start of January.

Production outside of China, by contrast, has only crept higher to the marginal tune of 255,500 tonnes annualised over the same four months.

Which wouldn't matter if what China produced stayed in China.

PARALLEL UNIVERSES NO MORE

China's 15-percent export duty on primary aluminium has historically kept the country partly isolated from the international market.

Alcoa chairman and chief executive Klaus Kleinfeld once famously described the two parts of the global market as "parallel universes", co-existing but rarely interacting.

Even at the time such a view meant brushing aside the inconvenient fact that China was a significant exporter of aluminium in the form of semi-manufactured products. These are not only free of export tax but qualify for a tax rebate.

However, the outbound flow of such "product" has in the interim increased to the point that it's impossible to ignore.

A massive 3.67 million tonnes seeped out of the Chinese market last year, a 20 percent increase on 2013. And the flow is still accelerating, up 46 percent to 1.45 million tonnes in the first four months of 2015.

Not only do such product exports serve to displace demand elsewhere but they include an unknown element of barely transformed metal, which is exported only to be remelted and reenter the primary supply chain.

Such remeltable exports are highly price sensitive and the collapse in Western premiums may help stem the tide.

But the real problem is the rebate on genuine products, which Beijing appears in no mood to change.

Indeed, it has just cancelled a 15-percent export tax on some forms of rods and bars, both in primary and alloy form. Experts such as Paul Adkins at AZ China play down the impact the tax code adjustment will have, arguing these are very specialist products and that China is in effect just tidying up a couple of anomalies.

But the symbolism is significant.

Faced with increasingly vocal international pressure to stem the flow of products, China has done just the opposite.

DOWN, DOWN THE COST-CURVE

The unwelcome fact for producers outside of China is that the country's exports are filling any deficit resulting from their collective supply discipline.

That's particularly galling since there is plenty of accumulative evidence that local governments have been subsidising loss-making smelters in parts of China, even as the central government stimulates product exports with its tax rebate scheme.

But there is another worrying trend in China. Cash operating costs are falling.

AZ China's Adkins estimates that the capacity-weighted cash cost fell by 100 yuan per tonne to around 13,330 yuan ($2,150) over the course of April. That largely reflected lower prices of alumina, the raw material to produce primary metal.

More significantly, however, cash costs in the northwestern province of Xinjiang are falling faster, reflecting the start-up of new smelters with better technology and captive power supplies.

In this respect Chinese producers are following exactly the same path as their western counterparts, moving their production down the global cost curve.

Alcoa, for example, has closed higher-cost capacity in Europe and the U.S. in favour of its new ultra low-cost Ma'aden joint venture in Saudi Arabia.

Rusal (HKSE: 0486-OL.HK - news) , the other non-Chinese producer giant, has idled and closed significant amounts of older capacity with exactly the same intention.

Rusal has also benefited from the tailwind of currency depreciation thanks to the slide in the rouble relative to the dollar. Its average first-quarter cost of production fell sharply to $1,437 per tonne from $1,741 in the same quarter of last year.

THEORY AND REALITY?

In an ideal world higher-cost smelters in China shouldn't be kept alive by government subsidies.

But it's not an ideal world and although older capacity is closing in China, economics are too often trumped by politics.

All the while, the new generation of smelters ramping up in provinces such as Xinjiang is pulling the whole Chinese cost curve lower.

Outside of China a combination of producer discipline and luck in the form of currency depreciation is also pulling the cost curve lower.

Yet, on current trends the global market is again moving to a state of oversupply with non-Chinese deficit filled by Chinese exports.

Maybe this is what a falling "all-in" aluminium price is signalling, in which case there may be further downside if prices have to fall to a level to force out more production capacity.

The world outside China can only hope that the theorists are right and that after the premium meltdown tremors have passed the LME price will re-adjust upwards to prop up the "all-in" price.

But with the latter trading just above $1,900 the theory is looking decidedly problematic.

(Editing by David Evans)