After the close on Monday January 11, Alcoa (AA) reported a loss of $277 million for the fourth quarter of 2009. Excluding special items, Alcoa earned a penny a share. The company turned free cash flow positive for the first time since June 2008
Evidence that the company, commodity producers in general, and the global economy are on the mend, no?
No! the stock market yelled. On the news the stock was down almost 9.5% for the day as of noon ET.
I often I cite a big move like this on short-term news as an example of the stock market’s tendency to turn quarterly mole hills into Mount Everest. But this time I think the market has got the long term story right. And the implications in Alcoa’s punishment today for other stocks, even those outside the commodity sector, and for the global economy are troubling.
Here’s the problem.
Alcoa’s results—even though they missed Wall Street’s earnings projections by roughly a nickel a share—may be as good as it gets for the company.
Not because global aluminum demand and prices aren’t climbing.
They are. Alcoa projects that global aluminum demand will climb 10% in 2010. Spot prices for aluminum climbed from a 2009 low of $1,500 a metric ton to the neighborhood of $2,200 a ton—a 14-month high—by the end of 2009.
But because higher demand and higher prices are bringing aluminum-production capacity on line far faster than demand is growing.
Take the case of China. The world’s largest consumer of aluminum is projected to consume 14 million metric tons in 2010. Huge good news, right? Well, no. China has idle aluminum production capacity of 7 million tons right now. That capacity is set to come back into the market as aluminum prices climb. China imported aluminum in 2009 but will produce a small surplus for export in 2010.
The idle capacity in China is only part of the problem. Other countries have been building new capacity that is set to start coming on line in 2010.
For example, Abu Dhabi, started production on December 1 at what will be the world’s largest aluminum smelter when it’s finished. Qatar and Oman are building new smelters. Alcoa itself is building what it claims will be the world’s lowest cost smelter in Saudi Arabia.
By 2020, the Gulf Aluminum Council projects, the Middle East will account for 12% of global aluminum capacity.
Why the Middle East? After all, the region is not exactly rich in bauxite, the rock that yields aluminum after smelting. Top bauxite producers include Australia (almost on e-third of global production), China, Brazil, Guinea, and Jamaica.
Because the key to profitably producing aluminum these days isn’t sitting in proximity to a big supply of bauxite, but access to cheap electricity. Lots and lots of it.
The new production capacity in the Middle East all hinges on long-term deals for cheap power. That’s easy when the region sits on such huge supplies of oil, and more importantly for electricity production, natural gas. And when Middle East governments are eager to cut deals that result in broadening their economies and creating new jobs for fast-growing populations. (In China aluminum producers continue to get below market rate power from local governments eager to protect jobs—even though the central government in Beijing has said that all companies should pay market rates for their electricity.)
That presents producers with existing plants with a two-fold problem. First, enough new capacity is coming on line to more than off-set in increases in global demand. And second, the new capacity will have lower energy costs that will make it tough for older plants and producers to compete.
In Europe, for example, the European Aluminum Association projects that up to two-thirds of the continent’s smelters are under threat.
For a company such as Alcoa the situation means that rising aluminum demand may not bring fast-as-projected rising sales or climbing prices as it competes with an increasing supply of aluminum from low cost producers. And if Alcoa wants to compete in this new world in the future it will have to scrap some of its existing high cost plants and increase its capital spending to build more new plants in low-cost countries.
I don’t think it takes a whole lot of imagination to see how the aluminum crunch applies to other industries. In everything from potash to car parts the world has a tremendous amount of idle production capacity that’s just waiting to come back on line. When it does, this new supply will act to contain price increases that in many cases investors are counting on to increase company earnings in the future.
In other words, the global economic recovery in general may not be as profitable as investors now hope.