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Aluminum Markets Flash a Warning for the Economy

Sept. 30, 2019
The trade war has impacted world aluminum demand in a sign of market instability.

When aluminum demand last contracted during the financial crisis and unwanted metal started flooding into warehouses, it took more than a decade to work through the glut. Now, the market is bracing for another sharp increase in inventories as demand growth grinds to a halt.

Aluminum has tumbled to a two-and-a-half-year low as slowing global growth and the U.S.-China trade war hurt demand for the metal used in airplanes, automobiles and beer cans. While stockpiles tracked by the London Metal Exchange fell to their lowest since 2007 last week, traders say inventories are building in the physical market as weaker order books leave consumers with more metal than they need.

That leaves traders preparing for a potential rebound in exchange stockpiles as the weakest demand growth since 2009 and tightening spreads encourage deliveries into warehouses. As was the case in the financial crisis, the supply imbalance could be exacerbated by producers who are loath to curb output in the short term, due to the heavy costs involved in bringing mothballed production lines back into service.

“In terms of all the economic indicators we’re looking at, everything is pointing to a further downturn,” Kamil Wlazly, an analyst at Wood Mackenzie, said on the sidelines of the Fastmarkets International Aluminum conference in Athens. “Next year could potentially be even worse because we don’t think the market has bottomed out yet.”

The slowdown in key sectors such as the European car industry is putting the aluminum industry on course for annual demand growth of 1% to 2% this year, according to Wood Mackenzie. Rival consultancy CRU Group expects an even worse year, with demand rising just 0.2% globally and contracting 1.2% outside of China, marking the first decline in usage since the financial crisis.

Macro uncertainties are also hurting the outlook for producers. Goldman Sachs Group Inc. last week downgraded Alcoa Corp., the biggest American aluminum producer, to neutral from buy.

To be sure, demand is still holding up far better than it did during the crisis, but traders are cautioning that there could be swift knock-on effects in the physical market as the industry’s previously impressive growth rates go into reverse. In the past, producers have been reluctant to make costly cuts to output in the face of declining orders and weak prices, exacerbating an imbalance between demand and supply.

LME aluminum traded at $1,727.50 a ton as of 12:31 p.m. in London. Trading house Concord Resources Ltd. says prices may need to fall a further 10% or more before meaningful supply cuts are made.

With LME inventories near their lowest since 2007, market participants see the conditions for another surge in stockpiles, although to a less dramatic extent than was seen in the financial crisis.

While it’s typically cheaper to store metal away from the exchange, traders on the sidelines of the Athens conference said the issue may come to a head toward the end of the year, as a spike in the spread between futures for December and January delivery is making it onerous for stockholders to keep hold of their positions over the period.

December aluminum traded at a $10.50 premium to January contracts on Thursday, in a condition known as backwardation that often draws inventories into exchange warehouses as stockholders seek to cash in on the higher nearby prices. On Friday, spot contracts spiked to at an $10 premium to the next day’s contract, the biggest backwardation in more than a year, adding to the short-term pressure facing stockholders.

Persistent backwardations are widely viewed as a sign the market is running short of metal, but participants say this one could prove short-lived, given that many traders, producers and consumers have excess stock on hand. Aluminum traders polled by Bloomberg said it wouldn’t be surprising to see 200,000 tons or more arriving on the bourse by year end, with top-end estimates seen at about 500,000 tons, if the backwardation creates a strong enough incentive for stockholders to deliver.

In such an event, the spread could quickly unravel back into a condition known as contango, where shorter-term contracts trade below those with later maturities. The rest of the forward curve has been moving into a widening contango as demand deteriorated over recent months, and the December-January spread could follow suit if metal does arrive on the bourse.

“I think the December-January backwardation will be a blip,” Wlazly said. “The fact that we’ve consistently seen wide contangos for the past few months suggests that there is enough stock to deliver to overcome these periods of short-term tightness.“

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