Alcoa is a leading producer of alumina, aluminum and products made from aluminum. There was a time when the company’s results were closely eyed since it was the first Dow company to post earnings and give investors a glimpse to the likely results of other industrial goods producers. However, Alcoa AA -0.87% was ousted from the Dow Jones Index last year. Nevertheless, aluminum, being one of the most important industrial metals, is closely tracked and followed by analysts and investors alike. Although Russian company UC Rusal is the biggest producer of aluminum by volume, Alcoa’s foreign listing makes it more important from an investor’s point of view.

Alcoa is a fully integrated producer of aluminum: it mines bauxite, refines it into alumina, makes primary aluminum and also produces midstream products like flat rolled sheets and downstream engineered products.

In this article, we take a closer look at Alcoa’s alumina business division. We will describe the cost structure of the business, the pricing mechanism for alumina, the reasons behind the poor performance of the division in recent times and the future outlook.

What Does The Alumina Division Do?

Alcoa’s alumina business involves processing bauxite and refining it to obtain alumina. It comprises Alcoa’s worldwide refinery system and bauxite mining operations. A major portion of bauxite mined by Alcoa is used internally. However, Alcoa also sources bauxite from third-party sellers to meet its requirements.

The alumina obtained by refining is sold directly to internal and external aluminum smelter customers worldwide or is sold to customers who process it into industrial chemical products. A portion of this segment’s third-party sales are completed through the use of agents, alumina traders and distributors. Slightly more than half of Alcoa’s alumina production is sold under supply contracts to third parties worldwide while the remainder is used internally by the primary metals segment to produce aluminum.

In 2013, Alcoa’s alumina division revenues were $3.3 billion from third-party sales while inter-segment sales accounted for $2.2 billion worth of sales.

Cost Structure

Bauxite and caustic soda constitute nearly 50% of the production cost for alumina with bauxite’s share at approximately 30%. However, the precise breakdown shows large variations depending on the grade of bauxite used and proximity of the alumina refinery from the bauxite mine. Low grade bauxite needs more caustic soda for processing while transportation costs add to the overall cost of bauxite.

The other cost components are electricity, natural gas and fuel oil. Electricity costs are typically around 25% of total production costs for alumina.

Pricing Mechanism

Alumina has historically been priced as a percentage of the more liquid and transparent aluminum price quoted on the London Metal Exchange. Contract terms have historically fluctuated in the range of 12-14% of the LME aluminum metal price. This ratio is typically arrived at through negotiations between alumina refiners and aluminum smelters, who are the customers. Spot prices have been much more volatile as the alumina spot market is a very thin market. For 2012, our calculations show that taking into consideration only third-party alumina sales, Alcoa’s average realized price for alumina was approximately 14.2% of the average realized price for aluminum.

Over the years, the aluminum industry has moved away from a vertically integrated model where producers had their own bauxite mines and alumina refineries. Many independent aluminum smelters have come up and they buy alumina in the spot market. In such a case, a fair price discovery can be better achieved through market mechanisms.

Therefore, Alcoa has implemented a move to price alumina based on an index of spot alumina prices rather than as a percentage of LME-based aluminum price. This change is expected to affect approximately 20% of annual contracts coming up for renewal each year. It will more fairly reflect the fundamentals of the alumina business in its own right, including the cost of raw materials and transportation.

Over time, we expect the pricing to be driven by the demand-supply dynamics for alumina in its own right rather than being linked to aluminum. For Q1 2014, Alcoa expects around 65% of alumina third-party shipments to be linked to the alumina price index or spot price. When Alcoa releases its Q1 report next month, we will check whether this assertion has borne out.

While several indices are used by industry players, Alcoa favors the use of the index developed by Platts.

Financial Performance Of The Alumina Division And Outlook

In Q4 2013, the alumina division reported after-tax operating income of $70 million compared to the Q3 2013 figure of $67 million. The ATOI for the primary metals segment, however, stood at a negative $35 million compared to a positive $8 million in the previous quarter. The performance of the primary metals segment was impacted largely by lower LME prices of aluminum, but the improved performance of the alumina segment demonstrates that the two divisions are less inter-linked now than in the previous years. Indeed, the price index for alumina showed a positive trend in the quarter which helped offset the negative impact of alumina sales benchmarked against aluminum prices.

The price of caustic soda, an input for alumina production, is expected to remain stable in the foreseeable future and productivity related improvements will continue. Aluminum has been trading at much lower prices than last year and the outlook for commodities isn’t looking up in the short term. QE tapering will lead to a stronger dollar and weaken commodity prices further.

At this time, the macroeconomic sentiment for Europe is weak and a sustainable economic recovery in the U.S. is still not guaranteed. China is self-sufficient in aluminum and in fact has excess production capacity. In short, we don’t see much macroeconomic driven upside for aluminum prices going forward. This will keep margins and net profits down for the alumina division since at least half the quantity of alumina sold is still linked to aluminum prices.