Summary

• Alcoa neglected, yet there are positive signs in its diversification downstream into specialty proprietary products.

• Negative is assumption is that oversupply of Aluminum will continue.

• Analysis of recent events in China indicates potential problems for current levels of Aluminum production.

• Short and long term factors indicate a return to favor for Alcoa.

Recently MoodyFX gave an optimistic short term view of investment in Alcoa (NYSE:AA), which has been in decline since the start of 2015. MoodyFX's analysis was based on a historical assessment of what follows sharp reversals in Alcoa's business. Two other articles have focused on emphasis on value added products and negative analyst sentiments and potential for Aluminum price recovery.

I have reached a similar conclusion to the above analyses about Alcoa's long term prospects, but I won't go over the ground that they covered. Here I address another long term issue that has not been discussed yet. I refer to likely developments in China, which is the elephant in the room as regards Aluminum production.

One of the potential headwinds suggested in David Zanoni's analysis is increased exports of Aluminum from China. Clearly China is the elephant in the room in terms of global Aluminum production. In 2014 China produced 23.3 million metric tons (capacity 32.5 million metric tons), the US produced 1.72 million metric tons (capacity 2.33 million metric tons) and worldwide production was 49.3 million metric tons (capacity 63.7 million metric tons).

Given the above, even a small percentage change in the level of Chinese Aluminum production could have a significant impact on Aluminum prices.

It is difficult to find out what is going on in China unless the Government decides it is happy to release the information. However, there are major currents running in the Chinese economy and its citizens are pushing back on environmental issues (mostly coal-related) that have reduced life expectancy by 5.5 years in Beijing. This is a very "hot" issue as exemplified by the documentary "Under the Dome" which was watched on line by more than 200 million people before it was censored.

Some statistics are well known about China.

Three that keep nagging at me are:

i) China has 21% of the world's population and 7% of available freshwater. This means that there is a looming water crisis in China;

ii) Centralized power generation (coal, nuclear) requires a lot of water for cooling;

iii) Energy intensive industries require a lot of power, which until very recently has been dominated by coal expansion.

An industry with huge emissions due to massive requirements (6th largest user of energy in China) is the Aluminum industry. China has been incredibly aggressive in growing this industry and it has based this almost entirely on coal providing the power (90%). In fact the Aluminum industry has been a major driver of the Chinese power industry.

I suggest that sooner rather than later the Aluminum industry will come under pressure. It isn't clear that China is prepared to be the proxy for the world's emissions from manufacturing any longer, as there is huge pressure at home to reduce emissions.

Although somewhat dated (2010/2011) the above report summarizes the problem, which must be substantially worse now since Aluminum production has almost doubled since 2008, the reporting date in that report.

Note that China has begun to address the issue of emissions intensive Aluminum smelting, with the number of Aluminum producers in China reduced from 120 to 64 in the last decade.

China is vulnerable on emissions as, whereas its Aluminum production is 90% coal based, much of the rest of the world's production has been substantially decarbonized.

The 2015 Aluminum China conference in Shanghai (July 8-10) is highlighted as "Creating a New Green Aluminum Industrial Reality". While there is no doubt an element of hype in this PR, when China points in a direction it tends to go there, so this perhaps indicates a public intention to address the pollution aspect of the industry.

The conventional wisdom is that China isn't going to slow down its Aluminum industry and so the glut in Aluminum levels is going to continue. Indeed a recent article indicates that Chinese Aluminum production is surging.

This has led to substantial rationalization by Aluminum producers in the rest of the world (including Alcoa).

I've been interested in Alcoa's story for some time, not only because it has invested in smart new alloys and downstream products involving Aluminum, but also because it has diversified into carbon-based fibers, to have two strands of aircraft manufacture based on Aluminum alloys or carbon fibers.

My prediction is that in the next 12-24 months, if China gets serious about reducing fossil fuel emissions as the recent agreement with the US indicates, then there will have to be consequences either for how its Aluminum industry is powered, or for how aggressively it continues to dominate world Aluminum production. This could be the trigger for a rise in the price of Aluminum.