Alcoa (NYSE:AA) is one of the world’s largest producers of aluminum. In addition, the company is also involved in lightweight metals engineering, primarily based on aluminum. The company’s fortunes are, to a large extent, determined by the trajectory of aluminum prices, which not only impact the realized prices and margins for primary aluminum and alumina sold by the company, but also those of the company’s value-added businesses. Aluminum prices have fallen quite considerably from the levels of over $3,000 per ton seen prior to the 2008 Financial crisis. [1] Aluminum prices have been quite volatile over the last few years. Currently, prices stand at levels of around $1,800 per ton, significantly lower as compared to the previous year’s high of around $2,100 per ton.

Aluminum has diverse applications in industry. The demand for aluminum is broadly correlated with industrial growth. Economic weakness in Europe and slowing Chinese growth contributed to the weakness in aluminum demand and consequently prices, over the last few quarters. Economic growth in China, the world’s largest consumer of the metal, is expected to slow to 6.8% in 2015, as compared to 7.4% in 2014. [2] On the supply side, there is a global inventory overhang, which is keeping aluminum prices subdued. London Metal Exchange (LME) aluminum stocks stood at 4.3 million at the end of 2014, which represents around 10% of global aluminum production. [3] [4]

The bulk of the inventory in LME warehouses is tied up in various collateralized financing deals. Low interest rates post the financial crisis have enabled various traders to buy large quantities of aluminum, borrow against the metal while paying warehouse rents, and benefit from the spreads between spot and futures prices. [3] An increase in interest rates may lead to an unwinding of these deals, which may lead to a dumping of LME aluminum inventory on the market. This would lead to a fall in aluminum prices, which would negatively impact the prospects of Alcoa. In this article, we will look at the impact of this scenario on Alcoa’s stock price.

Impact of Unwinding of Aluminum Financing Deals on Alcoa

With the strengthening of the U.S. economy, the Federal Reserve is expected to start raising interest rates sometime in 2015. [5] Though the exact timing and extent of the hike over the next few years depends upon the pace of economic and jobs growth, the start of the Fed’s interest rate hike cycle this year is quite likely. Assuming that the U.S. economy grows as per expectations and the Fed raises interest rates over the next couple of years, there is a chance of unwinding of aluminum-backed financing deals. A rise in interest rates will raise the costs of financing deals involving aluminum, which is likely to result in the unwinding of these deals.

If we assume that demand for aluminum does not vary significantly, a 10% increase in aluminum supply would depress prices significantly. This would negatively impact both the realized prices and margins for all of Alcoa’s divisions. In addition, we will assume that the company’s production plans and capital expenditure remain the same in this alternative scenario. Since we forecast capital expenditure as a percentage of EBITDA, in order to model this new scenario we have modified our forecasts in order to keep capital expenditure at the same levels in the new scenario. If we factor in these assumptions on the various drivers impacted in our stock price model, our price estimate for Alcoa decreases by 18% from $15.98 to $13.11. Thus, there is significant potential for a downward revision in valuation in case of the unwinding of aluminum-backed financing deals.