Alcoa Corrodes

 | Apr 09, 2012 | 1:30 PM EDT
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It's a shame that earnings season always begins with the report from Alcoa (AA), because it almost always assures that earnings season begins with a disappointment. I expect nothing better this coming Tuesday as Alcoa is primed to deliver a miss as it has for five of its last seven quarters.

Several things have been conspiring against Alcoa's progress over the past several years, and I have followed this aluminum giant and prayed for good news to turn the company around. Alcoa is almost a U.S. monopoly; its only real competition comes from the Aluminum Corporation of China (ACH), which is much more engaged in industrial aluminum and not the advanced applications for aerospace and autos.

In the commodity space, no single commodity is more due for a price run than aluminum, long the weak sister of the industrial metals, but any excitement over aluminum and Alcoa is tempered by the facts.

From a fundamental point of view, aluminum demand is controlled on the margins similarly to all the industrial metals -- namely, by demand in the emerging markets and most significantly by demand in China. And in China, much of that demand is satisfied by Aluminum Corporation of China and its state subsidies. For Alcoa, it's never been about penetrating China and other emerging markets; it has been about how strong its demand has driven global pricing and growth. And in China, demand, while still strong, has continued to slacken. Copper's price has withstood the Chinese slowdown better, but aluminum, after a decent run to $1.20 a pound in April 2011, is down to $0.93 a pound today.

Financially, the market has conspired to put a lid on prices as well. Similar to natural gas, a strong contango has put incredible pressure on buyers to store (as opposed to promptly use) the product, a situation that I outlined on Feb. 16 on Real Money Pro.

With demand on the margins dropping and with pressure to store product so strong, Alcoa is experiencing the same bad market confluence that many of the large natural gas players are experiencing, and for aluminum, it's significantly worse. It's relatively difficult to store natural gas, and we are in fact running out of storage; with aluminum, any warehouse will do, and it's virtually impossible to run out of places to put it. As long as the carry trade exists, the pressure on prompt aluminum prices will exist, too.

Alcoa knows this. The company has recently cut production of alumina close to 400,000 tons, but it is laboring against a Chinese competitor that is far less sensitive to relative price -- as long as Aluminum Corporation of China continues to receive government support, it is likely to continue to produce, no matter what the price does or how bleak the futures curve looks.

It's a tough spot for Alcoa, and even with shares hovering in the single-digit range, I would much rather wait for a market change that would put a little wind in its sails and give up the first few dollars that the Aluminum Corporation of America will rally as the contango eases, Europe returns from recession and some of the massive stockpiles of aluminum comes out of storage.

From all indications, that's unfortunately not on the horizon.


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