Energy prices haven’t helped either. Aluminum has a stronger bond than many other metals and must be dissolved through an electrolysis process and then reduced to its pure form. Electricity accounts for 20% to 40% of the costs of aluminum production. Electricity is typically generated from the use of various fossil fuels. It is common to see aluminum smelters strategically placed close to cheap electricity locations, but with the rapid rise in energy prices over the past year it’s easy to see why companies are struggling to make a profit. Also, the industry is fighting the cost escalation of key inputs such as natural gas, caustic soda, and calcined coke which have risen 47%, 88%, and 110% respectively.

Aluminum prices have plummeted over 35% since peaking along with copper, zinc, and oil. However, aluminum’s fall has been particularly steep since the spot price is currently below the marginal cost of production. That’s right- the aluminum fundamentals couldn’t be worse. Alcoa estimated one-third of world production is unprofitable at this time.

What to look for in 2009

With that said, this is a market condition that is not sustainable. The immediate reaction worldwide is to either suspend new capital commitments or reduce operations at high-cost production sites. Inventory levels are 70% above 5-year averages, a clear indicator of a market surplus. Companies such as Century Alumnium (CENX: 12.00, 0.00 (0.00%)) have already delayed major projects and by doing so have been able to maintain a positive free cash flow position to protect against the expensive financing environment we have today. It is going to take time for the entire industry to react in the same fashion as Century Aluminum. As for the supply/demand fundamentals going forward, there isn’t too much upside. The industry is not sustainable at the current spot price around $0.845 per pound, but according to analysts, aluminum prices will not stray too far from the cash cost of production which is approximately $1.00 per pound. China has rapidly increased production at a pace above consumption, so look for governmental assistance in order to keep that market afloat. Consumption is expected to slow to 4.2% from 6.1% in 2008 and 10.5% in 2007. Don’t be fooled by the notion that “it just can’t fall any further.” It definitely can, and in the case of aluminum it most likely will. Avoid aluminum at all costs, there is nothing positive or promising about an industry surplus.

-Darrell Reid

Disclosure: None