China Moves to Cut Aluminum Overcapacity

China’s central government is showing a renewed commitment to cut overcapacity in the country’s aluminum industry. The question now is whether local governments will refrain from meddling in the plan to improve efficiency in making the metal.

Whether or not China can implement the changes could play a pivotal role in the direction of global prices.

The National Development and Reform Commission said Monday that efficient aluminum producers will continue to pay the same rates they’re used to, but less-efficient producers will have to pay more.

Electricity accounts for around two-fifths of the cost producing aluminum, so even small electricity-pricing changes can impact profitability.

The NDRC, China’s top economic planning agency, said producers that require 13,700-13,800 kilowatts to produce a ton of liquid aluminum will be charged an additional 0.02 yuan per kilowatt, while those who exceed 13,800 per kilowatt must pay an additional 0.08 yuan per kilowatt. The surcharges would be effective increases of 1.8%-7.4% to produce the metal in Henan province.

That can make all the difference given negative margins in China, where it costs upward of $2,300 to produce a ton of aluminum compared with less than $1,800/ton for the benchmark contract on the London Metal Exchange. The government is hoping that the move will push producers who have kept older facilities running in the hope of higher prices to finally cut their losses.

This is the first concrete step the government has taken to curtail aluminum overcapacity since the country’s new leadership assumed office last year and since last month’s reform blueprint, which outlined plans to cut industrial overcapacity.

“It’s certainly positive for the fundamentals, but I think ultimately it depends on execution at the local level, how the policy is played out on the field,” said Wan Lin, a senior analyst at CRU Group, a metal and mining consultancy.

Local governments have thwarted previous central-government efforts to encourage companies to cut output, often by offering subsidies or cheap electricity. While Beijing is concerned about efficiency, local governments are more concerned about losing the contributions big companies like aluminum smelters and steel refineries can make to the local economy, including tax revenues and job creation.

Overcapacity in China is skewing the global market. Total Chinese aluminum output is expected to grow by 10% to slightly more than 26 million tons against demand of 25.8 million tons in 2014, CRU Group’s Ms. Wan estimated. That is consistent with production growth so far this year: From January-October, China’s aluminum output totaled 18.16 million tons, up 9.2% from a year earlier.

By contrast, the global aluminum market outside China is set to see a small deficit this year and a 275,000-ton deficit next year, as producers are cutting back by around 1.4 million tons, Barclays analyst Nicolas Snowdon said in a note last month. That could help to trim bloated inventories, however slowly. Stocks at the LME stood at 5.47 million tons as of Dec. 19.

The NDRC is trying to address the effects of protective local governments. It said Monday that they won’t be allowed to offer lower power prices to their aluminum producers and asked them to roll back any existing the preferential power prices. They are also being asked to collect fees from aluminum producers that have their own power plants.

Ms. Wan estimated that less than 15% of China’s total aluminum capacity requires 13,800 kilowatts or more of electricity to produce a ton of aluminum, limiting the potential cutbacks.

“Plus, there’s no way for the government to verify exactly how much power a producer consumes, because it is the producer itself that reports the number,” said a Shanghai-based aluminum trader at a foreign house.

If China does manage to ensure inefficient producers see their way to cutting production, it could help mop up some of the surplus aluminum in global warehouses and spur prices, which are down 14% in the year to date and 28% from three years ago. But unless local governments and producers play along, the light metal could remain in the doldrums for some time to come.

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