Aluminium Set to Soar in 2008

China's growing demand and falling supply could push aluminium prices higher in 2008 ¨C and smart indices may be a good way to take advantage of the trend. 

Forget oil. Next year's hottest commodity will be aluminium, according to a computer programme at Deutsche Bank that has a formidable track record in picking winners in the commodity markets.

The rules-based trading strategy takes a simple investment idea as its base assumption: yesterday's winners have a habit of becoming tomorrow's losers. Or as bankers say: markets tend to revert to the mean. Based on an index of just six liquid commodities ¨C crude oil, heating oil, gold, aluminium, wheat and corn ¨C this mean-reversion strategy overweights the trades it likes and under-weights those it doesn't.

Right now it is heavily invested in energy, but recently the strategy has been moving away from oil, and Deutsche reckons that by next year it will be staking as much as 40% of its portfolio on aluminium ¨C and judging by its recent successes that could be a winning trade. advertisement

For example, at the start of 2006 it liked grains, upping its position in wheat and corn to 70% while cutting energy exposure to just 5%. That helped it to dodge a slump in the energy market and gave investors a 46% return for the year. This year it has moved back to energy and taken advantage of the rising cost of crude oil ¨C it is up 44% so far.

According to a strategist at Deutsche, the move to aluminium could be inspired. "The index is doing this at a time when China is about to become a net importer," says Michael Lewis, global head of commodities research. "Of course, it's doing this purely mechanistically, but the timing is extraordinary.

China has been a net exporter of aluminium since 2001, which has helped to keep down the price of aluminium. During this time, its price has risen just 95%, which may seem a lot but is tiny compared to the 650% rise in lead. Nickel, copper, tin and zinc have also appreciated by hundreds of percent.

China is the world's largest producer of primary aluminium, with an estimated market share of 34% in 2007. It also has a voracious appetite for the commodity ¨C demand rose by 26% last year and is rising even more quickly this year, according to Deutsche. In other words, what happens in China can move the market in a big way.

For the past six years, Chinese production has kept the lid on aluminium prices, but not for much longer. "As a consequence of significant smelter capacity growth, the Chinese aluminium market has been persistently oversupplied," says Lewis. "However, it appears that this situation is about to change as the Chinese authorities have taken steps to close down inefficient smelters and restrict the level of aluminium exports."

Deutsche's computer doesn't know anything about the intentions of the Chinese government; it simply obeys a fixed set of rules to pick trades. The index is re-balanced whenever the one-year average price of any one of the commodities moves by 5% against the five-year average ¨C expensive commodities are sold down and cheap ones bought up, according to the rules.

Investors can access the index through funds, principal protected notes or with swaps, depending on their taste.

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