Deep Dive: Alcoa (AA)
Attractive industry demand & supply, sound balance sheet, cash flows, and improving returns to shareholders
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Which versatile metal is positioned to enjoy strong secular demand over the coming decade from vehicle electrification, renewables, and other de-carbonization use cases? We think investors should become familiar with aluminum.
This report will explain our thesis on Alcoa - the largest North American aluminum producer - with a focus on understanding the aluminum industry fundamentals and supply & demand dynamics. Commodities have regained the spotlight since the start of the year, as investors scrambled to understand whether we are in a world headed towards a structurally higher pricing environment. If you are looking for ways to gain exposure to commodities in your portfolio, perhaps this may be a good place to start.
We think aluminum has attractive medium to long-term fundamentals, and believe the recent pull-back in prices is a good opportunity to accumulate on weakness. Aluminum is positioned as the metal of the future, benefitting from broad-based demand growth driven by de-carbonization trends. Demand is just one side of the equation however, as commodities investing cannot produce good returns without orderly supply to support prices. We take a close look at the major aluminum producing markets and examine the structural constraints to global supply. Building on top of the industry discussion, we highlight the case for an investment in Alcoa by examining the company’s assets, operations, optionalities, and valuation.
Table of contents
Aluminum Industry fundamentals
Industry 101 to get you up to speed in 10 minutes
Production process, industry structure, energy use & emissions, aluminum pricing
Global demand and supply
Long-term demand growth drivers - examining usage across industries including EV and de-carbonization demand
China’s significantly lower supply trajectory expected in the coming decade (a marked departure from the past)
Structural constraints in other markets (Europe, Russia) - will not resolve in the near-term
US aluminum industry
Overview of the current state - industry players, domestic production vs. imports, policy
Decline of the US aluminum industry, its strategic role and opportunities in re-shoring
Global smelting portfolio, including the economic significance of renewables power source conversion
Recent operational highlights - capacity curtailments, restarts, expansions
Optionalities, including ELYSIS joint venture
Alcoa’s investment cases summarized
Alcoa’s P&L forecast at different LME prices
Calculating the enterprise value
Historical and peer multiples
Aluminum industry fundamentals
First, we cover some basics of aluminum production, supply chain, industry structure, and pricing that are prerequisites for understanding the business.
Extraction, refining, and smelting
Bauxite, a reddish brown rock mined just meters above the surface of Earth, is the main source of aluminum containing about 15-25% aluminum content. 90% of global supply of Bauxite comes from tropical/subtropical regions, most notably Australia, Guinea, Vietnam, Brazil, and India. There are 29 billion tons of known bauxite reserves on Earth, and at the current rate of extraction the reserves can last more than 100 years. But there are also reports of vast undiscovered reserves that may extend it to 250-340 years and beyond. As an element, aluminum is abundant.
Bauxite is fairly widely distributed across the globe, and because it also sits close to the surface, extracting it is also relatively straightforward. The bottleneck with aluminum is not in the extraction, but in the production (refining and smelting). Production involves two main steps: alumina refining, which converts bauxite ore into aluminum oxide (called “alumina”), and aluminum smelting, which converts alumina to pure aluminum. Four tons of bauxite is refined into two tons of alumina, which is then smelted into one ton of aluminum. To give you a sense of the value-add during each production stage, the prices (Alcoa’s third-party realized prices in 2Q) were $3,864 for a ton of aluminum, $442 for a ton of alumina, and $46 for a ton of Bauxite.
Bauxite is refined into alumina with what is known as the Bayer Process. Bauxite is crushed, grounded, then mixed with heated solution of caustic soda, creating a hot slurry. It is then filtered and dried to produce Alumina in the white powdered form (illustrated below).
Aluminum is then created by running huge amounts of electricity through alumina solution in a smelter. For the scientists out there, alumina (aluminum oxide or Al₂O₃) is just aluminum atom bonded to oxygen. To get aluminum in its pure form, oxygen needs to be separated by electrolysis, and that’s where the need for electricity comes in. The energy requirement during this step is enormous, typically running at about 30-40% of total production cost. It is this massive energy requirement that is the industry bottleneck. The most important thing for Aluminum smelters is being located in a region with powerful and stable, yet low cost, and preferably renewable source of energy. This is important, and will come up again and again in this report.
Primary vs. secondary aluminum
We have so far described the process for producing “new” aluminum from bauxite ore. This is referred to as primary aluminum production. The other type is secondary aluminum, which is aluminum produced using recycled scraps. Secondary production uses a different method and only consumes 5% of energy required in primary production. Thus, it is very clean.
However, the key constraint in the secondary production is availability of scraps, since aluminum content is locked in products until they are recycled. Even with better scrap collection rates, there is an upper limit on potential secondary production. There is also a limitation to quality and purity with secondary aluminum. During the recycling process, impurities like paint, dirt, and grease are mixed in and must be treated with separation technology. This is not perfect. Most downstream makers require a mixture of primary and secondary aluminum in their products, and a certain minimum amount of primary aluminum usually has to be used in order to meet the desired properties of the alloy.
The share of secondary aluminum has remained roughly consistent at about 30-40% of primary production. There are efforts to boost secondary production including better recycling technologies, and the share of secondary aluminum is likely to increase in the future given its reduced energy consumption. But the world cannot simply run on just recycled aluminum, and will continue to increase primary production to meet the growth in future demand. The International Aluminum Institute (IAI) estimates up to 90 mmt (million metric tons) of primary aluminum will be needed by year 2050 (compared to 67 mmt of primary production in 2021). In this report, we focus on Alcoa, which is predominantly a primary producer, but also has a nascent recycled aluminum business.
Upstream vs. downstream
In primary aluminum production, upstream includes processes from bauxite mining down to aluminum smelting, while downstream includes the subsequent metal fabrication stages (shaping aluminum into semi-finished and finished forms for industries such as automotive, aerospace, packaging, and others). The industry follows a cone shape, from the concentrated upstream operations, down to the tens of thousands of downstream companies. Some of the large global players operates in both upstream and downstream (Alcoa used to be in both, but in 2016 the company split into the current Alcoa Corp, which focuses on upstream operations only, and separate company Arconic, which is a downstream player). Major US-based downstream players include Novelis, Kaiser Aluminum, Constellium, and Arconic.
The chart below shows the top ten upstream producers by production. Many of these large players, including Alcoa, are vertically integrated in their operations, which means they mine their own bauxite and refine their own alumina. Smaller aluminum producers will typically operate their own aluminum smelters but procure the inputs (bauxite and/or alumina) from the larger players.
Alcoa mines ~90% of its bauxite in Australia and Brazil, and also does alumina refining in these countries. Then, alumina needs to be shipped to where the smelters are located. Alcoa has smelters in Canada, Iceland, Norway, The United States, Spain, Brazil, Australia, and Saudi Arabia. Close to 50% of Alcoa’s non-curtailed (or active) production capacity resides in Canada (Quebec), from where Alcoa supplies to the US market.
93% of bauxite extracted by Alcoa from the mines is used internally by the company, while 7% is sold to third party. For alumina, Alcoa uses 29% internally, while selling 71% to third party. Finally, 100% of aluminum is sold to third party (to downstream players). Revenue and profit contribution (from third party sales) is split roughly between 70% aluminum and 30% alumina, although this fluctuates depending on relative pricing between the two.
Energy use and emissions
Roughly 60% of the world’s electricity consumed in aluminum smelting is self-generated by the producers. The share of self-generation is particularly high in China (about 75%), where most producers would operate their own “captive” coal powered plants. The ratio of self-generation is about 50% in the Americas. In Europe, Africa, and Oceania, virtually all of the electricity is purchased.
China relies on coal for 80-90% of energy used in aluminum production. On the other hand, hydro accounts for about 75% of production in Americas and Europe. As a result, there is a big gap in the emissions of Chinese and Western aluminum, as shown below. The flat part of the bottom curve represents Chinese producers, which emits between 16 to 17 tons of CO2 per ton of aluminum produced, compared to most Western producers at below 5 (Alcoa averages about 4).
The London Metal Exchange (LME) is the largest exchange venue for aluminum outside of China. Keep in mind that 90% of aluminum with physical delivery are sold under bilateral contracts between producers and buyers, and not transacted on an exchange. However, the pricing in these bilateral contracts are benchmarked to LME prices. The realized price is based on the LME price, adjusted for regional premium (e.g. Midwest premium for United States) and product premium (e.g. particular shape and/or alloy, carbon-free aluminum). Alcoa’s realized prices have historically been 10-20% above LME prices reflecting these factors. Premiums can fluctuate depending on variables such as geopolitics (risks of disruption), inventory, shipping costs, tariffs, and other considerations.
Global demand & supply
We want to begin by showing two charts as a starting point to visualize the demand & supply picture.
The first chart (below) illustrates how aluminum is positioned relative to other elements. It shows aluminum as the only element in the “third quadrant” on the chart. What does this mean? The x-axis measures how broadly the element is used across different types of products (technological concentration) - e.g. copper on the right being the broadest, while Lithium on the left being heavily concentrated on just a single application (i.e. batteries). The y-axis captures the degree to which the production must scale up from 2018 levels to meet estimated demand from clean energy use cases by 2050. Aluminum being in the third quadrant means that it is both broadly used AND has the biggest demand gap - illustrating the strong case for aluminum.
The chart below shows, on the right side, the estimated demand breakdown by industries by 2030. The left side breaks down the supply growth that would be required to meet this forecast.
Now, let’s dive deeper.