Aluminium: Fund-driven volatility

Base metal prices have exhibited extreme volatility in recent weeks. This is a common phenomenon at the top of the cycle and adds weight to our view that prices have peaked. Speculative activity pushed prices to multi-year highs in early October followed by a sharp correction, triggered by reports of a slowdown in China's apparent copper consumption for July. The introduction of measures to cool China's economy in May led to a period of de-stocking and some volatility in raw material imports. This has been evident in more timely import data for some months.

However, the underlying base metal demand remains firm, supported by the synchronised global recovery. We expect slower, but still robust, global growth in 2005, driven by a modest post-election slowdown in the US and a soft-landing in China. This should keep metals prices above long-term averages, despite a cyclical downturn. Aluminium prices have probably peaked, but prices should remain above long-term averages through 2005, given the secular growth in China's demand.

Aluminium has seen less upside than other base metals during this cycle as China's production capacity growth has outpaced domestic consumption growth. China now accounts for 19% of demand and 20% of global production. China's output has continued to rise during 2004, despite raw material and power shortages. Inventory levels have been steadily falling on the LME, but IAI stocks have stabilised.

China's capacity will likely expand over the next couple of years, although growth will be curbed by government measures to limit investment in this particularly power-intensive sector. However, utilisation is likely to be limited by alumina and power shortages at least through 2005. Consequently, the global aluminium market is expected to stay in deficit in 2005. Suggestions that China may remove its 8% export VAT rebate on aluminium and even impose a 5% export tariff to curb exports are also positive for prices.

The key risks to this forecast are a sharper than expected slowdown in the US or a hard landing in China.