LONDON, June 10 -- Soaring electricity prices for power-intensive aluminium smelters in China will increase the cost of production and sustain prices despite a supply overhang.
Plans to launch physically-backed aluminium exchange traded funds (ETF) with the potential to absorb 1 million tonnes of the metal will also help buoy prices.
However, gains are expected to be capped by doubts about the long-term health of the global economy; demand for the metal from the auto, building, packaging and aviation industries; and, the unwinding of financing deals to release cash for producers.
China said last month it would raise power tariff surcharges by between 50 and 100 percent as of June 1 for some power intensive industries such as aluminium.
"It's not the demand or the supply, it's the cost pressures producers are experiencing that is supporting aluminium prices," said commodities analyst Eugen Weinberg at Commerzbank. "Power price rises in China will support aluminium prices."
Industrial metal prices in the first quarter of this year rose as markets factored in global economic and demand recovery. But Greece's fiscal crisis, contagion and sovereign default have since April undermined prices.
Benchmark aluminium prices on the London Metal Exchange at around $1,940 a tonne have tumbled about a
quarter since the middle of April -- below the $2,000 a tonne borne by the highest cost producers in China.
"Aluminium is the only one which at current levels we're well into the cost curve," said analyst Daniel Major at RBS. "If it goes significantly below $2,000 a tonne, I think you are going to start to see some forced closures."
Energy is said to account for about 30 percent of aluminium smelting costs in the world outside China.
The equivalent figure for China is about 45 percent -- estimated to produce more than one-third of the global market at around 37 million tonnes.
Underpinning aluminium prices are plans to make the market more easily accessible for investors.
The world's top aluminium producer, UC RUSAL said in April that it was considering launching a physically-backed ETF, with details being finalised in the second half of this year.
The market is also talking about the potential launch of a physically-backed aluminium ETF by the world's biggest commodity trader Glencore International and investment bank Credit Suisse.
Partially offsetting the advantages are the stocks of aluminium in London Metal Exchange warehouses, which hit a record high above 4.64 million tonne in January.
Currently they stand at around 4.5 million tonnes and are expected to remain high because of demand uncertainty.
"The market is massively oversupplied," said analyst David Wilson at Societe Generale, adding that new capacity was coming onstream on top of the rising stocks.
"A lot of material has been taken out of LME warehouses to non-LME warehouses to take advantage of the lower rentalrates. LME stocks could be falling, but overall, if you add up, the stocks are still very high."
Latest figures from the International Aluminium Institute (IAI), showed global aluminium production was at a record high in April and western world unwrought stocks were on the rise.
However, prices of aluminium over the past year have been buttressed by financing deals, which have tied up 75-80 percent of LME stocks. The tightness also drove physical premiums in Europe to their highest level in three years.
A typical deal consists of banks buying nearby aluminium from a producer, selling it forward at a profit and striking a warehouse deal to store it cheaply for an extended time period.
The deals were a good way for producers to raise money fast.
But now that discount is narrowing. For example the price difference between the three-month contract and December 2010 contract has narrowed to around $33 a tonne from levels above $200 a tonne in the early part of last year. "I wouldn't be surprised to see material starting to come back into the market over the next few weeks," Weinberg said.