FOCUS:China Aluminum Makers Maintain Output Despite Falling Margins

SYDNEY, June 28 -- China's aluminum smelters have been slow to cut production despite rising production costs and falling prices for the metal, challenging expectations that Chinese production cuts will put a floor under prices in the immediate term.

This could delay a price recovery and may instead push prices further down as continuing oversupply remains a concern for the market.

The 22% fall in market prices for the metal from its April 16 peak of $2,494/ton, combined with a sharp increase in energy prices for Chinese smelters from June 1, had raised hopes that the industry would trim its losses by cutting production.

In a similar case, when LME aluminum prices dropped below $2,000/ton at the start of November 2008, Chinese output fell 14% below its October level of 1.1 million tons within two months.  Production recovered to its pre-crisis levels only by August 2009, according to International Aluminum Institute figures.

Aluminum for 3-month delivery on the London Metal Exchange was trading at $1,951 a metric ton at 0630 GMT Friday.

But this time around, there has been little sign of a similar reaction from producers. Chinese aluminum production hit a record 1.42 million tons in May, according to IAI estimates, at a time when market prices were tanking and an increase in electricity tariffs had already been announced.

"We haven't really seen any significant cuts happening yet in China," said Yingxi Yu, a base metals analyst with Barclays Capital in Singapore.

That may become a cause for concern if the trend continues, although producers and traders are still counting on turning off the spigot of Chinese production to tighten market supply and support prices in the coming months.

"Continued cost pressure on marginal-cost producers will provide (an) upward price lift," said Rio Tinto Alcan Chief Financial Officer Phillip Strachan, in a presentation to analysts in Australia earlier this week.

"The next 300 dollar move for aluminum is not going to be down," said a trader at a major European bank in Singapore, citing analysis of producer cost curves indicating that as many as 40% of the smelters are operating at a loss at current prices.

But it is difficult to generalise as Chinese smelters report wide differences in energy costs at the provincial level. An official at a Shandong-based aluminum producer with an annual capacity of 150,000 tons said smelters that have their own power plants incur a production cost of roughly CNY 14,000/ton.

That would be enough to turn a bare profit at current prices, where the most-active September aluminum contract on the Shanghai Futures Exchange was trading around CNY 14,835/ton Friday.

According to Barclays Capital's Yu, smelters may also be hoping the current weakness in market prices is a temporary blip, in which case the savings from halting production would not outweigh the often considerable costs of shutting down plants.

Demand for the metal remains strong, according to Standard Chartered research published Friday, and LME stocks of the metal have gradually fallen to 4.5 million tons, their lowest level in 11 months.

"It's very unlikely that we'll have to shut down the plant because (of high costs)... and alumina prices are falling these days, so we still hope to see some recoveries in the coming months," the official with the Shandong-based aluminum producer said.

The price of alumina, the raw material used in aluminum smelters, is currently set around 14% of the market price of aluminum, helping producers maintain margins when prices fall.

Analysts said smelters in China's Henan province were harder-hit by the higher power tariffs because they used to enjoy preferential electricity prices.

"For smelters in Henan, their electricity bill has risen to CNY0.54 from CNY0.39 a kilowatt hour and their production cost is around CNY 16,500/ton," said a Guangzhou-based trader.

One of the medium-sized aluminum producers in Henan province said it had cut production by 20% so far.