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Measuring the fallout as the aluminum bubble bursts

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When a bubble bursts, it doesn't take long for the gas to escape.

As recently as September, much of the aluminum industry appeared confident that prices would rise in 2009. An average approaching $3,500 per tonne could be expected, analysts said with a degree of conformity that was almost disturbing.

Even when the unraveling of the financial markets gathered pace with the collapse of investment bank Lehman Brothers and the bailout of insurance giant AIG, plenty of observers remained confident that strong fundamentals and a high cost base would keep aluminum flying high.

How quickly things change. Analysts now are busy rewriting their aluminum price forecasts for next year, as are many businesses who are faced with a far worsening outlook for their financial performances in 2009.

The initial rejection by Congress of the proposed $700-billion bailout plan seemed to be the event that finally brought home to analysts and the wider public just how serious a crisis the world's markets are facing. Confidence in the growth prospects of the U.S. and European economies has finally worn thin, and aluminum, copper, steel and other metal markets are now starting to pay the price.

Of course, much remains unchanged. Long-term, the factors that underpinned the so-called commodities super-cycle remain in place. The extra billion or two people in Asia's emerging markets that are hammering on the door of the global economy have not disappeared overnight, and their desire for a Western standard of living—and arguably for aluminum-intensive goods in particular—remains undiminished.

Cost pressures have not abated either. Oil prices may have slid, and in doing so have dragged natural gas prices down with them, but long-term electricity prices, which are critical to aluminum production, remain historically high.

In fact, the cost of aluminum production is putting such pressure on smelters that many analysts estimate that large swathes of the globe's output is uneconomic at prices of around $2,500 per tonne. That's clearly not sustainable, and it's likely that we will see further curtailments in the wake of the closure of Alcoa's Rockdale, Texas, operation last month.

It will be interesting to see how long the fundamentals prop up the market and prevent a more dramatic collapse. Supply deficits can disappear with shocking speed once consumer confidence takes a dive off the nearest cliff.

As always, China remains key, and it may be the signs of slowing demand in that economy that present the most danger to the aluminum market. The outlook for China remains unclear, but what seems certain is that Beijing's priority has moved from preventing overheating to fighting a slowdown, especially in the all-important construction markets. The seeming failure of China's smelters to follow through on a much-heralded production cut announced earlier this year hasn't helped sustain prices either.

So what does this new market picture mean for North America's leading aluminum producers? In short, it's time to hold on tight and stick to what they know best. For Alcoa and its dynamic new chief executive officer, Klaus Kleinfeld, the game plan remains unchanged Take advantage—they even call it the Alcoa Advantage—of the company's integrated structure to work on new applications. The pressure to spin off downstream operations might abate a little in a downturn, too, as those much-maligned margins could become quite appealing if commodity prices continue to fall.

For Rio Tinto Alcan and its chief executive, Dick Evans, there's really no place like home. As the industry struggles with high costs and low prices, Alcan's captive hydroelectric power in Quebec becomes even more of a trump card.

Both companies will no doubt continue to forge ahead with expansion plans around the world, but with capital markets down the drain, aluminum prices on the slide and electricity supply still very much in demand, finding the right development package might be more difficult than it appeared just a few weeks ago.

The balloon collapsed quickly, but the sound of the pop could reverberate for quite some time.

DAVID BROOKS

SENIOR VICE PRESIDENT


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