HardAssetsInvestor

Written by Julian Murdoch  |

November 22, 2010

Aluminum: Does A Physical ETF Make Sense?

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For over a year, rumors have swirled about the possibility of a physically backed aluminum ETF. But if one does launch, should investors jump in?

 

Physically backed ETFs may currently be en vogue in the precious metals space, but for base metals, the playing field remains empty. Not one physically backed industrial metal ETF exists in the States yet—although rumors have swirled about their impending creation for years. Plus, last month we saw both J.P. Morgan and iShares file for physically backed copper funds. (We discussed the filings on a recent podcast.)

Now, just last week, Alcoa's CEO Klaus Kleinfeld told Bloomberg that he supported the creation of a physically backed aluminum ETF, too. But does a physically backed ETF make sense in the aluminum space?

To answer that question, first we must look at the metal's fundamentals.

 

Aluminum: A Roller Coaster Ride

For aluminum, the past five years have been a roller coaster:

 

Prices currently float around the $2,260/metric tonne level—still 10 percent down from earlier highs struck back in 2008, and mostly flat on the year.

At the same time, inventories have fallen nearly continuously since the 2008 peak, which, on the surface, sounds good for supply-side support for prices. Still, the market remains oversupplied when compared with the drastic inventory shortage that drove prices over $3,000/tonne back in 2008. Moreover, the inventory drawdown seems to have slowed lately:

 

 

Of course, global aluminum demand can be a tricky thing to parse, and nobody seems to agree on just how strong demand currently is.

On one hand, you have some producers remaining pessimistic on demand, including Kaiser Aluminum Corp's [NASDAQ:KALU] CEO Jack Hockema, who recently said, "The global demand is not that strong yet. The prices are ahead of the fundamentals."

But then you have China, the world's manufacturing behemoth, who estimated its total 2010 demand to be 16.8 million tons—a 22 percent increase from 2009. That's even with recent power curbs in China that have affected one-third of the country's aluminum production capacity. In certain provinces, the power curbs—which are part of the government's plan to reduce pollution and meet 2010 energy conservation requirements—have slowed or ceased coal-hungry aluminum production. Prices have since risen 17 percent.

Some companies, such as the world's leading aluminum producer Rusal, forecast that China's appetite for aluminum will only continue to grow, just more slowly. Rusal's CEO Oleg Deripaska told Bloomberg that consumption of aluminum in China will swell by 20 million to 22 million tons over the next three to four years. He also argues the same type of growth will occur in other parts of Asia, estimating that over the next seven to eight years, aluminum consumption will grow by 4 to 5 percent per annum.

Therefore, while the shorter-term market experiences relatively high inventory levels, demand prospects still look good in the medium to long term. But even still, is this the right environment for a physical ETF?