I’ve mentioned that I have been keeping an eye on aluminum stocks since the investment community turned seriously negative with a series of downgrades on AA – notably GS in early December, UBS in mid December, Jefferies in late December, and most recently Barclays reducing their price target following a disappointing earnings report on 1/9 (-.03 EPS vs -.01 estimate on better revs). Despite this series of downgrades, the stock hung in around the 8.60 level suggesting that anyone who wanted to sell had been shaken out in the 50+% decline from $18 to $8.50 from April to October. The stock then rebounded hard in the new year as a dog of the DOW, and as AA and others announced a series of production cuts. In fact, a WSJ article on 2/8 suggested that aluminum production as a whole in Australia (5th largest producing country) was basically not viable at these prices, and just yesterday the world’s largest producer – RUSAL – announced further cuts of 3.9M tons.

All of this is great – but the big X factor in aluminum production is China – the world’s largest producer. On their earnings call 1/9 AA said, “we believe china will curtail about 1.1 million tons” in 2012 which surely helped calm market fears over the China X factor. However, this morning Chinalco – the largest aluminum producer in China – announced that they expected China production of primary aluminum to rise 10.5% this year as capacity grows. China can do this because they are a non economic operator. In other words, it is more important for the Chinese government to keep workers employed than it is for them to keep their aluminum companies profitable.

One would think that the western aluminum cos would sell off pretty hard on this news – they were expecting a cut, and instead they were reminded that China is not a rational actor. They have rallied ~17% YTD making a pullback seem even more likely. However, the stocks haven’t moved down much, which suggests to me that the bottom is in on these stocks. WORST CASE I think you have ~17% downside to the strong support that developed during the series of downgrades in late Dec. Upside is substantial based on any kind of normalization of supply/demand in the next year or 2. To be clear – I don’t love these companies as investments – in fact, they are pretty crappy (10 year average ROE of ~4.5% for AA) but as a trade, I think the risk reward is there to go long.