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Alcoa’s (AA) Drop Today May Be Just the Beginning

By Paul Ausick

Since the beginning of the year, Alcoa (AA) shares have risen more than 20%. The price of aluminum on the London Metals Exchange in the same time has risen less than 10%. Copper prices have nearly doubled in 2009, and nickel has jumped about 50%.

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In the base metal sector, aluminum is not a top performer. Part of the problem is that mining and refining the stuff is energy intensive, and operating costs are very sensitive to electricity prices. Paying the electric bills drains cash, wreaking havoc with a company’s free cash flow.

For the first nine months of 2009, Alcoa’s cash flow from operations totaled $1.338 billion. Capital expenditures totaled $2.4 billion. That’s a negative free cash flow of more than $1 billion. Turning that around is going to be difficult.

Aluminum inventories were high during the first half of 2009, further depressing prices. The slow global economy contributed to the stockpiling, as demand for aluminum products also dropped.

There are some signs that the price for aluminum will recover in the second half of the year. Alcoa has indicated that it expects demand to increase by 11%.

But other signs are not so encouraging. China, the world’s largest producer and consumer of aluminum, has already increased its stocks of aluminum through a state-directed buying scheme that propped up the price and led to increased imports. But China’s warehouses are almost full now, and the state is not expected to buy more aluminum in the near term.

Demand for copper is also expected to soften through the end of the year, again, because China’s buying has slowed down. Nickel, which is used in making steel, has also retreated from summer highs.

Should the global economy hit another slow spot, especially in new construction, prices for base metals could drop or even collapse. Alcoa’s share price drop today is almost certainly due to the dollar showing a bit of strength. Still, weakness in base metals could just be getting started.

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