Up 25% in six months: is the aluminium rally just getting started?

If you look at the commodities market, as illustrated in the chart below, it's clear the rally has not been unanimous.

Silver is in a league of its own, while gold, palladium and lithium have all seen eye-watering rallies. Aluminium, by comparison, has still had a good run, but it hasn't exactly been swinging for the fences. That is notable given its critical role across industrial manufacturing, AI data centre build-outs and electric vehicles.

That divergence raises an obvious question. Is the market sleeping on aluminium, setting the stage for an explosive awakening, or are there other forces at play that justify its more subdued price action?

To explore that question, we sat down with Tim Zhao, Portfolio Manager and Analyst on the Australian Equity team at Lazard Asset Management, to discuss what is happening in the aluminium market, whether prices could break out as supply tightens, and the two stocks Lazard prefers for exposure.

Why has aluminium lagged other commodities in recent years?

I think you have to put these metals into different baskets. Gold and silver are very different. They are precious metals, and while silver has some industrial uses, both tend to perform well during periods of global uncertainty, geopolitical risk, or inflation concerns. People use gold and silver as safe-haven hedges.

Aluminium and copper do not really have that status. They have not attracted the same kind of flows that go into gold and silver, and that is probably the main reason aluminium has lagged.

If you compare aluminium with copper, there is also a difference on the supply side. Over the past 12 months, we have seen several production issues at Western copper mines, and near-term supply guidance has been pulled back. That has made the copper price action more acute. Aluminium has not had the same type of supply shock.

What are the key supply and demand dynamics investors should know?

If we start with a key difference between aluminium and copper, if you get to the nuts and bolts of it, it comes down to the manufacturing process.

Smelters can run in a very steady state for a long time as long as they have constant energy supply. Compared to copper, the mining side of aluminium is relatively straightforward.

And then when you look at the key players, we can put China Inc into one group, which has put pressure on prices as it industrialised its economy.

Over the past 10 to 15 years, China built a lot of aluminium smelting capacity, but the government put a cap at around 45 million tonnes. We are now at the cap and that cap looks quite firm.

From here, it is getting harder to add supply. Aluminium smelters are very capital-intensive, the payback period is long, and the key input is energy access. Cheap energy is becoming a bottleneck globally, particularly for Western companies.

Why are Western producers so cautious about boosting supply, even at current spot prices?

When we speak to Western aluminium companies, they are very cautious. Even though prices are high, they prefer to invest only in green aluminium, meaning smelters powered by renewable energy.

We are also now in the first year of the EU’s Carbon Border Adjustment Mechanism (CBAM), which imposes higher carbon costs on aluminium imports with high embedded emissions.

The problem is that green energy is scarce. Most green aluminium today comes from places like Canada and Brazil, which are backed by hydro power, and that is a scarce commodity at the moment. That's making companies cautious about investing in new capacity.

Another issue is that aluminium smelters are now competing with data centres for electricity. Data centres are willing to pay twice the amount for electricity as compared to a smelter.

If China's supply is capped and the West is hesitant, where could new supply come from?

Indonesia has become very important in the context of where aluminium could go from here.

 Indonesia has large bauxite resources, which is the main input for alumina and aluminium, and it also has abundant coal resources. That means energy prices can be very competitive.

Because of that, Indonesia has attracted a lot of Chinese capital. The question is how quickly that supply can come online. Infrastructure is still lagging, and China has become more reluctant to fund coal-fired power stations overseas.

In the near term, it is hard to see a strong supply response. In the medium to longer-term, Indonesia is the main risk investors need to watch.

What could derail the aluminium price outlook from here?

The first risk is Indonesia. If supply ramps up faster than expected, that could put pressure on prices.

The second risk is demand destruction. Aluminium prices are already around US$3,000 a tonne, which is above long-term averages. If prices stay too high, governments and manufacturers may push back, especially given aluminium’s role in electric vehicles, renewables and infrastructure.

There is also a policy balance. Governments do not want aluminium prices to be too high, but if prices are too low, no one will invest. That is why the current supply cap in China makes sense.

How does copper pricing influence aluminium demand?

There is a substitution effect between copper and aluminium. People often talk about the copper-to-aluminium price ratio, which is usually around three to three and a half times. Today, it is closer to four.

When copper becomes that expensive, manufacturers start substituting aluminium where possible. Aluminium is lighter, corrosion-resistant, and has good thermal and electrical conductivity. That can support aluminium demand if copper prices stay elevated.

How is Lazard gaining exposure to aluminium in portfolios?

We prefer diversified miners rather than pure-play aluminium producers. Our preferred exposures are Rio Tinto (ASX: RIO) and South32 (ASX: S32). While Alcoa offers pure exposure, we think diversified miners provide better risk-adjusted exposure at this point in the cycle.

What does the current aluminium price mean for the earnings and dividends of these companies?

Using spot aluminium prices for the rest of the year, we would expect around a 10% earnings upgrade for Rio Tinto and around a 20% upgrade for South32 over the next 12 months.

That could translate into a 15% lift in dividends for RIO, and 40% lift for S32.

That said, we normalise commodity prices over a three to four year view, and we are conscious that we are probably at the higher end of the cycle.

Are you bullish on commodities more broadly, and how is your fund positioned?

The Lazard Australian Equity Fund has an 18% weighting to materials.

Obviously, the big backdrop of the demand story from energy transition has continued to play out, and I think it will still be there for the next 3-4 years, but I'm conscious of drastic portfolio shifts when prices are getting high.

If you look at copper, I think the underlying demand from the world's biggest market - China - is weak. Aluminium is in a slightly better position given the lack of additional supply in the short term alongside low inventory levels.

So while the backdrop is attractive, we're taking a balanced approach given the cyclicality of the sector and elevated valuations.

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Lazard Australian Equity Fund (W Class)

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