With aluminum markets cyclically down, Alcoa (AA Free Alcoa Stock Report) is having a challenging time generating earnings momentum. A material increase in global aluminum supply, most notably from China, has resulted in nearly two years of flat or falling prices on the London Metal Exchange (LME). As noted, China remains the primary source of new production. As global output rose from roughly 34 million tons to 45 million tons between 2006 and 2012, Asia’s economic engine doubled its capacity to 19.5 million tons. To make matters worse, companies based in China are supposedly on pace to boost production by as much as 2.5 million-4.0 million tons in 2013, exceeding the 500,000-750,000 tons of output cuts it supposedly has planned. While many of China’s facilities are probably operating at unprofitable levels, likely state intervention (subsidies and/or favorable power contracts) has encouraged managers to maintain production lines. 

Concurrently, growth in this metal's demand is apt to be comparatively less, as a slower-than-anticipated rebound in industrial activity looms large. Most countries in the euro zone continue to exhibit contracting or lackluster economic activity and China's consumption and manufacturing rebound appears to be more moderate than previously anticipated. Other emerging markets are displaying similar conditions. An ongoing build-up in capacity has led to mounting aluminum stockpiles in certain markets.       

The ensuing fallout has been sluggishness in LME prices (recently $1,880 per ton). In all, the value of this metal has fallen more than 5% this year, and is down approximately 33% from the record of $2,800 set in 2011.            

Alcoa remains steadfast in its mission to limit the damage by curtailing cost and capacity. In 2012, it shuttered 531,000 tons, or 12% of its total production. Measures to cut expenses have resulted in substantial benefits, but forces outside its control are proving to be overwhelming. Accordingly, it is taking additional efficiency-boosting steps. This year, the producer intends to take out another 11% of its output. In the same vein, the impending completion of an $11 billion mining-smelting, and manufacturing facility in Saudi Arabia ought to help, enabling it to shutter many of its more expensive facilities.

However, Alcoa cannot single handedly stem aluminum’s slide. A collaborative effort is required in order to boost this metal’s fundamentals. The world’s biggest aluminum maker, RUSAL, cut output by 7% or 300,000 tons last year, and lowered capacity by 4% in 2013’s first quarter. It predicts nearly 4.0 million tons in industrywide reductions this year. But with China-based entities investing in new facilities, the benefits are apt to be minuscule, if any, in the short term. Taking these factors together, 2013 is turning out to be a more challenging year than previously envisioned for Alcoa.

According to Moody’s (MCO) Investors Service, successful efforts by this Pittsburgh-based entity to cut inefficiencies are insufficient to overcome tepid aluminum fundamentals. It lowered this company’s credit rating to speculative grade, a level reached by only former Dow Jones component General Motors Company (GM) in the last thirty years. Although this downgrade may not result in Alcoa’s removal from this venerable index, continued financial deterioration could.

The Dow Jones Industrial Average was established in 1896 by Charles H. Dow. After starting with 12 companies, it expanded in stages, before reaching 30 in 1928. The most recent change to the index was in 2012, when UnitedHealth Group (UNH Free UnitedHealth Stock Report) replaced Kraft Foods Inc. (KRFT) after the latter spun off its North American grocery business.  

The downgrade contributed to Alcoa’s ongoing share-price decline, down more than 70% during the past decade. Moreover, this company’s market capitalization of $8.3 billion makes it substantially smaller than that of The Travelers Companies, Inc. (TRV Free Travelers Stock Report), whose equity is the second smallest of the Dow stocks. During the same time, AA’s global share of aluminum production has dwindled from 15%, to less than 9%. In sum, while Alcoa is still a major industrial player, it no longer appears to be a bellwether stock. Diversified commodity plays including Rio Tinto plc. (RIO), Vale S.A. (VALE), and BHP Billiton Ltd (BHP) currently fill that role.

Our long-term outlook for aluminum is more favorable. But this hinges on firming demand from the auto manufacturing sector. Carmakers remain under pressure to build lighter, more fuel-efficient vehicles without sacrificing passenger safety. The alloy’s high strength-to-weight ratio should help boost its usage. An average of 340 pounds of this metal is currently used to manufacture a vehicle. An Aluminum Association report suggests this number will rise sharply (to approximately 550 pounds) in the decades to follow. 

At the time of this article's writing, the author did not have positions in any of the companies mentioned.