Market and product

For about 30 years, the cost of the raw material used to produce aluminium has been fixed as a percentage of the metal's price, with secretive negotiations between alumina refiners and aluminium smelters settling the ratio.

This entrenched scheme is under threat as some of the largest alumina producers, including Alcoa of the US, push for change.

The move for reform comes as the 40-year-old iron ore pricing system crumples. "There are some parallels with the iron ore market," says David Wilson, analyst at Société Générale in London.

But, unlike in the iron ore market, a price revolution in alumina is unlikely to happen straight away. Industry executives, traders and analysts say changes, if any, would be gradual. The pricing discussions are important for companies ranging from BHP Billiton and Glencore to UC Rusal and Chinalco, and come as growth in aluminium demand drives the alumina market to $25bn annually, similar to the magnitude of zinc, lead or nickel but well below the $200bn of the iron ore market.

For now, the traditional alumina pricing prevails.

After the latest negotiations, the price for the 2010 deals or for the multi-year contracts renegotiated this year was set at about 14-15 per cent of the value of aluminium. That was up from 13-13.5 per cent in 2009.

With the cost of aluminium hovering at about $2,400 a tonne, this means alumina costs about $350 a tonne, below the price paid in the spot market.

These contract prices have been below spot prices for the past five years.

BHP Billiton, the world's top miner and the driving force behind the iron ore pricing revolution, wants to close the gap between the spot and the contract markets for alumina.

Alcoa has thrown its weight behind moves for a radical change in the pricing system.

"It is time for the industry to develop a pricing methodology that is reflective of alumina fundamentals," says Timothy Reyes, president of Alcoa Materials and head of commercial activities for aluminium, alumina and bauxite at the company.

He suggests replacing the current system with an index based on spot transactions, similar to the new pricing system for iron ore. "We have had discussions with parties interested in developing this index, and we believe that the number of transactions in the spot market allow a reliable index to be created," Mr Reyes says.

But, as in iron ore, not everyone in the alumina industry backs a change. Some producers support the current system - or back less radical changes than those proposed by Alcoa - while aluminium smelters are head-on against a change that would increase, in most cases, their procurement costs.

The smelters strongly support the current scheme of pricing alumina as a percentage of the final value of aluminium because it protects their margins, executives say. "The smelters have zero incentive to move," says a senior alumina trader.

Still, rapid demand growth for alumina and a change in the industry's structure make a change in the pricing system possible in the medium term.

In the past, most aluminium smelters were vertically integrated with their own alumina refineries and bauxite mines.

But Jon Dudas, head of aluminium at BHP Billiton, says that the industry "has changed over the last 30 years with the emergence of non-integrated aluminium producers in China and the Middle East".

Non-integrated smelters are sourcing their alumina from the so-called third-party market, which has grown in size to almost 35m tonnes last year, up from 7m tonnes in 1980. Alongside this growth of the third-party alumina market has come the inception of a spot market, which has opened the door for the creation of an index.

The development of the iron ore spot market since the early 2000s was critical to changing the iron ore pricing system. Some believe it will prove the same for alumina.

(Source: http://www.ft.com/, By Javier Blas)