Why investors need to understand the cost curve

Previously in this series, we saw that Alcoa (AA) closed certain smelters that had high unit production costs. In this part of the series, we’ll discuss why being a low-cost producer is a key driver for aluminum plays.

Primary aluminum and alumina are commodity products. Producers don’t have much control over their pricing. The prices are decided by market dynamics. Please be aware that aluminum prices on the London Metal Exchange (or LME) are generally used as a reference point to price primary aluminum.

When aluminum prices start falling, high-cost producers become unprofitable much sooner than their peers that are placed better on the cost curve. Low-cost producers are able to tide over economic cycles better. Aluminum prices tend to go down in economic downturns. They rebound when the economy turns around.

The previous chart shows Alcoa’s primary business’ position on the cost curve. As you can see, it moved and became a top quartile alumina producer. In the aluminum business, it’s still in the second quartile. However, it reduced its costs by $50 per metric ton—relative to the industry—since 2010. By 2016, Alcoa wants to reduce these costs more.

Rio Tinto (RIO) is a top quartile aluminum producer. It has a competitive position in power generation. It generates more than half of its power requirement.

Other companies, like Century Aluminum (CENX), source most of their power requirements from third parties. This has been a key issue that Century Aluminum has been facing. Currently, CENX and Reliance Steel & Aluminum (RS) are part of the SPDR S&P Metals and Mining ETF (XME). RS is a metal service center. It distributes steel and aluminum products.

Why does Alcoa expect that its unit production costs will decrease even more? We’ll discuss this in the next part of the series.