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Outlook 2015: Alcoa’s Upstream Operations

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Alcoa’s upstream operations

In the previous parts of this series, we learned that aluminum demand is expected to be strong going into 2015. Now we’ll find out how Alcoa (AA) is positioned to benefit from this.

Alcoa has three business segments:

  • Upstream operations
  • Midstream operations
  • Downstream operations

Rio Tinto (RIO) and BHP Billiton (BHP) are among the major upstream players. What’s the outlook for Alcoa’s upstream operations segment?

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Commodity business

Upstream operations consist of alumina and primary aluminum production. It’s basically a commodity business. Producers don’t have much control over pricing, as this is essentially determined by market dynamics.

The price of aluminum on the London Metal Exchange is generally used as a reference point for pricing primary aluminum.

To price alumina, companies either use the alumina price index, or API, or a percentage of the prevailing aluminum price. Alcoa is moving away from aluminum-based pricing for alumina. Over the last few years, it’s been pricing alumina according to the API. The same trend is expected to continue in 2015, as you can see in the above chart.

Will this benefit Alcoa?

The move to the API pricing mechanism actually disassociates the fundamentals of the alumina business from the volatility of aluminum prices. If aluminum prices go up, Alcoa can actually lose revenue, as was apparent in its 3Q results. In contrast, if aluminum prices were to fall, the API pricing mechanism would benefit Alcoa.

Investors can access the aluminum industry through the SPDR S&P Metals and Mining ETF (XME). Currently, Century Aluminum (CENX), and Alcoa are among its top holdings.

In the next part of this series, we’ll find out what factors will drive Alcoa’s upstream business in 2015.

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