Aluminium futures in Shanghai may perform better than their London counterparts in the next few months as the outlook brightens for what has been one of China's most chronically oversupplied commodities.
Shanghai futures lost 6.4 percent in yuan terms and 15.3 percent in U.S. dollar terms from the start of the year to the close on Wednesday.
In contrast, the benchmark London Metals Exchange contract has been steady, rising 0.5 percent from the start of 2014 to Wednesday's close.
The Shanghai Futures Exchange contract has also been in a sustained downtrend so far this year, while the London equivalent has had periods of strength, being up 5.1 percent at its closing peak on April 10.
In dollar terms, the premium of futures in Shanghai narrowed to $298.18 a tonne over London on Wednesday, down from $515.94 at the start of the year.
The premium has narrowed in recent weeks to levels not seen for more than a year, suggesting that a widening is likely in months to come.
There are several factors supporting the view that Chinese aluminium futures will outperform those in London over the medium term.
The first is that the narrowing of the premium has made it more likely that China, the world's top producer of aluminium, will import more of the industrial metal as traders take advantage of the lower international price.
At current Shanghai prices, it's still profitable to import the metal, even accounting for duty, the 17 percent value-added tax, shipping and insurance.
China's imports of aluminium have been rising this year, gaining 239 percent in the first quarter to 153,291 tonnes, according to customs data.
While this is still a small amount relative to China's overall output of the metal, it shows that appetite for imports is up strongly.
China produced 5.8 million tonnes of aluminium in the first quarter, up 9.9 percent on the same period last year, according to the National Bureau of Statistics.
INPUT COSTS RISING
Another reason to start becoming bullish on Chinese aluminium prices is rising input costs.
The cost of China's imports of bauxite, the raw ore that is made into alumina, which in turn is processed into aluminium, has been climbing in the wake of the ban on the export of the raw ore imposed in January by Indonesia, formerly the world's largest bauxite exporter.
China's bauxite imports dropped 5.4 percent in the first quarter from the same period in 2013.
But more importantly, the price has been rising, with the average price in March being $59.49 a tonne, up 16 percent from the same month in 2013.
The situation is likely to worsen for while China has been able to find alternative suppliers for much of its bauxite needs, these have been considerably more expensive.
Brazil supplied 174,846 tonnes of bauxite in March, or about 9.5 percent of China's imports for the month, but the cost was $76.60 a tonne, well above the $52.98 for cargoes from Indonesia.
The Dominican Republic is also a new supplier, with 193,720 tonnes arriving in March for a 10.6 percent share, but at a cost of $61 a tonne.
While China built up stockpiles of bauxite in anticipation of the Indonesian ban, these will be largely run down within a year, meaning that the higher costs of the alternative supplies will start to feed through to the cost of production.
China's oversupply of aluminium may also start to ease slightly with the closure of 420,000 tonnes of outdated capacity this year as Beijing's campaign to reduce pollution gathers some steam.
While this is still a small fraction of China's total annual output of about 25 million tonnes, it's likely that more closures will be announced for next year as reducing pollution shows every sign of remaining a top government priority.
China's aluminium surplus may also reduce in the medium term through rising exports of fabricated aluminium products for use in items such as beverage cans and foil for packaging.
Technical indicators are also supportive for price gains for Shanghai aluminium futures, with the curve <0#SAF:> moving to contango from backwardation in the past few months.
The six-month future is currently at a premium of 2 percent to the front-month, while six months ago it was at a discount of 1 percent.
There are of course headwinds for China's aluminium sector as well, including slower than anticipated industrial growth and the ongoing subsidisation of loss-making producers by local authorities more concerned about jobs than profits.
But overall, these may be outweighed by the increasing positive factors that support Shanghai prices outperforming those in London