Although industry players have been maximising free cash flows with cost control and a reduction in working capital cycles, weak demand growth, import pressure, low physical premiums and sub-optimal capacity utilisation are likely to delay deleveraging.
China, which consumes 40%-50% of the global major base metals, is facing an economic slowdown. This means a surplus in the international market and therefore a delay in price recovery. For domestic players, slowing Chinese economic growth implies increased competition from low-cost imports into India as well as competition in the export market.
Prices of major base metals, including aluminium, copper and zinc, declined throughout 9M15. Current futures market being in backwardation indicates a continued negative sentiment on the price outlook. This is despite a substantial decline in the stock-to-use ratio. This means prices have fallen despite a tighter physical market.
Ind-Ra expects the industry to focus on controlling costs to protect operating margins. Industry players would continue to optimise production processes, postpone growth capex and suspend unprofitable production lines. The agency expects imported alumina to continue to replace domestic alumina due to the price difference between the two. It also expects non-integrated players in the aluminium sector to record improving operating margins.
Ind-Ra believes the weak domestic demand growth and surplus capacity could lead to low capacity utilisation in FY17. This is despite the agency's expectation of a moderate pick-up in consumption growth during 2HFY17. For aluminium, near-term new capacity, along with unutilised available capacity, is over 120% of the 2015 output. Imports into India are likely to remain steady, with excess capacity in China. Efficient new capacities in China as well as low alumina and energy costs have recalibrated the cost curve of the global aluminium industry.
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For copper, Indian custom smelters are likely to see steady margins with continued surplus in the availability of copper concentrates. For 2016, the agency expects rising volumes and weakness in the rupee to enable them to maintain margins, unaffected by low metal prices, as seen in 2015.
The agency expects local premiums for zinc to remain low despite concentration in the market, due to a global surplus. Weak demand in export markets is likely to lead to a surplus despite the global depletion in mining output. Locally, margin benefits of a weak rupee and a decline in energy costs are likely to be offset by lower capacity use and lower by-product realisation. However, industry players in the lowest quartile of the cost curve and with strong balance sheets are best placed to survive a prolonged period of low prices.
OUTLOOK SENSITIVITIES
Demand Growth in China: Strong growth in Chinese demand for base metals is the key sensitivity to Ind-Ra's sector outlook. A strong performance by the real estate and construction sectors in China can generate substantial demand for base metals. However, the agency does not use this as a base case.
Fiscal Incentives: Any protective measures, including a reduction in duty or floor prices, could help industry players protect margins in FY17. The increase in import duty on Al and Zn to 7.5% from 5.0% will help protect high-margin domestic sales to an extent.
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