By Pratima Desai

LONDON (Reuters) - A shortage of aluminum in China as domestic supplies fall has boosted prices in Shanghai, which are outperforming those on the London Metal Exchange where weaker demand in the rest of world is reflected, a divergence expected to dominate for some time.

Benchmark aluminum on the London Metal Exchange (LME) hit its lowest since January 2017 at $1,704.85 a tonne earlier this month, a drop of 12% since March when the trade dispute between the United States and China escalated.

Prices on the Shanghai Futures Exchange (SAFc1) (ShFE) between March and the middle of September rose nearly 8% to 14,600 yuan ($2,048.55) and are currently around 14,000 yuan. Aluminum is widely used in the transport and packaging industries.

(GRAPHIC - Aluminum prices in London and Shanghai: https://fingfx.thomsonreuters.com/gfx/ce/7/6834/6816/Aluminium%20prices.png)

"Normally the disconnect would not last as China would export less," said Citi analyst Tracy Liao.

That would normally mean more aluminum for local consumption, lowering prices. But demand from Chinese aluminum product manufacturers is also rising as they take market share from rivals in the rest of the world, keeping Shanghai prices buoyant.

"A price disconnect between the LME and ShFE for a couple of quarters won't change that dynamic. The disconnect would have to last for longer for the supply chain to adapt," Liao.

(GRAPHIC - China aluminum exports: https://fingfx.thomsonreuters.com/gfx/ce/7/6835/6817/China%20ali%20exports.png)

China accounts for about 55% of global aluminum supplies, estimated at around 65 million tonnes this year.

Data from the International Aluminium Institute shows China's aluminum production fell to near 21 million tonnes between January and August this year, down 13% from the same period in 2018.

Analysts expect the gap between new supply and demand in China to be covered by stocks of about seven million tonnes accumulated since 2010.

"The deficit is a new development. China has had chronic overcapacity and surpluses since 2009," said Wood Mackenzie analyst Edgardo Gelsomino, adding that year's was the only other deficit since 2001.

"Globally the deficit this year will be about one million tonnes but the reality is that most of that deficit is in China. However they have a big cushion with stocks."

The inventory draw in China can be seen in the stocks of aluminum in warehouses monitored by ShFE , which at around 314,000 tonnes are less than a third of May's levels of above 990,000 tonnes.

(GRAPHIC - Shanghai aluminum stocks vs prices: https://fingfx.thomsonreuters.com/gfx/ce/7/6833/6815/SHFE%20stocks.png)

China's aluminum deficit is mainly due to closures of about 3 million tonnes of production in the second half of last year, with more added this year, according to Citi's Liao.

These include Xinfa Group, one of China's top aluminum producers, shutting down a production line after an explosion at a plant in the northwestern Chinese region of Xinjiang.

Damaged facilities belonging to China Hongqiao Group (HK:1378), the world's top aluminum producer, after Typhoon Lekima wreaked havoc in the smelting heartland of Shandong also contributed to lower supplies.

Global aluminum stocks are expected by Wood Mackenzie to end the year at 12 million tonnes, which would be about 66 days of consumption compared with an average around 60 days.

"The global market is not short of metal," Gelsomino said.

Wood Mackenzie expects global demand to grow 1.1% this year, down from 3.6% last year and Chinese demand to rise 2.9% from 6.1% last year.

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