Base Metal Prices face vulnerability in the short term

This article is the first of two instalments devoted to base metals and was culled from Barclays Capital’s monthly commodities report The Commodity Refiner. Part 2 will appear in our Oct 21-27 issue.

Base metal prices are at a critical point in the cycle, trading close to key support levels on an aggregate basis.

While leading indicators and recent economic data point to a slow recovery, our base-case scenario assumes the U.S. economy will avoid a second recession, and we expect base metal prices to form a bottom during the final quarter of this year. We estimate the peak of the cycle will occur in 2004, with prices reaching a level approximately 30% above the trough.

However, in the event economic conditions deteriorate further, a break of key support (6% below current levels) cannot be ruled out, and supply response could be necessary to prevent a further price slide. At current price levels, we see little hope for producer response other than in the zinc market. Currency movements play an important role.

Nonetheless, historically low prices, much speculative selling activity already behind us, and evidence of buying interest on dips suggest significant further price falls will be avoided. As a result, at this point it is important to stay alert for any improvements of key leading indicators in order to benefit from an initial price recovery, which tends to be rapid and driven by speculators.

Base metal prices are at a critical point in the cycle. Trading close to long-term lows, prices on an aggregate basis are approximately 6% above key support levels, last tested in November 2001, January 1999 and November 1993 (see Fig. 1).

Macroeconomic-driven demand developments will play a key role in directing base metal prices, while market specific features, primarily related to supply, will decide the extent of any price move. For example, last year, when a hefty 11% of Western World primary aluminum capacity was shut because of high power prices in the U.S. Pacific Northwest and Brazil, aluminum prices still trended sharply lower. At the same time, demand growth fell to around 20-year lows in line with deteriorating economic growth rates. Hence, demand issues represent a key driver of prices. We think this relationship will be true again at this point in the cycle.

In light of continuous macroeconomic and political uncertainty, overshadowed by unusual negative circumstances such as risks of war and high oil prices, we believe base metal prices are vulnerable in the short term.

Risks to U.S. growth prospects were highlighted by the Federal Open Market Committee (FOMC) at the end of September. As long as an easing bias is maintained on monetary policy, we believe base metal prices will remain pressured. Nonetheless, demand improvements in base-metal-related industries are likely to be evident early in the cycle, and speculative trading activity on the London Metal Exchange and the Comex should ensure base metal prices rally ahead of any rise in interest rates, as history has shown. Our economists do not expect another interest cut in the U.S. this year, a view most recently supported by a better-than-expected U.S. employment report for September.

However, with extensive speculative short-selling activity already behind us, we limit this downside risk under our base assumptions to the lows registered in November 2001, at about 6% lower than current levels. However, should macroeconomic conditions deteriorate further, a break of this level cannot be ruled out and supply response could be necessary to prevent a further price slide.

Notably, while the U.S. should be the key driver of global growth (and particularly for Europe and Japan), other geographical regions are contributing very positively to base metal demand growth at present — China in particular, and other Asian countries, such as South Korea and Taiwan.

Producer response in a weak price environment?

Apart from the zinc sector, we believe there is little hope for significant producer reaction at current price levels.

Following the price slide last year, relatively large production curtailments have already been experienced in most base metal markets, with positive effects noted particularly in the copper market, where we expect finely balanced market conditions next year and several years of deficit thereafter. From a supply perspective, the outlook for nickel and zinc also looks relatively encouraging, while we expect the aluminum and lead markets to remain in surplus over the next few years.

Despite this, we do not foresee any production cutbacks in the aluminum industry over the near term, even though North American producers suffer from relatively higher production costs in dollar terms (though pressure has eased somewhat this year). We believe aluminum prices would have to fall below US$1,100 per tonne on a sustainable basis before any cost-related cutbacks materialize. At the same time, most production expansions take place outside the Western World, in China and Russia — regions unlikely to produce less because of poor LME prices. As a result, because of the oversupply situation, we expect aluminum prices to rise less quickly (compared with copper, for example) once the downward trend is reversed. Producers outside the U.S. have been enjoying relatively higher prices over the past few years.

Zinc is different. With large parts of the smelting industry, in particular, generating losses under prevailing low treatment charges and LME prices, we expect capacity to be closed sooner rather then later.

In light of this, several operations are up for sale — MIM’s Avounmouth and Duisburg smelters, Metaleurop’s Nordenham smelter, as well as Outokumpu’s Tara mine. If buyers for the smelters are not found soon, closures cannot be ruled out. Together, these smelters have annual capacity of about 320,000 tonnes per year.

Following production curtailments in 2001, market attention in the copper industry will focus on possible restarts instead.

We believe low-grade mining at Codelco’s operation will come to an end and that its total output will rise next year.

BHP Billiton — playing a major role in bringing producer discipline into the copper industry last year — will make a decision on its reduced output (approximately 170,000 tonnes per year) by the end of 2002. The decision will depend on prevailing market conditions. We expect the company will keep most of the idled capacity absent from the market. Capacity is also closed at Phelps Dodge (300,000 tonnes per year), and we expect it to remain closed in 2003.

Trading strategy

Most economic indicators remain discouraging for near-term base metal price activity. However, historically low prices, much speculative short selling already in place, and evidence of buying interest on dips suggest significant further price falls will be avoided.

At this critical point in the cycle, it’s important to stay alert for any improvements of key leading indicators and economic developments in order to benefit from an initial price recovery, which tends to be rapid and driven by speculators.

Therefore, our recommendation to consumers of base metals would be that current price levels are attractive, and we think it would be a good idea to lock in some forward pricing close to current levels.

Although base metal prices tend to move as a complex, the picture differs across metals, depending on the outlook for production and inventories. As a result, in light of expectations of large surpluses in the aluminum market, we think aluminum prices, for example, will recover less quickly than prices for the other base metals.

An important aspect for future pricing strategy will be currency developments. Weakness of the U.S. dollar has limited downside pressure on base metal prices expressed in euros and yen this year. Currency forecasting is a tough task, but we expect the U.S. dollar to strengthen against major metal-consuming and metal-producing currencies during the course of next year. As a result, a weaker euro rate would enhance any U.S. dollar-denominated metal price rally.

For producers, we would point out that base metal prices are unlikely to reach previous peak levels. Over previous cycles, price peaks have occurred at lower and lower levels, and in the next upturn, we expect the peak to occur at an even lower level. For example, in the next cycle, we expect aluminum to peak almost US$500 per tonne lower (on a quarterly basis) than the 1995 peak, and about US$350 per tonne and US$150 per tonne lower than the highs in 1997 and 2000, respectively.

The divergence in the copper peaks is even greater, with the next peak likely to occur at more than US$1,000 per tonne lower than in 1995 and about US$800 per tonne and US$250 per tonne below the peaks of 1997 and 2000, respectively. As a result, we suggest producers may need to revise expectations of forward price levels downwards and take advantage of price rallies. However, if the U.S. dollar avoids further depreciation, producers outside the U.S. should enjoy relatively stronger price rallies.

While aggregate base metal prices look attractive at current levels, there are certain metals we would recommend ahead of others to speculative investors. From a speculative point of view, we think zinc is attractive among the major base metals. This is because zinc prices have fallen much farther and faster than the other base metals in the previous cycle.

While prices should benefit from a turnaround in the industrial- production cycle, we believe the potential for supply reductions are large, which should enhance a rally. Even if nickel prices have already risen by more than 20% since the beginning of the year, nickel has the potential to perform even more strongly early in the cycle. Copper is also attractive on a relative basis, with the supply side already well-structured to capture exposure to an economic recovery.

What are the leading indicators telling us?

q U.S. — In the second quarter, the final real gross domestic product growth number in the U.S. was revised up to 1.3% at the end of September from the preliminary estimate of 1.1%, which is consistent with our GDP growth forecast of 4% in the third quarter and 3% in the fourth. Furthermore, we expect the U.S. to register quarterly growth of 4.5% during the first three quarters of next year.

Meanwhile, the latest monthly release of industrial production fell by 0.3%, month over month, in August, representing the first decline in eight months. Although July output growth was revised up to 0.4% from 0.2%, the data were largely disappointing and weaker than expected.

While risk remains on the downside, we have assumed, when forecasting metal demand, an industrial production contraction of minus 0.4% in the U.S. this year and growth of 3.7% for 2003.

q Japan — In Japan, the latest Tankan survey released by the Central Bank on Oct. 1 showed business confidence had risen in the past three months, with the large manufacturers index improving to minus 14 from minus 18.

However, the improvement was still less than the expected minus 11. We expect the Japanese economy to remain in an upward trend next fiscal year, assuming external demand will continue to contribute positively to growth and that falls in domestic demand will bottom out. Nonetheless, with growth staying nearly flat, the economy will remain vulnerable to external shocks and downside risks.

Meanwhile, the Japanese manufacturing Purchasing Managers’ Index fell below 50 for the first time in five months in September to 48.9, from 51.0 in August, giving little hope for a near-term rebound in metal demand in that region.

q Germany — In Germany, the Institute for Economic Research business climate index fell for the fourth consecutive month (and to its lowest since January) to 88.2 in September from 88.8 in the previous month, though this was still better than expected.

The fall in the index was due to a further weakening of expectations while current conditions improved a little. This is consistent with our reading that German gross domestic product growth, will, at best, soften between the first and second halves of this year and that there is significant risk of the economy slipping into recession.

Assuming the U.S. economy leads European growth, which would likely put the U.S.-dollar in a relatively favourable position against the euro, we believe European metal users could face sharply higher U.S.-dollar denominated base metal prices eventually.

q OECD — Sharp improvements in the Organization for Economic Co-operation and Development’s composite leading indicator (CLI) from October 2001 stalled in July/August this year, pointing to slow growth in industrial production.

For the U.S., the CLI fell by another half a point in August, following a 0.7 drop in July, while its 6-month rate of change also fell in August.

The CLI for the euro area fell by 0.3 point in August (after a 0.5-point drop in July), and its 6-month rate of change decreased for three consecutive months. In Japan, the CLI rose by 0.1 point following a 0.7-point rise in July. However, its 6-month rate of change has decreased for four consecutive months.

The CLI is designed to provide early signals of turning points (peaks and troughs) between expansions and slowdowns of economic activity. The OECD uses the 6-month rate of change of the CLI as its preferred pointer to possible turning points.

q Conference Board — Meanwhile, the U.S. Conference Board leading indicator fell for the third consecutive month in August to its lowest level this year (minus 0.2% after a revised 0.1% drop in July and a 0.2% fall in June). The decline was led by a rise in demand for unemployment benefits, a decline in consumer expectations, and a drop in orders to U.S. factories.

The leading indicator has not declined for three months in a row since October-December 2000 (just before the last recession officially began in March 2001). However, this time, there are several unusual circumstances driving the indicator lower, including threats of war, terrorism and higher oil prices.

A deteriorating Conference Board leading indicator suggests year-over-year growth in base metal prices may also slow.

q ISM — As base metal demand and prices are heavily exposed to manufacturing activity in the U.S., we look at the Institute for Supply Management (ISM) and other U.S. manufacturing surveys for some direction in demand and prices.

The latest ISM reading of 49.5 for September (released Oct. 1) shows that the manufacturing sector is treading water, as has been the case for the past two months. July and August were stable at 50.5 (modest expansion) and followed a sharp fall in June from 56.2.

An encouraging sign: the subcomponents showed a slight improvement in new orders, while employment and production indices declined. We expect similar numbers in upcoming months.

Base metal prices are likely to remain under pressure as long as manufacturing activity is slow.

q Durable goods orders — U.S. durable goods orders dipped by 0.6% in August, an impressive result considering that they had jumped by 8.6% in July. Excluding the volatile defence and civilian aircraft sectors, orders were down by 2.7% after rising by 7.6% in July. Altogether, these are pretty impressive numbers for the past two months.

The primary metal component rose by 1.9%, month over month, and posted a 2.3% gain year over year.

The relationship between changes in metal prices and durable goods orders is strong, and if the positive trend in order data persists, base metal prices will benefit considerably. At the very least, such a trend would seem to suggest that prices are close to their trough.

Restocking has been a key feature of metal demand growth this year, as underlying demand has been soft. While it is difficult to retrieve hard data on the inventory cycle at end-users, we look at reported business inventory data for some insight to the inventory cycle. Looking at the primary metals inventory component of U.S. durable goods orders, we conclude that the value of inventories is sharply lower compared with the end of last year, while there have been signs of restocking in the past few months.

Meanwhile, the latest data on U.S. business inventories (at factory, wholesale and retail levels) for July shows a similar trend, rising at the strongest pace since November 2000, at 0.4%, month over month. This represents the third consecutive monthly rise. However, the economy has shown signs of stalling since July, which may result in slower restocking in the months ahead.

The pressure from falling equity markets has been another main feature this year. Mining equities have a tendency to lead base metal prices. However, the lead-time has become shorter in recent years, owing to the increase in sophisticated speculative trading activity directly in underlying metal markets.

For example the FTSE Mining Index has fallen by 20% since the beginning of the year, while base metal prices have not fallen as much.

North American aluminum shares have fallen even more severely (minus 40% so far this year), reflecting demand and oversupply concerns in the metal market, which have given little inspiration to cover short positions on the LME.

We would view buying activity into mining equities as a good sign for improving investor sentiment toward a cyclical recovery and rising underlying metal prices.

Base metal prices are likely to remain under pressure as long as the easing bias is maintained, while base metal prices are likely to move higher before U.S. interest rates resume an upward trend.

The Federal Open Market Committee, which is the policy-making body of the Federal Reserve System, held short-term interest rates unchanged at 1.75% at its latest meeting in late September, with the easing biased maintained. The FOMC said economic risk remains on the downside, which could involve another cut before year-end.

The 2-year U.S. Treasury note yield has fallen to 1.7%, moving below the Federal Funds rate for the first time since April 2001. What this indicates is that investors are discounting another cut by the Federal Reserve. However, Barclays Capital does not expect another cut this year, and we forecast a hike in the second quarter of 2003. The next FOMC meetings are scheduled for Nov. 6 and Dec. 10.

The positive correlation between metal prices and bond yields is strong. Ten-year bond yields have fallen to their lowest level since the early 1960s, while base metal prices are also close to long-term lows. We expect both bond and base metal markets to improve as economic growth accelerates. Barclays Capital expects 10-year treasury yields to rise to 4.5% by December and to 4.6% by March 2003, from 4% in September.

Another key feature in metal markets has been the level of the U.S. dollar against local currencies. A strong U.S.-dollar environment during the 1990s had the effect of depressing base metal markets. This is due partly to a large proportion of metal production located outside the U.S. A strong dollar has resulted in relatively favourable local production costs. Meanwhile, local consumers have faced relatively higher prices.

We expect the U.S. dollar to come back into fashion, hence benefiting local production, as well as making U.S.-dollar-denominated base metal prices relatively more expensive for European consumers. On a 12-month view, Barclays Capital expects to see the euro moving back to 0.85 against the dollar.

— Next week’s instalment will focus further on the outlook for base metal prices. The opinions presented are the author’s and do not necessarily represent those of the Barclays group. For access to all of Barclays’ economic, foreign-exchange and fixed-income research, go to the web site at barclayscapital.com. Queries may be submitted to the author at kevin.norrish@barcap.com