Base metals demand poised to improve

While the main global themes of collapsing equity markets and dollar weakness continue to dominate the headlines, it is perhaps not surprising that some positive developments in base metals raw materials markets are being overshadowed.

During the report period July 8-12, the International Copper Study Group (ICSG) reported that the only way global refined metal production was able to rise in the first four months of the year was by drawing down stocks of blister and concentrate. The fact that spot copper treatment and refining charges are now at their lowest since the last trough in early 1999 suggests that there is little primary raw material stock left and that metal production will be severely constrained in the second half of 2002.

A shortage of concentrate has also hit zinc smelters, notably those in China, the world’s largest zinc producer, where capacity closures made so far this year now amount to more than 10% of the total. Lead mine production is also very depressed.

Overall, the base metals sector desperately needs a strong rebound in demand, and there are already indications that a modest one is under way. Should this rebound acquire momentum, the supply constraint would likely bite, most notably in copper and lead, and these markets could move quickly into deficit.

Copper prices continued to shed their recent gains, with London Metal Exchange 3-month figures falling sharply on July 11 and 12 as funds continued to liquidate large long positions built during the rally of late May. Since the fund long position is quite onerous and buying interest thin, with the exception of sporadic Chinese merchant activity, we see no reason why prices should not return to the lows of early May, below US$1,600 per tonne, before too long. However, price downside from there is likely to be limited since there are a number of positive fundamental developments that suggest that a snap back into deficit is imminent if demand continues to recover.

The ICSG released its latest figures for copper market supply and demand, estimating that the market had already moved back into deficit in April at a preliminary estimate of minus 16,000 tonnes. This is a little more positive than our own monthly estimates, which show the global market moving back into balance in June for the first time since February 2001. One of the most positive developments in copper so far this year is the decline in global refined production.

ICSG data show that copper mine production fell 3.3% in January-April 2002 and that refined production was only able to keep growing by drawing heavily on stocks of concentrate and blister. These stocks of raw materials are now at exceptionally low levels, as indicated by the dive in what smelters are able to charge miners for treating them.

CRU International reports miners getting spot enquiries at US$26-$27 and US2.6-27, matching lows not seen since the last trough, in the first quarter of 1999. This suggests that there are some pretty desperate smelters out there and that the chances of metal supply keeping pace with demand, if the recovery in consumption continues, are slim.

Aluminum prices held up well, proving resilient in the face of further inventory increases and collapsing stock markets. In thin volumes, European consumer buying helped consistently to support 3-month prices on the LME just above US$1,370 per tonne. However, the steady inventory rise is a clear sign that the market remains in substantial surplus, and this suggests that upside potential is limited at present.

We think it extremely unlikely that prices in the short term will break recent resistance at US$1,395-1,400 per tonne, and if copper weakens, as we expect it to, then a test of previous lows at around US$1,340 per tonne will become likely.

A sharp dip in U.S. Aluminum Association orders (down 10.4% in June) is also likely to undermine market sentiment, which had been supported by the big gains seen so far this year. However, the drop does not fit with a quick straw poll of U.S. aluminum companies, all of which report that orders are steady to good. It is also contradicted by comments made by Alcoa in releasing its second-quarter results: the company reported that automotive, commercial transport and industrial products markets all showed strength, along with seasonal expansions in building/construction and packaging/consumer markets. Alcoa is cautiously optimistic for the second half of the year. That is not to say that there are no downside risks to future U.S. aluminium demand growth. Particular areas of concern to us are the transport sector, where car sales are weakening, and construction, where housing starts are already so high that it is difficult to see them rising much further.

Second-quarter earnings for the big three U.S. car makers are expected to be positive, but it will be interesting to see what guidance they give about future sales volumes.

Nickel displayed characteristic volatility over the report period as prices closed above the key technical area of US$7,500 per tonne for the first time since October 2000. This price performance is better than expected and has been all the more impressive given that it has taken place despite the generally soft LME complex. Although the move is more representative of light commodity trading advisor/ fund activity, nickel’s fundamentals are also improving.

The stainless steel sector is recovering (though it has some way to go), inventories are continuing to edge lower (down 1,266 tonnes during the week under review), LME cancelled warrants are drifting higher (reaching the highest level since early April), and the latest data from the International Nickel Study Group (to May) show that production/consumption fundamentals are better. Furthermore, supply-side developments now suggest that prices could stabilize above US$7,500 per tonne over the short term.

The closure of Inco’s Manitoba nickel plant for maintenance is not the main reason why developments there augur well for nickel price prospects — its closure coincides with the start of labour contract negotiations. The current contract expires in mid-September and dates from late 1999. It was the tough negotiation process and eventual strike action back then that helped push nickel above US$8,000 per tonne. The talks process should therefore be watched closely over the coming weeks. As has been seen in the past, labour negotiations are a sensitive and politically charged issue in this part of Canada, and relationships between producers and unions can turn hostile.

Any deterioration in the talks process could coincide with stronger demand, underlining the upside risks to nickel prices in the third and fourth quarters.

Zinc continues to outperform the rest of the base metals complex, with the exception of nickel; LME 3-month prices reached a peak of US$850 per tonne, their highest since April. Profit-taking on the highs brought an end to the upward move, and some consolidation around the US$830-to-$840-per-tonne level is probably now due. Zinc has clearly got some momentum behind it and is benefiting not only from short-covering but also from a substantial amount of fresh speculative buying interest.

Some fairly disappointing news from Metaleurop did little to undermine this newly discovered positive sentiment: the company, elaborating on an earlier announcement that primary production at its 90,000-tonne-per-year Noyelles-Godault smelter, in France, is to be curtailed (recent operating rates have been well below the 140,000-tonne-per-year capacity), revealed that recycled zinc output will be only 20,000 tonnes per year lower at 70,000 tonnes per year. Nevertheless, the market is focusing on production shortfalls elsewhere in the world, most notably in China, where smelter cutbacks so far this year total almost 300,000 tonnes. Tellingly, the report period saw another Chinese smelter closure, this time at the 30,000-tonne-per-year Shangluo plant. The dramatic rise in Chinese zinc production has been founded on the growth of sm
all plants, such as Shangluo, but the evidence is that while China’s own concentrate production falls and availability on the international market tightens, these small plants are among the most vulnerable. Shangluo says it has no intention of restarting production until prices reach US$1,030-1,050 per tonne. Numerous other small Chinese smelters are in the same boat, and our projections for a 10% fall in Chinese zinc production this year could prove conservative.

The gold market has been overshadowed somewhat by the giants of the Dow Jones index, Nasdaq and the S&P500. However, apart from a slip in the U.S. dollar/euro exchange rate earlier in the week, gold prices failed to respond to the deterioration in the broader, extraneous trading environment. It is not necessary to explain the failure of prices to attract disaffected fund flows away from equity markets and into bullion; regular readers of this column will know that for several months, and throughout the gold price rallies, we have argued that the stronger prices owe more to the market’s micro-, than its macro-, economic environment. With consolidation in the gold industry having retreated to the back burner, and with hedge buybacks by producers already factored into prices and the physical gold market still in a state of near evaporation, these micro-economic issues are the reasons why gold prices have stalled between US$310 and US$320 per oz.

The risks of another sell-off in gold are limited, as long as equity and U.S.-dollar weakness remain features of the broader market. Until we have a clear indication that investors are willing to expand their risk boundaries, support levels should contain gold market weakness.

The second-quarter reporting season is now almost upon us, and indications are that some of the financials that emerge from this will act to restore, at least in part, investor confidence. The catalyst of the gold price rally was the announcement of producer hedge reductions. We suspect that until a catalyst emerges to reverse the gains, prices are likely to find support. Whatever form the “reverse catalyst” takes — improved sentiment, stronger equities, a more stable dollar — until it emerges, large-scale speculative fund liquidation and profit-taking are less likely.

In the meantime, however, the stagnation of the market’s own micro-economic fundamentals suggests that while supportive macro-economic issues may provide support at current levels, a return and push through the US$320s is unlikely. Thus far, the U.S. dollar has fended off parity with the euro, and a break of parity would almost certainly prompt fresh speculative buying. As far as looking for equity shocks to push gold higher is concerned, we maintain a cautious and skeptical stance. the latest figures from the Commodities Futures Trading Commission show that, despite registering some increases, the gold market has hardly experienced a revolution in turnover. Until the market can attract greater flows from broad-based asset classes, we continue to expect a return to US$300 per oz. over the short-to-medium term.

— 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 barclasyscapital.com

The Week at a Glance

– The copper price risk is on the downside in the short term, and we do not rule out a test of US$1,600 per tonne if technical trading funds liquidate large long positions.

– Aluminum has found good support from euro-related buying recently, but we doubt that the US$1,365-per-tonne level will hold, particularly if copper weakens and inventory continues to grow.

– Nickel reached new highs, underpinned by strike fears at Inco’s Manitoba operations, where there is a history of difficult labour relations. Until contract negotiations show signs of improving, downside is limited.

– Zinc prices also hit fresh peaks, despite disappointing news from Metaleurop. News of fresh production cuts from China is helping to underpin the rally.

– Gold price downside is limited by equity market and dollar weakness, though we doubt that this will be enough to spur the market to fresh highs or even to break back above US$320 per oz. in the short term.