Rapidly, market consensus seems to have shifted to a view that base metal prices have peaked. The firm uptrend of earlier this year has been interrupted, and market participants have become increasingly worried over growth prospects.
In a traditional metals-price cycle, troughs and peaks tend to occur before a marked shift in underlying supply-and-demand fundamentals. Here, investment funds play an important part, taking profits at the top of the cycle even before firm evidence of slowing metal order books. Indeed, funds were at the forefront at the start of the current cycle, covering short positions and expanding long exposure on the lows on an attractive risk/reward ratio despite poor demand at the time. Lately, funds have been actively liquidating longs. Some have even been keen to establish short positions, albeit held back by backwardations in several of the base metal markets. Protective trading strategies, including options, have now become more common. In a normal cycle, this would mark the start of a downturn. However, we believe current market conditions have several characteristics that make this cycle different from recent ones.
Base metal prices are showing strong resilience, supported by low inventories and limited availability. A vulnerable U.S. dollar and good prospects for a rebound in Chinese activity, after a short period of de-stocking this summer, are also important supportive features. Together, these factors challenge the broad-based assumption that base metal prices have already peaked, even though this conclusion would be in line with some leading macro indicators that suggest slowing growth ahead. There are still many risks to this assumption. We can identify several themes that argue for another push higher in prices. In actual fact, metal prices will most likely be much higher for the remainder of this decade compared with recent years, driven by the structural shift higher in global demand, boosted by growth in Chinese infrastructure and living standards set against only modest increases in metal output. Another consideration is the risk for a prolonged period of U.S. dollar weakness and investors’ lack of attractive alternative investment opportunities.
Undoubtedly, demand is the prime metal price driver, and the outlook for the Western World economies is key in guiding medium-term metal price direction. However, the following features in this cycle must be considered:
— Asian economies have become an increasingly important driver in metal consumption — China in particular. As a result, growth prospects in emerging markets such as China are now a much more important price drivers.
— History suggests that even in periods of slowing growth, rising interest rates and an appreciating U.S. dollar, metal prices have had the ability to trade higher (in the late 1980s, for example).
— Synchronized and above-trend global growth.
In our view, these price-supportive market features will remain sufficiently central to fend off the effects of easing growth. We maintain our “twin-peak” price scenario, and are looking for another leg higher in metals prices this year.
Although the nominal U.S. dollar price peaks of the two previous price cycles have been surpassed, base metal prices are still 30% below the price peak of 1988, when market conditions were similar to now (that is, a period of U.S. dollar weakness, strong demand, rising interest rates and tight supplies). In real terms, the falling price trend shows strong signs of bottoming out, in line with our upwardly revised long-term price forecasts, and significantly, current real prices are 50% below the 1988 peak. Finally, it should be noted that base metal prices expressed in euros are still 20% below the previous recent cycle peak of 1999-2000.
The recent downward move in various leading macro indicators (for example, OECD leading indicators) does represent a concern to many market participants. However, Barclays Capital economists reiterate that in 2004 and 2005 the global economy should benefit from the strongest two years of growth in more than 30 years. Critically, for industrial metals demand, the investment rebound in the U.S. is still at an early stage and an inventory-rebuild has not yet contributed significantly to growth. The metals component of U.S. durable goods orders continued to soar in July, which is in line with an Institute for Supply Management reading at high levels, and a robust Purchasing Managers’ Index well above 50 (signalling expansion in the manufacturing activity) in other regions such as Japan and Europe. In metals, strong demand and positive price prospects are evident from indicators such as high physical premiums across geographical regions, rising steel prices, and a rebound in freight rates.
Consuming about 20% of the world’s total, the outlook for Chinese consumption naturally remains a critical factor to guide prices over the course of the coming months. Indeed, the latest data for industrial production are evidence of the success of the government’s introduction of credit controls earlier this year. Chinese industrial production (IP) growth slowed to 15.5% in July from 22% in February and 16.2% in June. However, if Chinese IP growth can hold above 12%, year over year, then the outlook for industrial metals remains extremely robust. Admittedly, a more marked slowdown would see the latest downward price pressure intensify. However, China’s fixed-asset investment remained strong in the first seven months of this year (+31%, year over year), supporting our view that China’s economy is slowing gradually rather than abruptly.
In line with this, there are now firm signs of Chinese metal availability tightening quickly and that a period of consumer de-stocking in China since May is coming to an end. Domestic metal prices have risen sharply and are back trading at a premium to the London Metal Exchange price; physical premiums have rebounded; and copper producers now report renewed interest from Chinese consumers. In copper, stocks held at the Shanghai Futures Exchange have fallen to critically low levels (at only 37,000 tonnes in August), and robust underlying demand has seen stocks at bonded warehouses around Shanghai (containing non-custom cleared material) fall sharply. We estimate they fell below 100,000 tonnes in August, from around 400,000 tonnes in July.
Power constraints took their toll on Chinese manufacturing activity and metals demand in recent months, with power stations in key regions hitting full capacity. While we expect an energy-related pickup in manufacturing activity in the fourth quarter. Structural power constraints are having severe implications on energy-intense metal production, notably aluminum and zinc. In mid-June, electricity prices were raised for the third time this year, with special focus on aluminum smelting. Together with lower export-tax rebates and strong domestic consumption, large-volume exports of aluminum and zinc have slowed markedly, and this trend has helped tighten Western World metal availability even further.
Production growth has begun to accelerate in some markets (copper for example), but new material will not be available quickly to ease the supply tightness in the second half of the year. We therefore expect the global raw-materials squeeze to remain in place over this period at least. Data from the International Copper Study Group (ICSG) show that growth in copper mine output remained extremely subdued in the first few months of this year (only +0.6%, year over year, in January-May). Copper treatment and refining charges (TC/RCs) have picked up sharply from the lows in recent months, but from very low levels. This is in response to lower Chinese imports, higher output at the world’s two largest copper mines (Escondida and Grasberg), and fresh production at this year’s only new copper mine — CVRD’s Sossego mine in Brazil. In sharp contrast, raw-material feed to zinc smelters remains poor, as is evident from low treatment charges, while strong growth in primary aluminum production is slowing despite high prices. Labour disputes
are having an impact on aluminum production, with
Metals and mining unions are clearly watching the dramatic increase in metals prices. A push from metal and mining unions for higher wages should not come as a surprise, and, understandably, union officials are using high metal prices, revenues and share prices to argue aggressively for sizable increases in wages for their members. Historical labour costs, estimated by industry consultant Brook Hunt since 1987, demonstrate a strong correlation between changes in annual mine labour costs and metal prices. This provides another example of how the trend in real production costs is now being pressured higher, and suggests that more labour disputes can be expected.
This year has already seen a raft of labour disputes across the metals complex around the globe. Labour disputes tend to have a firming impact on metal prices, particularly during the current period of supply tightness, though not necessarily always on actual production itself. In fact, this year’s labour disputes have, in most cases, had a limited impact on actual production.
Falling metal inventories and high physical premiums confirm that the synchronized global upswing is continuing, with signs that Japan and Europe are beginning to experience faster and more durable growth. The Western World consumer re-stocking phase has much farther to go, while refined metal inventories are critically low.
Total LME open interest has fallen sharply, to levels last seen in August 2003, when metal prices were approximately 40% lower. For example, the net fund copper position on Comex is modest — less than half of the peak in October 2003. A combination of physical short covering and fund long liquidation was behind the fall in open interest, while during the second quarter, fund short selling was also a feature in the zinc market. Short selling in other base metals has been discouraged by backwardations. Historically high prices triggered some of the fund profit-taking in the first quarter, but as investors are getting used to these higher price levels, funds might become more comfortable establishing fresh length at current, relatively higher price levels. Furthermore, much of the profit-taking during the second quarter was in response to prospects of higher interest rates and a slowing Chinese economy. These macro themes have become a reality, but that should not prevent metal prices from trading higher. Interest rates and metals tend to move together, and the underlying growth trend in Chinese metal consumption is still strong, reinforced by strong export demand and investment into certain metals-intense end-use sectors, such as power transmission.
The direction of the U.S. dollar will continue to influence metals prices, and dollar weakness certainly helped fuel the more recent push higher in illiquid market conditions, considering the seasonally slower period for metals consumption at present. However, given the strength of underlying metal fundamentals, we would expect a second leg higher in metal prices even without the support from a weaker U.S. dollar. Importantly for metals, the Japanese yen is also on a strengthening path, driven by macroeconomic improvements that are already evident in base metals markets.
Again, we maintain our “twin-peak” price outlook, and have made only minor adjustments to our previously published price forecasts. Our quarterly price projections for the period 2004-2005.
Because of seasonal and typical cyclical patterns, we expect the timing of the next upward move to vary across the base metals. Nickel should continue to lead the metals complex, and recent technical selling pressure in nickel means near-term price performance of other base metals is likely to remain volatile until physical demand picks up in the fourth quarter. We continue to favour the base metals with particularly tight supplies, and expect copper and tin to perform particularly well as the second of the “twin peaks” establishes more firmly. Aluminum now also has the potential to see strong price gains. This metal has been an underperformer in this particular commodity bull market, and its supply-side fundamentals should improve sufficiently to justify fresh price peaks. Zinc should be the laggard in this move higher, which would be in line with previous commodity cycles. Unlike most other base metals, zinc prices are still held back by large stockpiles of refined metal, but as these are being gradually depleted, we expect a more sustained rally through the first half of next year.
To conclude, the risk-reward ratio is clearly not as attractive in base metals as it was a year ago. However, we can still identify extremely important factors that, we expect, will take base metal prices to fresh highs by the first quarter of 2005. Although the third-quarter price-supportive factors are seasonally the weakest for demand and despite the vulnerable technical picture, prices have been extremely resilient. We urge market participants to accumulate metal over the current period rather than wait for a further significant price correction. In our view, the most significant risk to prices is another major move higher as participants become more confident about the demand outlook, and, given constrained supply, deficit markets drive inventories lower.
For consumers, we would recommend taking advantage of near-term price weakness to rebuild inventories ahead of expected strong demand through to next year. Higher long-term metal prices also mean consumers will have to budget for purchasing prices higher than seen in recent years.
Producers will face new opportunities to sell forward at attractive prices. In addition, we expect far-forward price levels to trade at higher levels in coming years, which also offers opportunities to finance increased production.
We believe investors will be able to enjoy another ride higher in base metal prices later this year and into next year. Those investors who fear the cyclical peak has been reached and are expecting a full reversal of the upward price trend should appreciate the consequences of selling short in backwardated markets. The backwardations should ensure attractive returns for long-term investors looking at commodities as an alternative asset class. We believe specialized commodity hedge fund investors will find value in markets that are especially short of supply, and so relatively more immune to any disappointments on the demand side (such as tin and copper). We also see good potential for the aluminum and zinc market to perform well; we expect their respective supply sides to improve sufficiently to take prices to fresh highs, after relative underperformance so far in this metals price cycle.
— The opinions presented are the authors’ 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 authors at kevin.norrish@barcap.com and ingrid.sternby@barcap.com
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