Are speculators turning positive?

Base metals prices ended the report period May 14-18 strongly, with aluminum, copper and lead prices all achieving their best closes for the past few weeks and nickel sustaining big gains achieved in the previous week. The recovery came too late to influence average weekly cash prices, most of which showed small losses, with the exception of nickel and lead. Whether or not the latest gains can be sustained and built upon depends very much on the mood of speculators — the key influence behind the period under review.

The fund short-covering on May 18 was perhaps not surprising, given earlier events in the week. The 50-basis-point federal rate cut on May 15, which was in line with expectations, pushing the Dow Jones industrial average up by more than 500 points to its highest level since September 2000. The rate cut, combined with news of positive housing starts in the U.S. and a surprise widening of the American trade deficit, had the effect of inducing caution among the funds that have been selling base metals for the past month.

But have the funds really changed their view of base metals? Interestingly, other commodities also benefited from fund activity during the report period, with both crude oil and gold prices climbing sharply higher. In both these commodities, however, funds were taking out sizable fresh long positions, something they have yet to do in base metals. Although the U.S. economy is showing increasing signs of bottoming-out, the evidence from Europe is that the situation for end-use metals demand is still deteriorating, as it is in Japan.

Under these conditions, it appears rather premature for a fund-inspired rally to draw in any support from the trade, and, consequently, we think it unlikely to be sustained.

Copper prices ended the week in a position of strength, as an early break on May 18 above key technical levels at US$1,685-1,695 per tonne (the location of the 10-day and 30-day moving averages) drew in fund short-covering to take the 3-month London Metal Exchange (LME) price to a 2-week high of US$1,725 per tonne. However, the rally was mainly technical in nature and supported by non-copper-specific factors, especially the dramatic recovery in U.S. stock markets, which pushed the Dow Jones up 500 points earlier in the week to its highest level since September 2000. The rise in the Dow prompted U.S. funds to reduce some of their sizable net short position. Once this rally has run out of steam, we expect LME 3-month copper to head pretty swiftly back toward US$1,700 per tonne and possibly even lower against a backdrop of deteriorating fundamentals.

LME copper stocks have at last started falling, but last week’s 5000-tonne decline was unimpressive for the time of year, and the low level of cancelled warrants suggests that withdrawals will remain at modest levels — a symptom of a weak physical market. One of the few bright spots is China. Although Shanghai copper stocks climbed marginally during the report period, local copper prices have been rising, pushing the ratio to LME quotes to more than 10, the level that, in the past, has signalled profitable arbitrage trade and encouraged cathode imports to rise.

However, any increase in Chinese buying is unlikely to be enough to offset weakness elsewhere, at least in the short term. Although demand in the U.S. is bottoming-out (assisted by continued strong activity in the construction sector), industrial production remains sluggish, and there is little sign that successive interest rate cuts are doing much to improve expectations. De-stocking has exacerbated the downturn in copper demand so far this year, but if this is now over, then the worst for European copper demand may now be behind us. Still, big improvements are unlikely any time soon since end-use demand is still sluggish. Indeed, recent data suggest there is a risk of further deterioration.

After briefly dipping below US$1,500 per tonne in mid-week, aluminum prices recovered strongly to end the report period at US$1,540 per tonne (just above key overhead resistance). Production cuts due to power shortages (both actual and rumoured) again proved to be the main influence on prices, preventing a slide that at one stage looked as if it could return the LME 3-month price to the US$1,480-1,500-per-tonne trading range of late March and early April.

Meanwhile, nearby spread tightness continued to ease, causing LME 3-month backwardation to contract. Tightness may emerge again, depending on how much of the fund short position has been rolled forward into June or July, but the delivery of almost 100,000 tonnes of metal into LME warehouses in recent weeks should mean that lending will be a little more forthcoming next time around. This assumes that stocks do not fall rapidly in the short term, and with cancelled warrants at only 14,000 tonnes (compared with more than 80,000 tonnes at this time last year), such a fall seems unlikely.

In the week ahead, the market will be watching nervously for any news on production levels at Alcan’s 272,000-tonne-per-year Kitimat smelter in British Columbia. There was some speculation that Alcan was about to announce a substantial closure, though the company insists it has not yet reached a decision. We believe a major production cut at the plant is inevitable. If water levels in the reservoirs that supply hydroelectric power to the plant do not rise soon, the situation will become critical, and local weather forecasts suggest that drought conditions in the region will continue for at least another three months.

Alcan has already cut production at Kitimat by 40,000 tonnes over the next 16 months, and it recently announced it will be lowering output in Brazil by 12,000 tonnes this year, owing to low availability of hydro there as well. Other smelters in Brazil are likely to announce cuts after a plan to conserve energy was announced on May 18. The plan calls for energy-users to make voluntary cuts of up to 20% of consumption. This could put up to 200,000 tonnes of Brazilian aluminum production at risk.

Alcoa announced it will curtail its remaining 115,000 tonnes per year of production in the northwestern U.S. As well, the major will forego the fixed-rate Bonneville Power Administration supply to which it is entitled from October onward. The implication is that Alcoa will be keeping its 530,000 tonnes of idled smelting capacity in the region off-line for the next two years. Other companies in the region will likely follow suit.

Zinc prices broke briefly higher during the report period, with the LME 3-month price clambering above its 10-day moving average to challenge overhead resistance at the 30-day moving average at about US$975 per tonne on both May 17 and May 18. However, by the end of the week, prices had subsided back to the low US$960-per-tonne level. Earlier in the period, the LME 3-month price had tested a fresh 29-month low of US$947 per tonne, and there seems little reason, either fundamental or technical, why the downtrend should not resume soon.

Historically, zinc has been punctuated regularly by squeezes and price spikes. Indeed, there was a brief period of nearby spread tightness in early April. The problem, however, is that there are currently no large short-position holders of zinc off of which a squeeze could be leveraged. Fundamentals are poor, as well. Despite the low level of prices, production cuts have been few and far between, amounting to less than 200,000 tonnes at Los Frailes and Langlois combined (in Spain and Quebec, respectively).

The recent increase in Singapore metals stocks (up by 20,000-102,400 tonnes since the end of March) suggests that Chinese imports are still rising strongly. We predict a surplus of 160,000 tonnes this year and more than 200,000 tonnes in 2002, suggesting that zinc market fundamentals are the worst of any LME metal.

Nickel was once again the strongest performer out of the base metals complex, as prices registered their highest close since October 2000. Against a backdrop of price resistance in other markets, nickel’s strength is impressive, though so
mewhat suspicious. The rally in prices contrasts sharply with market fundamentals on both the supply and demand side of the equation, which suggests to us that, regardless of any potential improvement in copper and aluminum prices, failure to move above US$6,450 per tonne could cost nickel prices between US$600 and US$800 per tonne as disappointed long liquidation pressures prices toward pre-price rally levels.

The sharpness of the increase in the Relative Strength Indicator (RSI) suggests that short covering was the main driver of the price hike; if a short position holder is eager to cover a position, it is, after all, largely irrelevant what the RSI is doing, the only determining factor on the buy side is to cover a short position.

Two precedents in nickel’s recent price behaviour lead us to suspect that a price correction is imminent.

The most recent occurred last December, when prices were in a similar position; a large single day increase lifted prices to a higher trading range, suggesting they would test resistance at US$7,400 per tonne. They failed to do so, however, and within a week, prices had lost US$500; within three weeks, they had lost more than US$1,000.

The second precedent concerns the RSI. The last time the indicator peaked at a level comparable to that of the report period, the price correction that followed wiped more than US$1,500 off prices and sent nickel on a downward trend that pushed prices below US$6,000 per tonne during the first quarter of 2001. Clearly, precedent suggests that consolidation at these levels is not an option. Nickel prices can go higher if stops are triggered, though we believe it more likely that they will go lower, initially to the US$6,400-per-tonne area.

The technical position on May 18 took another encouraging step forward when the 10-day moving average (having already moved above the 30- and 100-day averages) crossed above the 200-day moving average for the first time since early 1999. The market nonetheless remained unimpressed by this technical signal. Prices weakened and failed, for the fourth consecutive day, to make any headway at breaking resistance at US$7,400 per tonne. The risks to prices now are twofold: disappointed long liquidation threatens to weaken prices further unless stops at higher levels can be triggered, and there is an increasing chance the market will go short at these higher levels before a price correction occurs.

Gold prices have sparked sharply higher since late on May 18, taking many in the market by surprise. After ending the London trading week in apparently quiet conditions, prices then took off in trading on the Comex division of the New York Mercantile Exchange, eventually ending US$13.80 per oz. higher at US$287.80 per oz. — the highest level since late September 2000. Gold made further gains in overnight trading in Asia, with US$299.25 per oz. the highest level paid for spot.

As yet there is little explanation for the sudden price increase. Several factors — a step up in nearby lease rates, a tighter forward contango as a result of lower U.S. interest rates, and a strong technical position — combined to give gold prices their most positive environment in many months. Still, the force of the rally is surprising. The market has been nervous for some time about the large fund short position on Comex, and, as the price surge began on May 18, the easiest explanation was that it was being fuelled by fund short-covering. However, recent data show that funds had covered their short positions by May 15 and begun building a net long position for the first time since July 2000, with the net short position of 25,788 lots switching to a small net long of 1,531 lots.

This last fact suggests that fresh fund buying, rather than short-covering, has helped push prices higher and that gold prices have more chance of being sustained at current levels than if the reverse had been the case. Despite its US$10-per-oz. retracement from overnight highs in Asia, gold looks strong technically, and further volatility, and possibly another test of US$299-300 per oz., cannot be ruled out.

— The opinions presented are solely the author’s and do not necessarily represent those of the Barclays group.