Base metals benefit from modest recovery in US equities

The pressure on metals prices lifted over the report period Aug. 19-23, thanks to a more positive tone in U.S. equity markets. The recent signs of stabilization in metals are not surprising given the need for at least a modest technical bounce after the sharp price falls seen over the second half of July.

The levels to which several of the major base metals had sunk by early August implied a sharp contraction in global growth levels, which also looked a little overdone. In the short term, it would not be a surprise to see the top end of recent trading ranges being tested and overcome. Although, with an awful lot of uncertainty still surrounding the broad economic outlook, the upside is limited for the time being and it would not take much to induce another selloff, pushing prices back down to their recent lows.

A steep rise in oil prices could be the catalyst for such a move. Oil and metals prices typically move in tandem, though the past two months have proved a major exception. The Organization of Petroleum Exporting Countries’ control of supply, combined with nervousness over Iraq, has prevented oil prices from going the way of base metals (during the week under review, West Texas Intermediate oil prices reached their highest level since early 2001). Our recent analysis shows that declining stocks of oil have helped erode the Iraq war premium built into oil prices earlier this year. With speculation growing more intense by the day that an attempt at “regime change” in Iraq is imminent, it would be no surprise to see oil prices climbing back to mid-US$30-per-barrel levels. This would come at the worst possible time for the major Western economies, and any resulting threat to the fragile recovery would quickly translate into a “war discount” for metals prices.

Copper prices continued to trend gradually up from their recent lows, supported by a more positive tone in U.S. equity markets, a sharp fall in Escondida’s July output, and data showing another big surge in China’s refined metal imports.

The more positive tone to U.S. financial markets was probably the most important factor. It enabled the market to shrug off a 9,175-tonne increase in exchange stocks and an announcement from KGHM Polish Copper that it plans to raise output by 10%, possibly within a year. In the short term, we expect the focus will continue to be to the upside. The US$1,520-per-tonne level will continue to be the key area of resistance, and above that the 30-day moving average at US$1,529 per tonne. But supply factors are not wholly supportive.

Should the economic gloom continue to lift, then copper is well-placed to benefit from investment money flowing back into the market. A shortage of raw materials provides a highly supportive fundamental factor, and recent evidence suggests that this is soon likely to result in some major shortfalls in refined production.

Chinese import data for July showed that imports of copper concentrate fell by almost 100,000 tonnes (gross weight) from the corresponding period last year, and have been 7% down, year over year, for the first seven months of 2002. China’s refined production has yet to show any signs of contraction (having grown 11.8%, year over year, in the January-to-July period), but if the contraction in concentrate imports continues, which we think likely, then a substantial decline in refined production will occur in the second half of the year.

Nevertheless, the window of opportunity for copper prices to move higher as a result of lower metal production is likely to be limited. Although Escondida announced that its production was running around 10% below year-ago levels, a big increase in output is due there as a result of the beginning of an expansion phase in September. Add to this KGHM’s announcement that it will boost production considerably, and there is every likelihood that global refined output will begin to accelerate again, in 2003.

After aluminum’s failure to break above the 30-day moving average at US$1,325 per tonne on Aug. 23, short-term price prospects are fragile. A recovery in U.S. stock markets and a slight lifting of the economic gloom that has dogged markets since early July may reduce some of the immediate downside price risks, but a break back below the US$1,300-per-tonne level still looks likely before too long.

Supply developments continue to dominate the aluminum picture, and recent news has been poor. Data from the International Aluminum Institute show that production in July rose 4.3%, year over year — its fastest rate of growth since October 1999. When production not covered by the IAI is factored in, it would appear that global aluminum production accelerated by 7.8% in July and was up 6% in the first seven months of the year.

Thanks to a modest pickup in consumption, we estimate a surplus of only around 200,000 tonnes so far in 2002, based on movements in visible stockpiles. However, with the demand outlook now in doubt, the concern is that the surplus will be even bigger in the second half.

Expansion in China is one of the main drivers of global output growth. Primary production has risen by almost 500,000 tonnes so far this year, and the rate of increase is likely to accelerate as capacity continues to grow during the second half. Despite healthy consumption growth in China so far in 2002 (up 17%, we estimate), net exports of primary are rising much faster than most market participants had expected. Our analysis of official production and trade data shows net exports of primary running at 185,000 tonnes for the year to date, substantially in excess of earlier forecasts.

Another important factor to note is the acceleration in local alumina production and imports. The boost this has given to Chinese alumina supply (up by more than 900,000 tonnes so far this year) suggests that the chances of a lack of alumina constraining Chinese metal production growth any time soon are remote.

Nickel increasingly looks to be the best-poised market on the London Metal Exchange to capture upside price risks associated with the broad recovery in manufacturing demand. Both supply and demand factors have moved in nickel’s favour. Even the narrow improvements in demand (led primarily by the stainless steel market) allowed prices to briefly target US$7,000 per tonne during the report period, in an LME trading environment that has been bearish, to say the least.

With prices able to maintain such strength on the basis of a nascent and still narrow recovery in demand, the price prospects for later in the year and 2003, when demand is expected to develop and broaden out, are moving higher. In the short term, the implications of this are that funds and commodity trading advisors are likely to be further dissuaded from playing the nickel market from the short side, even if the rest of the complex loses its grip on current support levels. We expect the 10-day moving average at US$6,700 per tonne to provide initial support for nickel, with upside risks now pointing toward US$7,000 per tonne.

Stainless steel indicators remain positive. Eramet recently released first-half results showing an increase in turnover of 7%, year over year, with nickel deliveries rising 1.5%, year over year, to just more than 30,500 tonnes. Both increases have been attributed to the improvement in stainless steel production. This rose by 4.5% in the Western World as a whole in the first half, while pan-European production increased by almost 8%.

Furthermore, expectations of greater import levels from China (which has a stainless steel production capacity far below its consumption rates) and a tight scrap market add additional pressure to the stainless market, and therefore nickel demand. With prices responding well to these pockets of improvement, a broadening recovery in nickel demand over the medium term clearly has strong potential for price prospects.

Sentiment in the zinc market improved towards the end of the report period, though it is still too early to be over-optimistic about price risks, particularly if prices reach and hurdle the resistance around
US$800 per tonne.

Despite several mainly supply-side developments, nothing materially changed in the zinc market over the report period. Producers have continued to warn about the risks to zinc market fundamentals if production levels continue unabated, but fresh reductions are yet to take place. A sudden and sharp jump in the number of cancelled warrants in zinc to a record high on Aug. 23 of more than 43,000 tonnes is positive, and stock withdrawals have started to come through (down 3,100 tonnes on Aug. 23).

Once again, however, there is a drawback: at more than 640,000 tonnes, the stock overhang in zinc remains sizable and, in the absence of production cuts, may again face upward pressure if cancelled warrants fail to lead to the now-anticipated reduction in inventories over the short term. However, in an environment of improved expectations, short selling so close to zinc’s historical price low is far less likely, and support above US$770 per tonne should strengthen.

Clearly, the future of MIM Holding’s UK and German zinc smelters is uncertain. The company’s combined annual production of 200,000 tonnes has key implications for zinc’s supply fundamentals. MIM’s decision to write down the value of its two European smelters was accompanied by some fairly blunt comments referring to the non-viability of zinc smelting in Europe in the current demand and price environment. No cuts have yet taken place, but the perceived axe hanging overhead may shore up support.

The reduction in Chinese exports is also providing some fundamental support. Exports in the first seven months of the year are running 8% below year-earlier levels. July’s level of 30,523 tonnes takes the total to 279,127 tonnes. However, without a big increase in demand, this will only reinforce support rather than drive prices sustainably higher.

After a dramatic start, gold market activity ended the report period with a bit of a whimper. The US$6-per-oz. price slide at the start of the week left prices looking bruised for the ensuing days, with the risks remaining focused on the downside.

It was not, on balance, an auspicious week for gold. Not only did comments from the Bundesbank emerge once again, muting the idea of selling some of its reserves, but the recovery in the Dow and the fall of the euro below key support areas against the U.S. dollar increased downside price risks.

Our target for some time now in gold has been the US$300-to-302-per-oz. level, and recent developments have confirmed our opinions. Ahead of the long U.K. weekend, an unimpressive end to the week was not surprising. The stability, however, belies the weakness that is now creeping into prices above US$300 per oz. The first net speculative short position of the year so far during the previous week seemed to characterize well the sentiment in the market for much of the report period. The recent decline in prices is associated, by many, with the rise in the Dow, which reached above the 9,000-point level for the first time since July 10 July.

Gold prices, however, have been on a downtrend since late May/early June, weeks before the Dow hit its bearish nadir at the end of July. So with what does the downtrend in gold prices coincide? The answer is the downtrend and eventual eradication of the speculative long position on Comex. And to what did the speculative funds respond? Clearly not the Dow — this was still heading south when speculative funds first bailed out.

Our view is that the rapid back-peddling that speculative funds have engaged in recently reflects the absorption of news that producers are reducing hedge exposure rather than any change in the macroeconomic environment. Indeed, since prices began trending lower, it can easily be argued that this has deteriorated and that the political climate has become more volatile during the summer.

That producer hedge restructuring has been factored into prices is not surprising. No factor apart from physical consumption can have a permanent and structural impact on prices. However, this does not suggest to us that prices will now settle above US$300 per oz. As the second half progresses, we think it increasingly likely that prices will begin to be based on a more balanced view of the market.

The reminder from the Bundesbank that it is reserving a place in the post-September 2004 sales queue is one factor which has been ignored by those who spent the first six months of this year trying to usher gold into a new false dawn of broad-based investor interest.

The weakness in physical consumption is also a troublesome cloud on gold’s horizon now that speculative buying on the back of hedge reductions has dried up. The downside price risks in gold were postponed during the week under review as pre-weekend caution determined prices and activity.

However, going forward over the short term, proved the U.S. dollar and its related assets can hold on to their gains, we expect a drift toward US$300 per oz.

— 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

Aug. 19-23 at a Glance

– Copper’s price risks are gradually moving toward the upside as sentiment improves.

– Aluminum remained fragile after a disappointing week for prices and evidence of output growth.

– Nickel has begun to target US$7,000 per tonne again, thanks to good demand from the stainless steel sector.

– Zinc has strengthened, but fundamentals are showing only tentative signs of improvement.

– Gold is facing renewed downside risks, and our expectations of a return to US$300 per oz. are increasing.