The following is an overview of base metals markets. Detailed reports on the base, as well as precious, metals will appear in subsequent issues.
After two years of negative Western World industrial production growth and another year of subdued economic expansion, base metal markets are looking considerably healthier.
The cyclical trough was formed in the fourth quarter of 2001, but not until the breach higher in the second quarter of this year was the current up-trend confirmed. We believe the upward trend has the potential to continue, despite consistent macro threats in the form of a large U.S. budget deficit, high consumer debt and a weak labour market. But improvements in key leading indicators for metals demand, notably the manufacturing surveys and the possibility that the European and Japanese economies have bottomed, in conjunction with evidence of large interest in commodities as an alternative investment, outweigh those threats over the medium term. In addition, any significant consumer business is yet to come, which could surprise on the upside as downstream inventories remain low and as activity picks up after the quieter summer period. It is now time to look at how high base metal prices can go in the current cycle. On an average aggregate basis, we estimate another 15% upside potential for prices ahead of the assumed economic cycle peak in early 2005.
How high can base metal prices go? Analytically it is perhaps easier to determine how low they could go in a down-trend by looking at where production curtailments are likely to occur as producers turn cash negative. The cyclical trough in the fourth quarter of 2001 was triggered by extensive production cutbacks in conjunction with early signs of leading indicators for demand starting to improve.
The current commodity price cycle has been extraordinarily volatile and not until recently has the upward move become more forceful, with any price dips now shallower and briefer. This is a reflection of the fact that fundamentally driven investment funds are convinced the macroeconomic environment is improving. Financial markets suggest a “reflationary” scenario, most notably in the synchronized rise in bond yields in the U.S., Europe and Japan. Strong performance by mining equities also paints a positive picture for metal prices, as these traditionally show the lead.
We are at a positive stage in the commodity price cycle. Observing historic price cycles, the most striking features are that each cycle has become shorter and has peaked at a lower level than in previous cycles. The declining real price trend over the longer term is primarily the result of lowering production costs, while a higher degree of market regulation today is also helping to prevent any extreme (constructed) price spikes as witnessed in the past (for example, the Sumitomo affair in the mid-1990s).
Real aluminum prices have fallen relatively quickly compared with other base metals, as aluminum smelting processes are new compared with more established techniques. Equally, solvent extraction-electrowinning for the recovery of copper has resulted in lower production costs in the copper industry. Currency moves have also affected production costs. As a large share of the world total is produced outside the U.S., the sharp appreciation of the U.S. dollar in the second half of the 1990s played an important role in lowering production costs, while the U.S. dollar depreciation of late has had the reverse effect. A situation where economic growth improves and the U.S. dollar falls would have dynamic positive implications on base metal prices. Our base case scenario assumes stronger U.S. economic growth (gross domestic product growth of +5.0% for the third quarter and +4.0% for the fourth), accompanied with dollar strength. Still, our foreign-exchange strategists do not forecast a return to euro/U.S.-dollar parity over a one-year forecast period.
An up-trend can be divided into three parts. The first phase, driven by the systematic (technical) speculator, is now largely behind us. The second phase of the price recovery has just started, with fundamentally driven funds adding more aggressively to long positions as indicators suggest the economic recovery is gathering pace. This phase is also traditionally characterized by consumer restocking. The third and last leg higher is still ahead, when serious consumer business kicks in. This is not likely to occur until next year. At that time, investors are also likely to start exiting commodities ahead of a cyclical downturn. Assuming the economic cycle peaks during first half of 2005, we believe metal prices will reach their cyclical highs towards the end of 2004 at a level 15% higher than current levels on an aggregate basis.
Low interest rates
Adding to the constructive demand picture are the facts that U.S. interest rates are at 45-year lows, end-use inventories remain low (permitting additional consumption through re-stocking), upstream inventories have started to decline, and Asian demand remains strong. The marked trend divergence between the Fed Fund rate and base metal prices is unusual. But recent comments from the Federal Reserve suggest that increased economic growth is not likely to prompt a rise in rates, and the Fed could in fact even ease rates should conditions of persistent economic growth not be accompanied by a steady rise in jobs.
At the same time, U.S. President Bush has outlined an economic plan to ensure a full economic recovery to address the sluggish job market. Base metal demand could significantly benefit from an upswing in the U.S. manufacturing sector supported by the low-interest-rate environment.
Still, U.S. manufacturers are complaining about the loss of production to cheap locations such as China, but increased pressures from the U.S. of a renminbi revaluation could in fact have positive implications on commodity markets. In theory, we would argue that a stronger Chinese currency against the U.S. dollar would help encourage imports and discourage large export volumes of refined metal to the Western World. China is already a large net importer of copper and nickel, but prospects that net exports of lead and zinc will be further restricted (already happening because of strong domestic demand and constrained production) are bright, which would further improve the outlook for those markets.
The outlook for aluminum would also improve, in our view. In 2002, China became a major net exporter of primary aluminum. Being dependent on large quantities of raw material (alumina) imports, there is a possibility that the Chinese aluminum market will return to balance sooner than expected (our current prediction is 2006), which would support aluminum prices.
Nonetheless, a sharp appreciation of the renminbi is unlikely and China is still many months away from answering the call for greater exchange-rate flexibility. Much of China’s trade surplus with the U.S. has come in the form of foreign direct investment in China anyway, and a currency appreciation would not significantly change the wide factory wage differential between the two countries already in place.
Asian growth
However, of growing concern are fears the Chinese economy is overheating and that its banking system is overstretching itself in issuing loans, causing an unsustainable boom that will end badly. Chinese officials have allowed the situation to continue because of unemployment fears. In commodity markets, there are still no marked signs of demand slowing, with import demand still strong. Even if Chinese growth rates do slow down (which is part of our base case), the start of more positive Western World growth trends are likely to offset any negative implications from slower Chinese growth. To date, growth has been centred on the Asian regions, while the largest Western World regions have experienced slow growth rates.
Trends in other commodity and financial markets also suggest that the current up-trend is still at an early stage. Inflation is the common theme for bond and metal markets, and the rise in bond yields across regions strongly implies higher inflation expectations along with rising metal prices. As commonly discussed in our more frequently published research, manufacturing surveys have been supportive for the base metals in the past few months. Not only are the headline figures encouraging, but so are, in particular, the different components of the surveys, which indicate orders have surged while inventories have continued to decline. This relationship should feed through to continuously strong manufacturing data going forward.
Apart from a more supportive macro environment, important components that will decide price peaks other than demand include the reactivation of idled capacity and the degree of producer forward selling as prices rise.
As cyclical price peaks occur at lower levels, forward prices are also moving into backwardation at lower prices in each price cycle. This reflects producers’ hedging at lower prices in line with falling costs of production. Additionally, the number of producers/utilities that hedge has generally increased, as has the volume of future production that they will hedge, though corporate consolidation (for example, Alcan/ Pechiney) could help restrict some of the growth in hedging business.
Closures
After a period of depressed demand and prices, significant reductions of production capacities have occurred in most base metal markets. The combination of low primary prices and high energy costs have had a particularly severe impact on aluminum production, while the additional combination of low treatment charges and strong local currencies has forced capacity closures in the lead and zinc markets more recently. Copper has been somewhat different, where closures have in several cases been voluntary in order to change the low price environment. It is difficult to estimate when idled capacity will come back on-stream, if at all, given the many factors involved in a decision (byproduct prices, social and governmental pressure, etc.).
To get a sense of the vulnerability for restart as prices rise, we have analysed production cost data to see at what price most of capacity is profitable, as well as what percentage of production is profitable at current prices. A closer look at this data suggests that even if the aluminum market seems to have a lot of spare capacity, prices would have to rise significantly (well above US$1,500 per tonne on a sustainable basis) for any sizable restarts. For example, Alcoa’s Ferndale smelter in the U.S. Pacific Northwest is preparing temporary closure because of the continuously unfavourable aluminum/power price ratio. According to data from Brook Hunt, Ferndale’s estimated cash costs for 2003 is US$1,400 per tonne, highlighting the current tough operating environment, even when London Metal Exchange (LME) prices have recovered from the lows.
Given the nature of several capacity closures in the copper industry (voluntary), restarts will not entirely depend on profitability, or at least not the degree that occurs in the aluminum market, for example. Improvements in demand conditions will be a determining factor, with capacity restarts expected at BHP Billiton’s Escondida on any recovery in order to maintain the “producer discipline.” We have assumed full production at Escondida next year. The ramp-up to full capacity at Phelps Dodge’s operations will be more dependent on the price level, with current prices starting to look attractive for a startup of idled capacity at Sierrita (+55,000 tonnes per year), while yet significantly higher prices would be required for profitable production at its Baghdad mine (+30,000 tonnes per year).
Spare capacity in the Western World lead and zinc industries is relatively limited (both on the mine and smelting side), and over the past year there have been several permanent closures as a result of structural issues. These operations are unlikely to reopen unless prices move significantly above recent peaks, which we do not expect. Zinc smelting capacity in China is heavily under-utilized, but with availability of concentrates expected to remain low, Chinese smelters are unlikely to raise production significantly in the near future.
Inventory levels
Up-stream inventories remain substantial, despite drawdowns during the first half of this year. Nickel and tin are the exceptions, where total reported inventories are already close to levels seen during the last cyclical price peak.
While the nickel market appears to be particularly short of material at present, there are significant inventory overhangs in most other markets, particularly aluminum, copper and zinc. To put current inventory levels further into context, stocks measured as weeks of consumption are also high at present. Extensive absolute inventory levels will not hinder prices gains per se (as long as the trend is downwards), but rather are likely to make any upward move more muted than would otherwise have been the case.
We expect the long-term real price trend to remain in a declining trend. Lead and zinc prices saw extremely muted spikes in the previous cycle, owing to the negative impact from rapid growth in Chinese production and large volumes of refined metal flooding Western markets. It is therefore more difficult to compare historic cycles in those markets. Nickel has also differed from the other major contracts in that it has seen prices peak higher in later cycles. This is in line with upside pressure on production costs, as new technology did not progress as planned.
All metals bar nickel are trading well below their long-term averages. Worth a mention too is aluminum, which is only marginally below its nominal mean since 1990, while zinc in contrast is trading significantly below.
Base metals have enjoyed a 2-year rally, and it’s tempting to extrapolate that trend out in time and assume an inflationary spiral has begun. However, a cursory glance at the LME index is sufficient to dampen such enthusiasm. Ever since the index peaked in 1995, base metals have been locked in a structural downtrend punctuated by deep periodic corrections.
At the moment, it is far from certain that the 2002-2003 rally is anything but another of these corrections. The rally from 963 is contained within a clear trend channel and has yet to exceed the bounds of a standard retracement level of the fall between 2000 and 2001: 66.6% and 75% corrections of that decline are at 1246 and 1281.
If any of the components of the index were breaking decisively higher, we would be eager to call for an LMEX rally to 1400; unfortunately this is not the case. Aluminum lead, nickel and zinc are all the wrong side of multi-year highs (respectively at 1471, 530, 10500 and 877), and copper has yet to take out 1861 (75% retracement level of the decline from 2036 to 1334). Until those levels are breached, we are reluctant to get too enthusiastic for the LMEX at the range high; there is no reason why it will not fall back to trendline support at 1167 before the end of the year.
Because of the large involvement by systematic commodity-trading-advisor funds in commodity markets, technical chart patterns cannot be ignored. While the chart suggests a well-defined up-trend in place since the cyclical trough in 2001, convincing challenges of recent highs will be necessary for the up-trend to persist. Because of the current position in the economic cycle, and positive metal specific fundamental developments, we think this is possible, and we expect the base metal complex as a whole to reach a peak approximately 15% above current levels before the estimated economic cycle peak in the first half of 2005.
To summarize, we foresee a relative preference within the base metal complex and future price profile. Undoubtedly, nickel possesses the strongest fundamentals, owing to a combination of low inventories and little new supply, with positive exposure to China being another key support. A strong price performance is already behind us, though we still expect further upside potential for nickel in the magnitude of 13% from current levels to the expected price peak. Tin and zinc are our favoured metals, estimated to rise approximately 19% and 14.5%, respectively, on an equivalent basis. Tin is still trading about 11% below its 1990-2003 nominal mean and about 21% below the previous cyclical peak. As with nickel, this market should benefit from relatively low inventory levels apart from an improving economic cycle. The upside potential in aluminum and copper should be restricted by high inventory levels in both markets, as well as the potential for the restart of idled capacity or new production as prices rise. Aluminum is already just 1.4% below its nominal mean since 1990, while copper too is relatively close to its long-term mean, compared with the other base metals.
— 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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