Base metals prices: yet higher

METALS COMMENTARY

The outlook for base metals prices remains extremely constructive. After very strong performances again in the first month of 2006, we see the price up-trends continuing, with particular upside pressure in the first half of this year. We remain most positive on zinc for 2006, followed by aluminum and copper and lead, respectively, compared with 2005 average prices.

We also see nickel and tin prices reversing their falling price trends of the latter half of 2005. We have made some adjustments to our forecasts since our last review. Far-forward contracts also continue to offer value, in our view, especially in zinc. In nickel, we expect a nearby backwardation to return as the market starts to tighten from its current surplus.

Base metal prices have risen for four consecutive years. Copper, zinc and lead continue to hit new all-time highs, while aluminum is around its highest levels since the late 1980s. Against general expectations, high prices have failed to rapidly attract new production. At the same time, the global demand environment has remained strong. This powerful combination, as well as extremely low global metals inventories, will generate even higher prices in 2006, in our view.

The broader macroeconomic backdrop remains extremely positive for the industrial metals, with a low interest rate environment, robust global growth and prospects of a weaker dollar. The skeptics continue to cite rising interest rates, downside risk to the U.S. economy and subsequent risk to the Chinese economy.

However, we see these fears as overdone; we believe China’s metals demand will continue to grow strongly even in the event of an external economic slowdown, due to domestic infrastructure-led investment. Strong demand from other emerging markets, for example India, is also becoming increasingly important.

In a strong demand and price environment, production should grow. But serious short and long-term supply constraints persist, and production costs are on the rise. We believe the risk of a correction in prices caused by a sudden near-term flow of new production is therefore small.

Fund involvement is also widely regarded as a threat to the sustainability of high base metals prices. Indeed, long-term investment money continues to flow into commodity markets, including the base metals, and this trend shows no signs of abating.

Shorter-term fund activity, however, is generally not excessive on the long side. As a result, we see little risk of substantial fund-driven corrections in prices. In the event of downside price pressure, it is likely to be shallow and brief once again, given the amount of buying interest from consumers and funds on lower numbers.

Aluminum: We see the entire forward curve continuing to shift higher due to ongoing cost pressures at smelters, and structurally strong demand. High alumina costs are the key factor slowing growth in China’s aluminum smelting, while high energy prices are the key constraining factor in the Western World.

We expect further drawdowns in exchange inventories on strong cyclical demand, boosted by consumer restocking, and lower aluminum shipments from China. Chinese exports have picked up recently, in response to rising London Metal Exchange (LME) prices, but we believe this is unlikely to be a sustained trend as the government seems committed to reducing exports of energy-intense production, and is likely to raise export taxes further if necessary. With prices hitting our initial target of US$2,500 per tonne, a test of US$3,000 per tonne for 3-month prices is a distinct possibility.

Copper: Along with the more actively traded 3-month contracts, far-forward prices also continue to move higher. This is the result of a reduction in producer forward sales, consumers moving out on the curve, and buying of commodity baskets by long-term investors. Fundamentals remain strong. Consumer inventories are low, global demand robust, while producers continue to struggle from depleting ore grades (e.g., at major mines in Chile and Indonesia) and new projects tend to take longer to launch due to rising production costs (related to energy, water, labour and currencies).

More workers’ strikes in 2006 cannot be ruled out in response to record high prices. Any output disruptions, especially at smelters and refineries, would feed straight through to prices, in the absence of shock absorbers such as spare capacity and stockpiles.

We expect a sustained breach of US$5,000 per tonne for a 3-month contract in the first quarter.

Lead: Prices will remain strongly supported because of low inventories, which also make prices very sensitive to any supply side disruptions. While global mine output growth has picked up, the concentrates market remains tight, at a time when refined lead demand is very strong, driven by the industrial battery sector. Against general market perceptions, we do not believe fund length is excessive in this market, by either actively trading hedge funds or by long-term strategic investors. Prices have already breached the higher end of our expected trading range in force (partly due to short-covering), and given favourable fundamentals still, a move up to US$1,500 per tonne is looking possible.

Nickel faced very poor demand conditions during the latter half of 2005, driven by cutbacks in stainless steel production and consumer de-stocking. While prices eased some 30% during the period, even the low occurred around a historical high level of US$11,500 per tonne. Supply disruptions, with some 45,000 tonnes of production lost (partly due to the lack of feed), halted the downside in prices, and even though LME inventories have been rising, they remain relatively low in a historical context.

We are positive on the nickel price outlook. We see the existing surplus diminishing going forward, driven by a rising trend in Chinese refined imports, a pick-up in buying from European stainless steel mills, and low growth in mine output. This should also cause a steepening of the curve. Our near-term, 3-month price target is US$16,000 per tonne.

Tin: Along with nickel, tin was a distinct underperformer in the second half of 2005. However, prices have stabilized after a brief test below US$6,000 per tonne (also the 200-day moving average).

And fundamental prospects are looking up. In the near term, the outlook for output in key Asian tin-producing regions is dampened by the monsoon season. A generally higher production cost environment also means that prices around US$6,000 per tonne are generating unattractive returns for producers. While prices have suffered from short selling by funds on a negative price trend, consumption of tin has remained robust, driven by China’s electronics sector, and by a move away from lead-free solders. Our previous near-term price target of US$7,500 per tonne for 3-month tin prices was quickly surpassed in January, with US$8,200 per tonne our next near-term target.

Zinc: Having caught up with the strong performance in copper prices in the second half of 2005, zinc remains one our favoured base metals for 2006. LME inventories are in a steady decline in response to strong demand from the galvanized steel sector, and the lack of sufficient supply growth. The absence of new mine capacity will remain a key market feature over the next couple of years, and together with rising refined zinc imports into China, is a key reason for our bullish stance.

The risk of larger-than-expected mine output from China is muted, in our view, as China’s zinc mines are generally small, and reserves are being depleted. Any technical price correction, given extensive CTA fund length, should only provide a buying opportunity as we see a large deficit again in 2006. Far forwards also offer value, in our view. Our near-term, 3-month price target is US$2,500 per tonne.

— The preceding is an edited portion of Barclays Capital’s Commodity Refiner Q1 2006. It repre
sents the opinions of the authors and does not necessarily represent those of the Barclays group. For access to all of Barclays’ economic, foreign-exchange and fixed-income research, go to the website at www.barclayscapital.com.