Base metals: targeting new highs (May 09, 2005)

METALS COMMENTARY

Market conditions for base metals remain favourable and, in our view, the upward price trends are set to continue. We expect prices to test fresh highs in the second quarter of 2005, driven by concerns over supply shortage, with critically low inventories being brought to the markets’ attention by robust global growth.

In March, we made upward revision of about 10% for each year to our base metals price forecast for the period 2005-2007. We see the most upside potential in copper and nickel during the second quarter, while zinc is our preferred exposure in the medium term. We have dropped aluminum as one of our preferred base metals, after 3M prices reached our price target of US$2,000 per tonne. As well, supply constraints are now expected to ease beyond the second quarter, owing to larger-than-expected shipments from China and the re-start of idled capacity in North America.

We expect prices to fall back through the second half of the year as increased refined metal availability is set against easing demand conditions. This should see inventories build through the second half of 2005. However, we believe that by the end of this year inventories will still be lower than they were at the end of 2004; thus supply shortfalls are likely to intensify again in the first half of 2006.

Current prices are, of course, already high in nominal terms, inconveniently high for consumers (still needing to buy) and investment funds (still looking for long exposure), but seemingly still not high enough for producers seeking to lock in attractive forward sales, while opportunistic short-selling is being discouraged by the backwardations. After several hefty price corrections last year, price dips have become shallower and briefer, signalling strong underlying price support. We believe those looking for better buying opportunities may miss out.

There are several reasons why we have revised higher our price forecasts for the base metals:

q Consumers forced to chase prices higher — Crucially, global consumption patterns remain positive for the upward base metal price trends to continue. Consumers are still looking for buying opportunities, and in many parts of the world (the U.S. and China in particular), they have brought down their inventories to a minimum. Rising interest rates do not represent an immediate threat to metal demand, and we believe base metals prices and interest rates will hold to their traditional pro-cyclical relationship. Monetary policies remain extremely accommodative, which will continue to encourage robust spending levels, and the tightening cycle has much further to run. In the U.S., capital spending continues to grow at double-digit rates, and new manufacturing orders also look supportive.

The slowdown in the Organization for Economic Co-operation and Development’s leading indicators for economic growth last year show signs of stabilizing, which, together with similar signs from China, creates a positive combination for metals prices. In China, physical metals consumers are reluctant to buy in the current high-price environment, as they are unable to pass on the higher costs to their customers. This has caused drawdowns in consumer inventories, but we believe consumers may now be forced into the market despite prices remaining at high levels. While Chinese copper semis production has slowed, there are early signs that physical orders are starting to pick up, and domestic prices have firmed, pointing to a sound underlying trend in consumption.

q Supply constraints to last longer — Against positive demand prospects, base metal supplies are still looking surprisingly constrained going forward. We believe supply growth will be insufficient to offset deficit markets in several of the base metals markets next year. In copper, after a surge in mine supplies during 2004-2005, we expect current smelter constraints to alleviate in the second half, which should help reverse the decline in refined inventories.

However, inventories are unlikely to rise sufficiently to prevent another push higher in prices in the first part of 2006, with copper mine supply set to slow dramatically again as a result of a lag in investment in mine capacity in the past few years. However, more recently, high prices have sparked a wave of new investment in the mining sector. But rising production costs (for steel, for example), shortages in capital equipment and other regulations related to the environment and labour mean project lead times are much longer than ever, and more substantial metal supply additions are unlikely until 2007.

In the meantime, the base metals markets are extremely vulnerable to any supply-side disruptions or positive demand-related surprises. This makes metal price forecasting more difficult than usual, but at present we argue strongly for potential severe upside price pressure on base metals. The industry has highlighted that output facilities are operating flat-out, representing a substantial risk for disruptions. This ties in with anecdotal evidence of difficulties in sourcing replacement parts and mining equipment at present, which is further threatening the performance at metal production plants.

q Inventories to fall further from already-critical lows — In the current demand-and-supply environment, base metal inventories will continue to fall from already-extremely-low levels. Low inventories are the key basis of our expectation of sharp price spikes in the second quarter of 2005. A prime example of this is the lead market, which has seen its total reported stockpile fall below its “critical” level, and consequently, a sharp reaction in prices has been seen. Copper and nickel stocks are also particularly low, while aluminum and zinc, coupled with the strong demand from the galvanized steel sector (especially in China), we believe zinc inventories are likely to reach critical levels by the end of the year, accompanied by higher prices.

q Currencies less supportive, but strong investment appetite among funds — A key supportive factor for base metals during much of this bull run has been the weak U.S. dollar. In theory, dollar depreciation encourages consumer buying and discourages supply in non-U.S. dollar countries. However, in reality, the strong inverse relationship between the U.S. dollar and metals prices has been driven by trading activity by U.S.-based funds. Hence, some metal price weakness on dollar strength is only to be expected. However, in the current strong metal-specific fundamental environment, we would expect good buying support from both consumers and long-term investors on currency-related price dips, which should provide solid underlying price floors for base metals.

While our foreign-exchange experts expect upside inflation risk in the U.S. to be positive for the U.S. dollar in the medium term, they predict the euro/dollar exchange rate will stay largely at current levels (1.30) over the coming year. At the same time, they expect further dollar weakness against the Japanese yen. Overall, this scenario is largely neutral for the base metals. The other key currency-related issue is the Chinese yuan peg; in this case, we would regard appreciation as a mild positive to the base metals prices.

Arguably, much of the positive impact on base metal prices from currencies has already happened. So far this year, aluminum has shown the strongest negative correlation with the euro/dollar among base metals, while the influence on zinc has been the weakest. If the dollar should strengthen over the nearer term, it would support our relative base metal preference based on metal fundamentals, which favours zinc, while we are less positive on aluminum as it reached our target of US$2,000 per tonne.

Investment funds are long base metals, but in our view their long exposure is not excessive in relation to fundamentals. Detailed data from the Commodity Futures Trading Commission on activity in the Comex copper market show new length is still well below the record highs of October
2003, representing only about 15% of its total interest, compared with a high of 44% in October 2003. This suggests to us that there is more room for speculators to buy.

— 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 or ingrid.sternby@barcap.com