Base metals: targeting new highs (April 04, 2005)

Market conditions for base metals remain sufficiently favourable that upward price trends will stay intact and prices in the second quarter will test fresh highs. Higher prices will be driven by concerns over supply shortages, with critically low inventories being brought to market attention by robust global growth. As a result, we see a further 15% upside potential from current prices to our spot targets on an aggregate basis and expect nearby price spreads to widen.

We have made upward revisions to our base metals price forecasts for the period 2005-2007, of about 10% for each year (see accompanying table). From current price levels, we see the most upside potential in zinc, followed by copper and nickel. We have dropped aluminum as one of our preferred base metals after meeting upside targets from our previous forecast review, in December 2004. We believe aluminum is relatively closer to its justifiable peak level and see its supply constraints easing considerably beyond the second quarter with larger-than-expected shipments from China and the re-start of idled capacity in the U.S.

We expect prices to ease 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 inventories by the end of this year shall 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. The basics for upward revisions to our base metal price forecast revisions are several-fold:

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 have, in many parts of the world (the U.S. and China, for example), reduced their inventories to a minimum. Rising interest rates do not represent an immediate threat to metal demand, and we believe base metal prices and interest rates will maintain a positive relationship. Monetary policies remain accommodative, which will continue to produce rapid growth in spending, and the monetary tightening cycle has much further to run. In the U.S., capital spending continues to grow at double digit rates, with a positive outlook for this year, while new manufacturing orders also look supportive.

After a slowdown last year in economic growth-indicators of the Organization for Economic Co-operation & Development, those same indicators now show encouraging signs of picking up, which, combined with similar signs from China, represents a powerful combination for metals prices. In China, physical metals consumers have been discouraged to buy in the current high-price environment, as they are unable to pass on higher costs to their customers. This has caused drawdowns in consumer inventories, but we believe they may now be forced into the market despite prices remaining at high levels. There are early signs that buyers are gradually accepting prevailing prices, and after a rare contraction in Chinese copper semis production at the end of last year, downstream output growth shows signs of picking up again.

Supply constraints

While we have become more upbeat on near-term demand prospects, base metals supplies are looking surprisingly constrained going forward. We believe supply growth in both nickel and zinc, as well as copper, will be sufficient to offset deficit markets next year.

In copper, after a surge in mine supplies during 2004-2005, we expect current smelter constraints to alleviate, which should help reverse the decline in refined inventories. However, these are unlikely to be boosted sufficiently to prevent another push higher in prices in the first part of 2006, when copper mine supply is set to slow dramatically as a result of the lack of investment into new mine capacity in recent years. More recently, high prices have indeed sparked a wave of new investment in the mining sector. But rising production costs and other restrictions related to regulations and the environment mean the lead time is longer than ever, and more widespread metal supply additions cannot be expected 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 the base metals. Facilities are operating flat out, and this leaves the risk for disruptions substantial. This ties in with anecdotal evidence of difficulties in sourcing replacement parts and mining equipment, which is further threatening the performance at metal production plants.

Inventories to fall

In the current supply/demand environment, base metal inventories will continue to fall from levels that are already extremely low. Low inventories are the key basis for our expectation of sharp price spikes in the second quarter of this year. A prime example of this is the lead market, which has seen its total reported stockpile fall below its “critical” level, and consequently seen a sharp reaction in prices. Copper and nickel stocks are also particularly low, while aluminum and zinc have still some way to go.

Because of an increasingly tight supply side for zinc, coupled with strong demand from the galvanized steel sector, we believe zinc inventories are likely to reach critical levels by the end of the year, accompanied by higher prices. Aluminum availability, however, will be better (driven by Chinese production), and we believe aluminum will find relatively less price support from its inventory levels.

Strong investment appetite

Weakness of the U.S. dollar was a key supportive factor for base metals over the past year. Dollar depreciation encouraged consumer buying outside the U.S.-dollar region, while production outside the U.S. was also dampened by relatively higher production costs. The negative relationship between the U.S. dollar and metals prices has been enhanced by speculative trading activity by funds. Therefore, some metal price weakness on dollar strength is to be expected. However, given the strong fundamentals of today, we expect good buying support from both consumers and long-term investors on currency related price dips, which would provide solid underlying price floors for the 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, the dollar may find support only when the U.S. yield curve has flattened out. There are signs that the quality of U.S. current account financing is improving, but so far this points to some mitigation of the negatives for the U.S. dollar, rather than any striking positive. They expect the euro-U.S.-dollar exchange rate largely to hold around current levels (1.30) over the coming year, and they also predict further dollar weakness against the Japanese yen. This scenario, overall, is supportive for base metals. The other key currency-related issue has to do with the Chinese Yuan peg. In short, we regard appreciation as a mild positive for the base metals prices.

Arguably, much of the positive impact on base metal prices from currencies is now behind us. So far this year, aluminum has shown the strongest negative correlation with the euro/greenback exchange rate among the base metals, while the influence on zi
nc has been the weakest. Should the dollar strengthen over the nearer term, this would support our relative base metal preference based on metal fundamentals, which favours zinc, while we are less positive on aluminum at current prices.

Investment funds are long on base metals, but 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 net length is still well below record highs of October 2003, representing 30% of its total interest, compared with a high of 44%. This suggests there is more room for speculators to buy, especially after recent profit-taking driven by a broad-based selloff in commodity markets.

— 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 ingrid.sternby@barcap.com,kevin.norrish@barcap.com and kamal.naqvi@barcap.com