Base metals trend upward following copper production cuts

Base metals were in a strong position at the end of the report period Nov. 5-9. In a delayed reaction to cuts to copper production, prices across the whole base metals complex broke through stops in the late afternoon of Nov. 9. The upward move was fuelled by options-holders covering against negative gamma and by fund short-covering, pushing prices to their highest levels in several weeks. However, with the global economy still looking shaky, it’s doubtful that upward momentum will be sustained in the short term.

Copper production cuts by two of the world’s leading mining companies, BHP Billiton and Corporacion Nacional Cobre de Chile (Codelco), show a refreshing change of attitude to low prices. Traditionally, miners have tended to resort to high-grading their orebodies when prices fall, in order to reduce their unit costs and maintain revenue by keeping output high.

The practice has attracted criticism because not only does it contribute to lengthening price downturns; it also reduces the potential of the orebody itself, robbing shareholders of better returns when prices are high. This time, lower production is to be achieved by low-, as opposed to high-, grading, thus achieving lower output (which is better for the market), avoiding the social and financial costs associated with a mine closure (which is better for company and workers), and enabling an increase in production when prices have recovered (better for shareholders).

The recently announced copper cuts certainly improved 2002 supply projections and, along with recent reductions in interest rates, significantly increase the likelihood of better prices next year.

Given the scale of the copper production cuts, price action was initially disappointing during the report period, though the London Metal Exchange (LME) 3-month figure finally rallied to a peak of US$1,410 per tonne late on Nov. 9. There continues to be speculation over further cuts, this time by Grupo Mexico, but demand issues hold greater sway than supply at present, and we project a range of US$1,350-1,420 per tonne for the short term.

The cuts announced by BHP Billiton and Codelco are another step in the right direction and should help bring the copper market back into balance. At the Escondida mine, BHP is to slash 80,000 tonnes per year by mining lower-grade ore, while, at the Tintaya operation, 90,000 tonnes will be eliminated through the cessation of sulphide operations. Codelco is said to be contemplating an annual reduction of 100,000 tonnes, to be achieved by reducing ore grades at the Chuquicamata and El Salvador operations. Such an action would accelerate a tightening in the concentrates market.

Spot treatment and refining charges have already fallen below a combined US15 per lb. this year, suggesting that smelters and merchants are having increasing difficulty in sourcing concentrate. The concentrate market will likely be in deficit next year, and stocks may well fall to what could be their lowest levels ever. We expect this to filter through to cuts in metal production by the first and second quarters of 2002. Prior to the announcement, our global market balance projection for 2002 stood at a surplus of 165,000 tonnes (assuming growth of 3% in demand), but it is now showing a deficit of around 100,000 tonnes.

Aluminum prices continued to drift, with short-covering pushing up prices during the second half of the report period, ending at a peak of US$1,310 per tonne on Nov. 9. LME stocks have fallen almost 32,000 tonnes since their peak of 729,000 tonnes in mid-August, the fastest rate of decline of any LME metal. In the short term, US$1,310-1,320 per tonne is likely to provide strong resistance, while US$1,255 per tonne should provide good support.

Prices for zinc picked up sharply on Nov. 9, though the market was prodded into life by higher copper prices rather than any fresh news in the zinc market itself. LME 3-month prices broke through both 10- and 30-day moving averages at US$767 and US$777 per tonne, respectively, to end the week at US$780 per tonne. In the absence of any fresh news, we expect zinc prices to continue trading within their recent range of US$755-785 per tonne.

The recent cuts to zinc production have failed to impress the market. To the cuts of 350,000 tonnes per year announced in recent weeks can be added a substantial number of other cuts, made earlier this year and in 2000. In total, more than 800,000 tonnes of mine supply have been removed from the market over the past few years. In part, the lack of market reaction can be explained by the poor demand prospects that still face the industry. In addition, overproduction over the past three years has caused a substantial build-up in concentrate stocks, so that even though we expect a big concentrates deficit next year, inventory should remain high.

Nonetheless, there are signs zinc metal production is under pressure in China. According to an official at China’s second-largest smelter, Zhouzhou, stricter government control of small mining operations could result in a 200,000-tonne reduction in output in 2002. This, in turn, could trigger a fall in zinc production to 1.8 million tonnes in 2002 from 2 million tonnes this year.

Against the tide of rising stocks (up 660 tonnes, to reach the highest level of the year so far), nickel prices performed strongly, closing on Nov. 9 at the highest level since mid-October. Higher stocks were not the only hurdle prices had to overcome; an initially slow response by the metals complex in the face of large and unexpected production cuts has highlighted the fact that supply-side developments have difficulty deflecting market preoccupation with demand-side data. The deterioration in industrial fundamentals over recent months was reflected in the 50-basis-point rate cuts by the Fed and the European Central Bank; the cuts in copper and zinc reflected the risk current prices pose for producers, whereas the cuts to our eurozone growth forecasts reflect the deterioration in medium expectations. How long will it be before cuts are applied to the nickel market and production scaled back?

While production cuts in copper, aluminum and zinc have all received attention, the impact of low prices has not been widely addressed in the nickel market. The most important cut so far has been that of Sumitomo Metal Mining, which has vowed to slash up to 5000 tonnes of production between now and March 2002 in response to poor Japanese electronics markets. Rezh, the Russian nickel plant that produced 2,945 tonnes of nickel in the first half of 2001, is to remain closed until prices improve. Are others likely to follow suit? With the U.S. dollar still strong, production costs in local currencies remain artificially low despite price weakness, and with no sign of the greenback weakening, cuts may have to be prompted by further falls in price.

The short-covering rally on Nov. 9 does not reflect a more confident market but rather the extent to which speculative funds have become the main price-drivers during times of low volume and low consumption. Unless it proves sustainable, however, such price behaviour may serve only to postpone further price falls, and we are not, therefore, ruling out the risk further cuts to output.

Gold prices are still struggling to find a role in the post-Sept. 11 environment. This was clearly illustrated during the report period, with prices moving in a malaise of US$278-280 per oz. in markets characterized by low volumes, low volatility and low interest rates. The subsequent fall, toward the end of the report period, to 2-week lows has, for the short term at least, confirmed the lack of fund appetite above US$280 per oz. Furthermore, physical interest has also remained slight. In the weeks immediately following the attacks, consumers, cautious of more volatile price ranges at higher levels, entered the market toward and below US$280 per oz., as this was seen as good buying territory. With the upside risks to gold prices now severely diminished, will consumers still enter the market as buyers at these levels, or will gold, as a commodity, be regarded as overpriced at these levels?

Recently, the head of AngloGold remarked that gold should not be seen as a safe haven, valuable only in times of abstract insecurity and disaster. This view was contained within an overall opinion that it is only through concerted marketing of gold as a consumer good that prices can find a reliable source of support. This view, expressed by the world’s dominant producer, carries important implications for the industry and the price mechanism.

We know, for example, that after Sept. 11, funds have not changed their investment patterns; they have continued to ignore gold, and even funds active in the gold market built up only a small net long position on Comex, which has been at constant risk of liquidation. On Nov. 8, we saw the result of these risks. Without an attempt to restore the damage inflicted upon gold’s reputation, the downside risk to the price increases as funds either liquidate or avoid bullion entirely. Relying solely on consumers at a time of falling consumer confidence and changing trends (note the increases in demand for platinum jewelry), is a risky business indeed.

— The opinions presented are solely the author’s and do not necessarily represent those of the Barclays group.