Better fundamentals prop up base metals prices

So far in the second quarter, base metals have turned in a disappointing performance. But although the prospects for a concerted recovery in prices over the second half of the year are tentative at best, there are signs that fundamental conditions are improving. The London Metal Exchange (LME) index, though currently trading around 3.5% below its first-quarter highs, has nonetheless gained more than 2.5% since its trough in mid-to-late May. Copper led the way during the report period May 27-31, and after a strong close at the end of the week, just below its peak for 2002 (to date) of $1,670 per tonne, fresh gains look possible.

Anecdotal evidence of improvement in demand from both metals producers and consumers remains patchy, and prospects for some important end-use markets even look a little shaky. Those markets that are exposed to high-tech sectors in the Far East appear to be the most positive. Order levels from the U.S. automotive sector are also good. On a worrisome note, however, there are reports that orders for copper building wire and plumbing tube from the American construction sector are slowing. Nonetheless, U.S. leading indicators for metals demand still look good, and we remain positive about the prospects for the U.S. economy. Indeed, recent data, notably factory orders and the Chicago Purchasing Managers’ Index, both of which were better than expected, are supportive of our view. What remains somewhat puzzling is the weakness of the U.S. dollar: we see its current malaise as temporary and expect a rebound as evidence mounts that growth is taking off. Its weakness has come at the right time for metals markets, however, eating into the profitability of many non-U.S. copper and zinc smelters, thus helping to hasten the process by which mine production cuts feed through to the metals markets. The stronger euro and yen should also encourage consumer restocking. However, local currency prices may need to fall a little farther before this process gets under way, and in any case, it’s unlikely to happen before the summer holiday season, when many fabricators take extended shutdowns.

Copper‘s mid-week move into a higher trading range looked more convincing as the report period wore on, culminating in a strong close on short-covering after better-than-expected data from the U.S.

The catalyst for the move higher was BHP-Billiton’s announcement of an 80,000-tonne-per-year extension to its production cuts at the huge Escondida mine in northern Chile. Hard ore and problems related to the concentrator have been causing Escondida to produce at well below previous target levels.

The mine’s problems have already contributed to a significant tightening in concentrate availability in 2002. However, this has yet to bite decisively into metal supply. Trade data for the world’s two largest importers of copper concentrates, China and Japan, show that, in the first quarter, imports were stable (compared with year-earlier levels). Global copper production is likely to fall during the second and third quarters — a process that should be aided at the margins by the weaker greenback, which is contributing to the erosion of profitability at many non-U.S. smelters. However, with the giant Escondida phase-4 expansion due to start in September, raw material availability will be accelerating and supply will once again become a negative factor for the red metal.

Aluminum prices finally broke out of their 6-week downtrend as the rise in copper sparked off large volumes of fund short-covering. However, with the uptrend in LME stocks signifying that the market still remains in substantial oversupply, the prospects for significantly higher prices over the next few weeks or so do not look bright. From both a technical and fundamental perspective, the US$1,400-per-tonne level looks a difficult one to hurdle in the short term, and if US$1,380 per tonne fails to hold, a resumption of the downtrend may not be far off.

Nickel‘s strong close on May 31 belies the fact that near-term supply issues have eased. Recent price movements underline the trading range for nickel over the short term, which seems likely to remain at US$6,400-6,800 per tonne. Short-covering ahead of the long U.K. weekend pushed prices above this level on the Friday of May 31, though we expect the move toward US$7,000 per tonne to be short-lived.

Although the outlook for most of the year continues to look encouraging for nickel, there remain short-term difficulties which may limit price prospects beyond short-covering. These difficulties are illustrated by inventory increases in LME warehouses. Although nickel stocks remain low, prices are now in an environment of rising stocks. LME stocks rose by 2,070 tonnes during the period under review — a proportionately hefty rise considering total LME inventories are still below 30,000 tonnes. While this environment remains in place, resistance between US$6,800 and US$7,000 per tonne may be difficult to break in any way that could be sustainable.

The zinc market failed to be impressed by the recent announcement from China’s Zhuzhou smelter of a cut in production of 50,000 tonnes. The US$785-per-tonne level proved an insurmountable barrier, and with producer-selling still lingering above the market, the prospect for any major short-term improvement in prices still looks extremely limited (notwithstanding a late rally on May 31).

Some tentative signs of an improvement in market fundamentals may be beginning to emerge, though the impact is likely to be severely diluted if Outokumpu announces the reopening of its 200,000-tonne-per-year Tara mine, as we expect. Official figures show that China’s zinc output fell by 70,000 tonnes in the first quarter (minus 10%). The fall is due to a lack of concentrate availability at local smelters, a result of last year’s mine production cuts. Taking into account Zhuzhou’s cutback, production is likely to continue falling in the coming months, but consumption should continue to rise. So far this year, China’s zinc exports have held up close to last year’s levels, but we believe that, because of the slip in production, this has been achieved by a significant rundown in stocks, which began sometime in late-2001.

Reports, from some Asian consumers, that China’s exports have fallen below contracted levels in recent weeks suggest that excess inventory has now been worked off. If so, a sharper-than-expected drop in exports is probable.

It was clearly another week of strong trading for gold, with prices reaching the highest morning fix (on May 31) since mid-October 1997. Over the short term, prices still appear to remain on the upside. However, news of Placer Dome’s unsolicited bid for Australian producer AurionGold, at the start of the week, is a reminder of why this gold price rally is really taking place.

Based on comments made and commitments given in financial reports, we estimate that producers intend to cut the amount of hedged positions by 3.5 million oz. in the second quarter. For 2002, producers have also committed themselves to continuing the policy of hedge reduction on a quarterly basis. As a result, commitments made by producers to cut hedged positions this year represent a total of about 10.4 million oz. This figure is based on data available from the world’s largest gold producers and accounts for around two-thirds of the gold mining industry’s committed forward sales program. Extrapolating the figures to account for all gold producers increases the figure to 15.7 million oz. However, we doubt that the same corporate drivers are affecting the smaller gold producers, which will probably mean that their hedge portfolios will remain largely unchanged.

If producers are to be responsible for an extra 350 tonnes of demand this year, why do we not expect this to improve the demand-side fundamentals of the gold market? The answer is found in the latest set of consumer demand indicators from Gold Fields Mineral Services (GFMS) and the World Gold Council. These show that gold consumers are in a process of withdrawal as high prices eat
into demand. Take last year’s figures, for example: GFMS calculates that producer purchases added 150 tonnes to gold consumption. However, higher gold prices in both U.S.-dollar and local-currency terms, combined with lower consumer confidence, stripped overall demand by more than 100 tonnes, compared with the previous year. Fabrication of gold fell by 249 tonnes. Using the latest consumption data from the World Gold Council, the impact of higher gold prices is equally clear. Demand during the first quarter was down by 125 tonnes, led by a 40% decline in Indian demand, gold’s largest single market. Anecdotal evidence from consumer markets continues to suggest that, given recent gold price increases, the physical market has all but evaporated. And given the relationship between high prices and low demand, the latest Indian gold price developments suggest that demand is set to remain on a weak course this year.

Forecasting gold consumption can at best produce only an indicative figure. The conditions by which the level of demand is determined, however, are a little clearer. Indian demand is set to remain weak — in fact, we may have only yet seen the start of the reversal of the strong growth in Indian consumption that took place in the late 1990s. Jewelry consumption only fell by 0.8% in 2001, year over year, with jewelry fabrication falling by a similar magnitude. However, it should be remembered that until the end of 2001, gold prices were comfortably below US$280 per oz. The impact on Indian demand once prices climbed above US$300 per oz. and began their steady ascent to US$330 was clear in the the first-quarter consumption figures from the World Gold Council. Even this steep decline leaves demand at historically high levels, and it can therefore be assumed that India will continue to lead global physical consumption of gold lower in 2002. If hostilities between India and Pakistan escalate, gold consumption could be driven lower.

The current gold price rally is not indicative of a market which has found its footing. The arithmetic suggests that every extra tonnege of demand from producers delivering into hedges leads to a corresponding reduction in demand from consumers. Gold prices are riding on a micro-economic bubble which is at risk of bursting. They reflect producer manoeuvres and are far from safe at current levels. When the sums are done, the net change in fundamentals could amount to zero and the return toward US$290-300 per oz. could be no more than a burst away.

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