Metals prices continued to move in lock step with equity market indices for the time being. This is not the usual picture in the early stages of an economic upturn. Weak equity markets have not hampered strong recoveries in base metals markets in the past. In fact, a big fall in share values has often been the precursor to big gains in commodities prices. However, fears that current share-price weakness will feed through into a much poorer economic performance over the next 12 months are discouraging the kind of speculative buying that has tended to fuel the early stages of a bull market and that, during the report period, saw a massive withdrawal of speculative money from base metals as hedge funds and commodity trading advisors reversed their bets.
One bright spot that has come to light in volatile metals markets is an impressive volume of consumer buying. This provided a floor for prices and now holds out the prospect of better times. Consumer buying has been notable by its absence so far this year, despite the slide in the dollar against the currencies of many major consuming countries. However, several producers reported their busiest days in recent memory during the report period, as the price slide prompted a big increase in forward buying. This indicates that consumers’ own order levels are continuing to recover from last year’s big drop, holding out hope for a significant improvement in demand as the market picks up seasonally in the fourth quarter.
After the collapse in copper prices during the July 22-26 period, the market is expected to pause for breath. It’s now clear that the move up to the June peak at US$1,720 per tonne was mainly a result of fund buying and took London Metal Exchange 3-month prices to a level right at the top end of that justified by fundamentals.
The good news is that the week’s sell-off has cleared the speculative froth, pushing prices back down to a level where, if anything, they are slightly undervalued. Funds are now probably net short in aggregate, though sharp moves higher in price look improbable until it becomes clear that equity markets have bottomed. For the time being, we think it unlikely that LME 3-month prices will break above US$1,600 per tonne, though support at US$1,500 per tonne should hold.
In releasing their second-quarter results, most copper companies were downbeat about prospects for the second half.
Outokumpu said that although it had seen reasonable demand for its copper products in Europe, demand in the U.S. had been more sluggish than expected. Strong demand for automotive radiator strip was a highlight of the first half of the year, but demand is not expected to pick up significantly in the second half.
Phelps Dodge says Asian demand proved stronger than expected but that demand in Europe and the U.S. had slowed. The company forecasts a growth rate of 2% for the year. Rio Tinto was slightly stronger, at 2.5%. Growth in demand at this sort of level, when superimposed on our supply forecasts, would leave the market in surplus by more than 200,000 tonnes this year.
Our own forecast is for demand growth of around 4.5%. With supply constrained by shortages of raw materials, the market could well move into substantial deficit in the second half of the year, though this is unlikely to become apparent until fabricators return to work in September.
After dipping to within US$40 per tonne of its November 2001 low, the LME 3-month aluminum price staged a mild recovery over the second half of the report period as euro-based buying helped steady the market. However, as production continues to accelerate, the fundamental justification for higher prices is fading, even if demand does continue to pick up.
In any case, the below-expectations dip in U.S. durable goods orders for June raises concern over the demand outlook. It adds weight to the sharp fall in June Aluminum Association orders data — one that we and others had viewed with suspicion.
The decline in durable goods (minus 3.8%, month over month) was much smaller than the decline in Aluminum Association orders (20%, month over month). However, the fall in the former was widely spread between several different categories and does suggest underlying weakness in a broad range of important end-use sectors for aluminum.
In the short term, forward-buying interest should continue to lend support at the US$1,300-per-tonne level, but the prospect of LME 3-month prices getting back above US$1,350 per tonne appears to be slim.
Meanwhile, recently released data paint a picture of accelerating aluminum supply. Figures from the International Aluminum Institute show production in June climbing at its fastest rate since February 2000, at 3.4% year over year, boosted by restarts in North America (plus 4.9%, year over year) and South America (plus 14.2%, year over year) as power shortages ease. Global supply is growing even more rapidly, having increasing by 5.3% in June. Furthermore, China’s exports of primary aluminum soared in June, climbing to 45,000 tonnes. That’s almost double the monthly average for the year so far, which is 23,000 tonnes.
Nickel has not failed to live up to its volatile reputation: in the space of just two weeks, prices fell from a high of more than US$7,700 per tonne to a low of almost US$6,400.
In line with the rest of the LME complex, the unwinding of fund positions has placed large downward pressures on prices, weakening the technical position of prices and removing the positive sentiment that had developed in the market. Although this positive sentiment was, in large part, overdone, it can be argued that aspects of it were based on a sound interpretation of nickel’s improved fundamentals.
An over-reaction to the start of labour talks at Inco’s Thompson, Man., division propelled prices to the high US$7,000s, and this cannot be considered to have been rational.
However, other aspects of nickel’s current position suggest that prices over the report period represent short-term lows, enabling nickel to stabilize above US$6,600 per tonne and return to a less-oversold range of US$6,600-6,800 per tonne in the immediate term.
Parts of the improved story in nickel’s outlook have been a feature of price determination for several weeks now, and we have covered them in previous reports. Stocks have remained low and on a steady downtrend, and cancelled warrants have continued to indicate that this will remain a feature of physical conditions for the foreseeable future. The latest figures from the International Nickel Study Group have also painted the market’s supply and demand indicators in a more positive light, pointing toward a balanced market for the year as a whole.
Fresh encouraging indicators came in the form of AvestaPolarit’s interim financial report for the second quarter. The stainless steel producers reported a 29% increase in profits, year over year, and an even stronger quarter-over-quarter increase (37%), all of which indicates improved conditions in the market. The report notes that stainless steel supply-demand fundamentals remained in balance in the second quarter and that inventory levels have returned to normal levels. Couple these developments with the tighter scrap market in nickel, and downside risks should begin to ease.
After giving up all of its recent gains during the report period, zinc prices appear unlikely to experience a rebound, even if the demand environment improves and conditions get better for the rest of the base metals complex.
Prices are now back at close to the lows of last November (US$750 per tonne), and they will need to fall further still before the kind of production cuts that are required to restore balance to the market are made.
In the short term, the market appears to have established a floor at around US$765 per tonne, and there is limited upside to around US$800 per tonne. In the medium term, a move down to below US$750 per tonne is required.
What looks like a rather cynical attempt to talk the market higher was made when a group of Chinese zinc producers announced that they would joi
ntly reduce metal production in 2002 by more than 200,000 tonnes. However, the cuts announced by Zhuzhou (50,000 tonnes), Huludao (130,000 tonnes), Zhongjin (10,000 tonnes) and Baiyin (20,000 tonnes) had already been announced — Zhuzhou’s in May and Huludao’s as long ago as last July. It is not surprising, then, that what amounted to little more than a reiteration of actions already taken fell on deaf ears. Indeed, these cuts are one of the major reasons why Chinese zinc exports have been trending down for some time now. The fall of 8% in second-quarter exports was the sixth one in the past eight quarters, and we expect further declines over the second half of the year as small Chinese smelters continue to get squeezed by a lack of concentrate availability and as China’s own zinc demand continues to grow.
Despite the recovery from the lows of the week in the key equity indices and the U.S. dollar, gold prices delivered the largest week-over-week fall since the start of the bull run last year. The fall on July 26 to under US$305 per oz. was a bleak testament to the price’s failure to absorb capital flows that exited equities and other U.S.-dollar-denominated assets.
Regular readers of this column will know that we have maintained a steady and skeptical view of gold’s price developments and the reasons behind them. Even using rough calculations of gold market size and the liquidity this affords participants provides some explanation of why gold prices have failed to benefit from weakness in the U.S. dollar and in equities. We have consistently argued that the processes that determine gold prices are more a function of micro- than macro-economic factors in the contemporary trading environment. In light of the fact that gold-price momentum failed to take hold, we now expect the micro-economic factors to return to the forefront.
With the second-quarter financial reporting season under way, it will be interesting to see whether the commitments made by producers to restructure hedged positions were honoured in the first half of this year. The micro factors drove gold above US$300 per oz. If these are perceived to have weakened, we expect to see a further weakening of gold’s position above US$300 per oz.
Clearly, the gold market has been experiencing a large level of fund liquidation, which has pushed prices toward a test of the last remaining support areas above US$300 per oz. However, the level of outward capital flows needed to cause such a move is negligible compared with the capital movements we have recently seen in equity markets.
Based on Comex data and the two leading U.S. equity indices, we calculate that before the recent sharp fall in gold prices, the level of buying in gold had been around 3,500 times smaller than the corresponding level of selling in the Dow Jones Industrial Average and the S&P 500 combined. The failure to react to the weakening macro-economic environment was clearly a bearish development for prices, but, in our opinion, the speculative buying seen in recent weeks in gold was not really based on the naive expectation that a weaker Dow/S&P 500 would result in corresponding gains in gold prices.
We believe that much of the speculative buying that has taken place in gold harks back to the process of consolidation and hedge-book reassessments during the first half of 2002. The gold price rise, and its recent fall, has gone hand-in-hand with the action in the gold equities markets. Second-quarter financials should shed light on whether hedge reductions in practice have met the rhetoric of six months ago. If producers have reduced hedged exposure and issued buybacks, the timing will be crucial.
The Bank of England came under pressure for selling gold at lower than current prices. If producers have bought back hedged positions at higher than current prices, the discontent that many have experienced in corporate America in recent weeks may spread to gold equities and gold-price sentiment.
— The opinions presented are the author’s 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 author at kevin.norrish@barcap.com
July 22-26 at a Glance
r Copper price risk to the downside is limited now that large fund positions have been liquidated. With the market entering its quiet holiday period, sideways trading in a US$1,500-1,600-per-tonne range looks likely.
r Aluminum supply continues to grow rapidly, outpacing demand growth and suggesting that any recovery from the report period’s lows will be sluggish.
r Prospects for nickel prices look good if stainless steel volumes continue to pick up. AvestaPolarit expects a resumption to the uptrend in volumes to resume in the fourth quarter.
r Zinc prices appear to be heading lower after some big falls during the week. Prices are still too high to encourage the kind of production cuts that are required to balance the market.
r Gold prices fell sharply, seriously undermining the view that the yellow metal has acted as a safe-haven investment during recent equity market weakness.
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