Copper, nickel prices robust; zinc firm but hesitant

We expect base metal prices to continue to perform strongly over the near term, even though we have already seen multi-year highs. We also believe the rising price cycle will turn after this year.

In the analysis that follows, we offer an overview of copper, nickel and zinc markets.

Copper

The overhang of idled capacity has largely vanished in the copper market. Prices prices continue to rise and the general resumption of production will do little to ease tight concentrates availability as demand takes off and amid unexpected production problems at several major operations.

The loss of production at the world’s second-largest copper mine, Freeport-McMoRan Copper & Gold‘s (FCX-N) 780,000-tonne-per-year Grasberg mine in Indonesia, is more severe than most had feared, with production of 220,000 tonnes below previous estimates (at least) for 2004 confirmed.

The combined effect of technical problems at the 200,000-tonne-per-year Ok Tedi copper mine in New Guinea and a strike at the 130,000-tonne-per-year Cerro Colorado mine in Chile means smelters (primarily Asian) will continue to starve for material. In addition, many of those are already suffering from appreciating exchange rates, and with contract treatment charges settled just above US$40 per tonne for 2004, almost half the world’s copper smelters are in the red.

The lower concentrate production increases the deficit we were forecasting for this year. On the other hand, the deficit has been offset, to an extent, by higher production at Phelps Dodge (PD-N), which finally announced the restart of idled capacity at the Sierrita, Bagdad, Continental and Ojos del Salado mines. That combined production should add 110,000 tonnes this year and about 66,000 tonnes in 2005. As most of this material is being consumed within the organization, the concentrates market will not start to ease until mid-year, when new material emerges from CVRD‘s (RIO-N) Sossego mine in Brazil (the only major new copper mine this year) and when BHP Billiton‘s (BHP-N) Escondida mine in Chile ramps up to full capacity of 1.25 million tonnes per year. Although the Chilean mine, the world’s largest, is expected to produce at full capacity this year, we estimate output will fall short of target (perhaps by 100,000 tonnes) amid technical problems).

On the demand side, soaring Chinese net imports in December 2003 (+52%, year over year, to 138,000 tonnes) confirmed that country’s position as the world’s largest copper consumer, with 1.3 million tonnes imported in 2003. And in the U.S., the Copper & Brass Servicenter Association reported copper shipments rose a hefty 30%, year over year, in December 2003, and by 4.6% for 2003 as a whole, suggesting the re-stocking phase is now under way.

In light of these dynamic supply-and-demand developments, we note two features of copper trading:

— first, London Metal Exchange (LME) open interest has fallen along with rising prices, suggesting a combination of short-covering against physical deliveries that has more than offset long liquidation by technically driven funds;

— and second, a parallel shift higher in the forward price curve suggests the consumer has been the dominant force (hedging forward and pushing forward prices higher), while the absence of any significant producer selling has helped ease the steepness of the backwardation.

Exchange rate moves explain this second pattern, for producers outside the U.S. dollar region have not seen similarly steep price gains in local currencies. This is partly why a reversal of the falling U.S. dollar will be important for helping decide the peak in metal prices.

Nickel

This relatively smaller contract on the LME has started the year in a extremely volatile fashion, following impressive price gains of 130% in 2003. The size of the market and the nature of trading activity during the past year are two factors behind these recent violent price swings, which caused an approximate 25% loss in value during two weeks alone in January.

The fundamental outlook for the nickel market remains strong, and nickel probably has the tightest supply side among all base metals against robust demand, mainly driven by imports to China. Chinese imports of nickel for its stainless steel business soared to 9,200 tonnes in December 2003 alone, leaving full-year imports at 70,200 tonnes, which is 110% more than in the previous year. However, the strong price performance last year and the speculative nature of the price rally could be cause for concern.

Reflecting trends in other base metals, there has been a sharp fall in LME open interest of late, which suggests that along with the recent price correction, fund length has been liquidated. Major technical support around US$14,000 per tonne has held well, the net speculative long is now much leaner, and fundamentals remain strong as well. Against this, we believe the upward price trend could resume. Indeed, current market conditions are similar to those detected during the last major price spike, in 1989, when prices surged to US$19,000 per tonne. At that time, when demand was strong, the U.S. dollar faced a period of major weakness, and there were two successive strike actions at Inco and Falconbridge.

A 3-month strike at Inco (N-T) last year resulted in 24,000 tonnes of lost production, and workers at the Sudbury division of Falconbridge (fl-t) recently went on strike following two months of talks. [Editor’s note: the strike ended shortly before presstime, with workers signing a new, 3-year labour deal.] Output of about 2,000 tonnes per month was affected. As nickel prices are trading around 14-year highs, the union’s bargaining position may have appeared superior at first glance. However, the appreciation of the Canadian dollar put the company in a less favourable cost position. According to industry consultant Brook Hunt, average nickel production cash costs rose by almost 30% last year, to US$3,770 per tonne (US$1.71 per lb.), partly because of the effects of exchange rates.

In the current strong price environment, and with low raw material availability, steel producers are increasingly shifting output to low-content nickel stainless steel production (200-series containing 1-4% nickel) from high grade (304-series with about 8% nickel content), which is helping restrict demand growth. Scrap availability has improved from low levels, and yet, despite higher output targets announced by Inco, we expect the nickel market to remain in a substantial deficit over the next year.

Zinc

Zinc prices have been firm, but hesitant, after gaining almost 30% in 2003. Higher prices have been fundamentally justified with an approximate 400,000 tonnes per year of refined capacity curtailed in response to tough operating conditions in 2003, while Chinese exports (which have dampened LME prices severely in recent years) eased on strong domestic demand and tight raw material availability. As these features will likely remain in favour of zinc, the market should register a deficit this year.

However, total reported inventories of zinc continue to rise, which suggests there is still plenty of material available, even if production falls short of demand this year. This could work against higher prices, though the eventual reversal of the rising inventory trend should trigger fresh investment money into this market on better demand prospects.

In light of this, the large nearby price contango points at limited urgency among consumers to secure metal for prompt delivery, while its forward curve is flat compared with the other base metals. The flat curve also reflects less eagerness among producers to hedge, for they believe they can achieve better prices at a later date. Comparing our own price forecasts with future prices, however, suggests that producers should start to consider locking-in forward sales at current prices, with front-end prices likely to rise more than prices far outside the curve as the curve moves into backwardation.

In February, negotiations over contract treatment and refining charges will be of key interest, while miners and smelters are still in disagreement about the outlook for global concentrate availability. The concentrates released from refined capacity closures in the Western World were quickly absorbed (primarily in China), and there is no major new mine capacity available this year, while concentrate stockpiles are low. Despite this, Teck Cominco (TEK-T) decided to shut its newly acquired Lennard Shelf mine until market conditions improve, reducing concentrates availability by about 60,000 tonnes per year.

We are skeptical about a potential revival of the 80,000-tonne-per-year Aljustrel mine in Portugal (idled since 1993), given its high production costs. EuroZinc Mining (EZM-V) had said it might restart the operation by 2005.

— 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 and ingrid.sternby@barcap.com

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