Fund liquidation brings base metals to earth

Base metals prices suffered two waves of heavy fund liquidation during the report period May 29-June 2. The first came early, in response to the surprise settlement at Inco’s Sudbury, Ont., operations, where a strike had been widely expected. The second came late on June 2, as poorer-than-expected order data from U.S. factories sparked fears of a worsening outlook for metals demand. Many regarded the data as a sign that the U.S. economy is slowing and that, consequently, the Federal Reserve Board will be under less pressure to raise interest rates. Both the 10- and 30-year U.S. bonds climbed by more than a point as yields fell. Traditionally, when U.S. bond yields begin a cyclical downturn, metals prices fall as well. However, on the basis of just a few data releases, it is too early to tell whether the U.S. economy is approaching the peak of monetary tightening.

The sharp fall has left metals prices looking weak from a technical perspective, but good trade buying was seen from producers and consumers on June 2, suggesting that the markets may not be far from their lows and that a recovery could kick in this week.

Copper was hit by two waves of selling during the period under review — one in the first half of the week, as selling of nickel spread to other base metals, and another late on June 2, as the market reacted negatively to the big decline in U.S. factory orders. However, chances are good that the price will recover from the 1-month low, on June 2, of US$1,732 per tonne. Fundamentals are still strong, with London Metal Exchange (LME) stocks falling rapidly and cancelled warrants close to an all-time high. Equally positive is the fact that the recent liquidation has reduced fund long positions, which built up in May. After a period of consolidation in the low US$1,700s, we expect a move back to the US$1,800-per-tonne level.

LME stock withdrawals have continued, and, with cancelled warrants (CWs) still close to their all time-high of 91,000 tonnes, it looks as if there will be little let-up in the pace of shipments out of LME warehouses over the next month or so. CWs refer to material still in LME warehouses (and thus still part of the total reported stock figure) but which is due to be shipped out. LME data on CWs, which have been published since late 1997, are a good indication of how much metal is expected to leave the warehouses in the near future.

However, the current high level of CWs does not necessarily mean that the overall rate of stock decline will continue at its current pace, since, in terms of demand, the market is approaching its quiet summer period. We would expect the fall in exchange stocks to slow significantly over the next few weeks as deliveries to LME, Comex and Shanghai warehouses begin to offset withdrawals.

A move to a wider contango in nearby spreads in the past few weeks suggests that the pressure on those with short positions has eased. The cash-to-3-month spread has gone from a recent low of US$16 to US$24 currently.

Farther forward, however, spreads have continued to tighten with significant volumes of borrowing, particularly of the December-2000-to-December-2001 spread, which, during the report period, contracted to US$8 from US$20 per tonne.

Of all the base metals, aluminum suffered the least from the sharp decline in nickel prices early in the report period, though, given aluminum’s disappointing performance over recent months, this is not surprising. The LME 3-month price spent most of the week in a narrow range between US$1,460 and US$1,480 per tonne but closed poorly on June 2 at US$1,438. Current low price levels and a stronger Euro have spurred some consumer forward buying interest, though volumes remain low. In the short tem, prices need to hold at the US$1,430-to-US$1,440-per-tonne level in order to arrest the recent downtrend.

Nickel had a hugely volatile week following the surprising settlement between Inco and its workers in Sudbury. Knee-jerk liquidation and some fund short-selling drove prices down to a low of US$8,600 per tonne. Prices subsequently recovered strongly, supported by a widening of the cash-to-3-month backwardation, though by the end of June 2, they again came under further selling pressure. Aluminum eventually finished the report period at US$9,055 per tonne.

Further volatility should be expected, particularly in nearby spreads. The cash-to-3-month backwardation flared violently during the second half of the report period, at one stage trading at a high of more than US$500, and indications are strong that it may widen in the short term. Fund buying of June US$10,000 calls, combined with selling of June puts in the US$8,500-to-US$9,000 range, means that covering against these positions could exacerbate volatility ahead of options declaration on June 7.

Furthermore, the latest LME open interest report shows that there is a single position-holder in the 20-to-30% futures band with a notional position of 21,000 tonnes, compared with an LME stocks total of just 22,158 tonnes. These factors suggest that potential exists for a squeeze. If one does occur, there will be little relief for the shorts since, at present, there is no spare nickel to deliver to LME warehouses. Also, it is unlikely the LME will cry foul, because, from a fundamental perspective, the nickel market is clearly tight. Consequently, unless those holding warrants are prepared to lend to the market, we will almost certainly see the nearby spreads tighten further.

Zinc prices suffered during the report period, along with the rest of the base metals complex. June 30 saw the greatest fall, as prices slipped to a low of US$1,141 per tonne from a high of US$1,170, following the long liquidation at the start of the week in the face of the successful vote taken by Inco’s Sudbury workers. Like the other main metals, zinc took a back seat during trading that was largely dominated by events in the nickel market. In anticipation of an unsuccessful outcome in Sudbury, which could very well have resulted in further price hikes, speculative funds ditched long positions. The sell-off, which again hit all metals on the afternoon of June 2, dragged prices down to a disappointing US$1,109 per tonne — the lowest level in two months. Prices recovered some of their losses only slightly, to end the day in London at US$1,117 per tonne.

The fall in zinc prices resulted in the breaking of several key levels of technical support, as prices closed each day’s trading at consecutively lower levels. Prices should find some support in the range of US$1,120 per tonne, with the next support level coming in at US$1,100. Given the healthy fundamentals for the current zinc market, it is disappointing that prices have failed to fulfil any upside potential.

The directionless trading, which has been a strong theme of the gold market, was interrupted on the afternoon of June 2 in London when prices broke out of their tight US$272-to-$274-per oz. range. After looking lacklustre, prices jumped to a 1-month high in afternoon trading to reach a high for the day of US$282.5 per oz.

The rally followed the release of U.S. data showing that May unemployment had moved up to 4.1% from 3.9% in April and that average hourly earnings had edged up by just 0.1%. The news, indicating a slowing of the U.S. economy, was interpreted as a sign that any possible future hikes in U.S. interest rates would be muted.

The importance of the data for gold is, we believe, minimal, and the link between the short-term rally on June 2 and the timing of the release of the data is rather tenuous. The view taken on June 2 — that a weaker labour market lessens the pressure on the Fed to raise interest rates — would, according to the traditional view of the gold market, lead to higher prices (reflecting “safe-haven buying,” as investors move out of U.S. dollar-based-assets). However, we doubt that this theory holds up in today’s market; in any event, it is too early to say that the Fed is no longer inclined towards tightening.

The data triggered short-covering by a large fund with a short position rumoured to be around 1 million oz., and this brought in further short covering throughout the market. The effect was a surprise rally. Still, this does not change the overall view of gold which, at best, remains neutral to bearish.

News from the Swiss National Bank showed that since the start of its gold sales, on May 1, more than 24 tonnes had been sold. In the first tranche of the bank’s sales plan, 120 tonnes are to be sold before September. As we saw on June 2, rallies in the gold price face strong resistance on the upside, owing to the fact that selling and profit-taking place a firm cap on any upside potential. Therefore, we do not expect prices to make a serious bid for higher ground above their current levels.

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