Leading indicators bleak for base metals

Assuming that the ISM is a leading indicator of IP and base metal prices, the prospects for an improving economic environment (hence rising metal demand) and stronger metal prices from current levels seem bleak in the short run. The ISM has fallen sharply in recent months and it was flat in August at 50.5. While the August figure was discouraging (albeit still reflecting expansion as it remained above the critical 50-level), the new orders component fell below 50. There is a strong correlation between that specific component and the total index, with the new orders component leading the total index marginally. This suggests that manufacturing activity is likely to remain weak over the coming months, which would also, in our view, disable a near-term recovery in base metal prices. Some of this pessimism, we feel, has already been priced in.

Recent key events in the copper market include announcements of refined production cutbacks in China, in light of concentrate shortages and the prospects for improving demand following the latest economic data releases. Starting with those, we think copper demand is likely to remain weak in the near term, as a result of its good correlation with industrial production. We think the consequent few poor quarters of end-use demand coming up for copper will most likely result in a continuing weak price environment in the near term. Not until there are convincing signs of improving demand will we see renewed speculative interest, which we believe will be the force behind the next rally.

On the supply side, the gathering of ten copper producers in China, which cut output by 120,000 tonnes this year, failed to impress market participants. Although the meeting was conceived with the best of intentions and has possibly been helpful for sentiment, evidence that these cutbacks have been implemented will be required before any real bearing on market impact becomes evident. However, importantly, this development is a further encouraging sign of the effects of a tight concentrates market, which has been compounded by shipment problems at the Ok Tedi mine due to drought. So far the lack of deliveries from Ok Tedi has had no apparent negative impact on refined production. The mine experiences similar problems almost every year; the worst one was 1997-98. Our understanding is that the current situation is by no means as bad as that year, although treatment and refining charges could contract further. The bottom line is that the supply side in the copper market remains constrained, but this won’t have a material positive impact on prices unless demand improves.

Aluminum prices have held up relatively well over the past week, especially when compared with copper. While copper fell out of its recent trading range, aluminum remained above the key support of US$1,295 per tonne. While fundamentally not very attractive in our view, recent buying support seems to ride on the back of a combination of factors.

Firstly, European physical premiums have risen to one-year highs, with end-users apparently having some difficulties in sourcing material for prompt delivery. Secondly, there is some nervousness that a potential war in the Middle East could disturb production or shipments of aluminum in that region, which represents about 7% of total western world production. However, we think any such fears are overdone, as the impact on economic growth in the event of a war would most likely outweigh the chances of supply disruptions. During the Gulf War at the beginning of the 1990s, aluminum was the only base metal to spike temporarily, and later fall sharply — for exactly these reasons, we believe.

From a medium-term perspective, the outlook for aluminum end-use demand looks superior to that of copper. In fact, aluminum demand has greater exposure to key markets (the U.S.) than copper, and when U.S. economic growth picks up, we believe aluminum demand will be among the first to recover. In 2001, the U.S. accounted for almost 30% of western world aluminum demand, and only about 22% of western world copper demand. While demand factors tend to be the key price driving force, the extensive aluminum supply overhang due to capacity expansions and large stockpiles is likely to cap the upside.

Nickel has maintained an overall positive tone over the past week, with its mild uptrend in place since mid-summer remaining intact. The International Nickel Study Group has released statistics for July over the past week. In July world consumption of refined nickel registered its tenth consecutive monthly year-over-year rise — of 6.7%, to 94,500 tonnes.

However, over the month, consumption fell by 2.7%. Refined production rose (+4.6%) compared with the prior-year period to 93,000 tonnes, but was lower than the previous month (-3.5%). As a result, the world nickel market was finely balanced in July (demand exceeded supply by 900 tonnes). World producer stocks were reduced by 100 tonnes to 92,700 tonnes over the month. Producer stockpiles are by far the most important category of total commercial stocks, representing about 75% of the total. However, producer stockpiles of nickel have not fluctuated much over the past few years, averaging 93,000 tonnes since the beginning of 2000.

With the stainless steel sector (which accounts for about 70% of total demand) having shown signs of improving during the first part of this year, we believe the July’s decline in demand primarily relates to the poor state of other end-use sectors of nickel. A higher stainless scrap utilization rate may also have had a negative impact. Nonetheless, we maintain our relatively favourable bias towards nickel, and believe downside price risk remains less severe than in the rest of the complex. With low stocks and a finely balanced market, the outcome of Inco’s Manitoba labour negotiations (scheduled for Sept. 15) takes on even greater significance.

Market-specific fundamental developments have been few for zinc over the past week, with prices trading mainly in line with the rest of the complex as a result. After a brief period of trading activity below US$770 per tonne, that level was again regained as other key base metals recovered at the end of the week.

In last week’s commentary we noted a sharp rise in European galvanized steel prices (usually well correlated with zinc prices) during the first half of this year. We acknowledge some upside risk to prices if supply-side factors improve. Currently suffering from oversupply and high stockpiles, improvements in demand will not be sufficient, although key, for prices to move higher. However, as with galvanized steel prices, encouraging signs are evident in data for physical spot premiums, with premiums in Singapore having shown a sharp rise this year. This has not been reflected in stock movements, with LME warehouses in Singapore well filled. In fact, that stockpile has risen without interruption throughout this year, representing the second-largest warehouse location (of 182,600 tonnes).

Therefore, the rise in premiums may reflect the fact that a lot of the visible stock is tied up in finance deals. Meanwhile, earlier this year, total commercial stockpiles of zinc moved above the million-tonne mark for the first time since 1996, highlighting the poor state of this market from a supply-side perspective.

The forces that have helped push gold prices upwards on an impressive trend since the second half of August continued to make themselves felt last week. Randgold Resources’ close out of 148,500 oz. of call options for 2004 followed on from Placer’s announcement on August 30 that it is to reduce the amount of its forward sales by 20% this year, keeping the positive hedge reduction story at the forefront of the market’s collective mind.

Tuesday’s fall in U.S. stock markets was the largest since the first week of trading following the Sept. 11 attacks and also provided some upward momentum. Perhaps the most significant factor in gold’s rise, however, was the growing war fever surrounding Iraq and the approaching Sept. 11 anniversary on Wednesday.
President Bush was to address the UN on Iraq the day after.

Given this combination of events, it is perhaps not surprising that few market participants would want to be short over the weekend.

However, the likelihood of gold’s rise being sustained is limited, even if war fears do continue to intensify next week. Market makers have learnt their lesson from the price spikes of the past few years and have taken the opportunity to cover options exposure, so that few are now short of gamma, reducing the need to cover aggressively if speculators pile in to take the market higher early next week. Even this scenario looks a little unlikely, because funds are now probably running sizeable net long positions after starting this week already slightly long, and the risk-to-reward ratio of buying more gold as it closes on its recent peak is not favourable.

One slightly puzzling aspect of Friday’s market action was that as gold strengthened, so too did the U.S. dollar, despite a week of unremittingly poor data. The moves reversed the strongly negative correlation that had existed between gold and the dollar in recent weeks. Our foreign exchange analysts argue that the dollar will be undermined by a war with Iraq and its recent gains will prove unsustainable as the risk premium on U.S. assets rises again. For slightly different reasons we feel gold’s recent strength is also unsustainable. The bulk of producer hedge buy-backs are behind us now and gold will soon need to rely again on physical demand. Assessing the sharp dip in imports by major Asian and European gold buyers so far this year, CRU estimates that gold demand from those countries could be down by as much as 8% for the full-year 2002, so prospects are not good.

— 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

In light of the latest Institute for Supply Management (ISM) survey, we have taken a closer look at the relationship between the U.S. manufacturing sector, broader industrial activity and base metal prices. The ISM was a good leading indicator of base metal prices during the 1990s. The ISM has also been leading industrial production, while industrial production and base metal prices have been fairly well correlated.

Sept. 2-6 At a Glance

– Copper: demand is likely to remain weak in the near term, while supply factors continue to improve.

– Aluminum: demand is likely to recover quicker than copper demand, due to its greater U.S. exposure.

– Nickel: demand weakness in July mainly reflects poor demand from other sectors than stainless steel.

– Zinc: high stockpiles remain a pressing factor, even if physical premiums have improved.

– Gold: environment remains positive, although the likelihood of gold’s rise continuing is limited.