Short covering flatters to deceive

Aug. 12-16 at a Glance

– Copper prices remain more cushioned on the downside, owing to a shortage of raw materials, but a test of the January low of US$1,434 per tonne is still likely in the current environment.

– Aluminum is still threatened by further weakness despite the brief rally that occurred during the report period. The latest data releases highlight the absence of a demand-led recovery and indicate the increasing risk of a move below US$1,100 per tonne.

– Nickel prices have held on to most of their gains since the start of the year, though a big jump in Russian exports could undermine their stability.

– Zinc has registered a fresh record low on the London Metal Exchange (LME), and over the coming weeks, we expect prices to move farther into uncharted territory.

– Gold has remained stable in a thin and quiet market, but we continue to question claims of renewed investor interest. The latest data from the London Bullion Market Association show a big drop in July volumes.

The latest short-covering rally in base metals prices has served only to highlight the sector’s poor sentiment and weak fundamentals.

The disappointing deterioration in economic fundamentals so far in the third quarter, particularly in U.S. indicators, is a reminder that despite the ripples commodity trading advisors and speculative funds can cause in a thin trading environment, the direction of metals prices continues to be governed more by demand fundamentals than by the momentum of short-covering funds.

Although supply-side factors offer support to some metals, they remain overshadowed by demand concerns and continued uncertainty over the pace of economic recovery. The focus for most in these markets now is the price nadir of last November, and the question is whether or not we are set to return to those low levels once again.

Some markets are more at risk than others. The key to determining which are most vulnerable lies in supply factors. The capacity overhang in aluminum suggests that a return to November 2001 levels cannot be ruled out and that prices could move even lower thereafter. In zinc, the reluctance of producers to cut production has already led to LME prices registering fresh all-time lows. Copper and nickel look more secure. However, the brevity of the report period’s late rallies highlights the weakness faced on the supply side by some of these markets and on the demand side by all of them. With expectations for U.S. data again turning toward the downside, we expect price risks for the LME complex to remain pointing in a similar direction.

In copper markets, the immediate prospect for a test of US$1,434 per tonne (the LME 3-month low from January this year) appeared to recede as fund short-covering, spurred by some slightly-better-than-expected U.S. industrial production and capacity utilization data, pushed prices back above the 2-week-old US$1,510-per-tonne resistance level. However, from a technical perspective copper’s gains never looked terribly secure, representing little more than fund profit-taking. The market remains extremely vulnerable to poor U.S. economic data, though it should get some respite in the immediate term, when no major data releases are scheduled.

From a fundamental perspective, copper still appears to be one of the healthier LME metals, thanks to the extreme tightness in raw materials markets, which is holding back refined production growth. Other positives for copper include the continued high level of Chinese imports, the steady draw in visible stocks (exchange stocks fell 11,400 tonnes during the report period), and the strength of demand for brass mill products from the Asian high-tech sector.

Ranged against these, however, is a formidable list of negatives. The wire and cable sector (representing more than 70% of copper demand) remains depressed in most regions, with the weak telecommunications sector seriously hampering recovery prospects. Moreover, Escondida Phase IV will be on-stream soon, easing concentrate availability. Lastly, there is little sign yet of the expected contraction in Chinese refined production — growth in July accelerated 16.5%, year over year. Although the downside for price remains limited, the above factors suggest that LME 3-month prices will struggle to get back above US$1,600 per tonne in the short term.

Although aluminum prices surged sharply higher late in the week, hitting a 12-day peak of US$1,333 per tonne, the major data releases continued to paint a sharply deteriorating fundamental picture. Barring a substantial turnaround in demand prospects, LME 3-month prices appear destined to return below US$1,300 per tonne in what we now expect to be a steady descent to last November’s lows of US$1,255 per tonne. Price direction will then depend on the extent of producer response to what appears to be a dramatic buildup of overcapacity worldwide. The risk is growing that prices will need to dip below US$1,100 per tonne, even in a fairly optimistic growth scenario, in order for this overcapacity to be trimmed back.

Deterioration in orders reported by the U.S. Aluminum Association continues to cast a shadow over the possibility of any second-half recovery in aluminum demand. July data showed that orders contracted further after their big fall in June and were flat on last year’s extremely depressed levels.

While demand prospects look shaky, primary supply is still growing rapidly. China’s July output level reached 363,000 tonnes as growth accelerated to almost 29%, year over year — faster than the average rate of growth of 26% registered for the first seven months.

The growing imbalance between supply and demand is being reflected in an extremely rapid upward trend in visible stocks, with a relentless climb in LME inventory more than offsetting recent declines in International Aluminum Institute producer stocks and Japanese port stocks. Since the recent trough in November 2000, reported inventory of primary has risen by 700,000 tonnes and there appears little likelihood of a slowdown any time soon.

Risks of a test of US$6,400 per tonne in nickel markets have eased. The commodity trading advisors/fund short-covering rally that occurred earlier in August was sufficient to push prices a little higher. However, in a holiday market characterized by thin volumes and low turnover, such a price move is not surprising and offers few suggestions as to where prices will move over the short-to-medium term.

Right now, nickel is perhaps the most difficult to predict of all the LME metals. Its fundamentals are contradictory, and while price behaviour this year has been broadly positive (LME 3-month prices have risen about 20% since the start of the year), this solid performance has left prices exposed to downside risks should the economic climate turn even more sour later in the second half. Any price gains right now are likely to be based on short-covering alone, and consequently brief. However, providing the outlook for the fourth quarter and 2003 improves, the balance for nickel continues to favour the upside.

Although it remains sluggish and sporadic, demand is improving. Stainless steel production is estimated to have increased by 4.5%, year over year, in the Western World during the first half of 2002, largely thanks to the 7.5% increase in Europe.

The latest data from the International Nickel Study Group shows demand for nickel rising almost 7% in the first half, and although production is up almost 4% during the period, growth in output has been lower. However, the jump in Russian exports may act as a check on prices. Total exports in the first half were up more than 100% at 162,100 tonnes, while Noril’sk’s exports from Russia reached 108,700 tonnes. Noril’sk added that these figures did not include the 60,000 tonnes tied up as part of the collateral of its international bank loan earlier this year.

Assuming the rest of the exports of nickel from the Commonwealth of Independent States were similar to 2001 (around 20,000 tonnes), this implies that Noril’sk has already exported around 33,000 tonnes of
its physical collateral for storage in the Netherlands. Even stripping out the collateral material, Russian exports therefore increased by an estimated 68% in the first half — sufficient, in a nascent recovery, to cap price prospects.

Zinc prices recovered dramatically from recent all-time lows as LME 3-month figures spiked US$30 per tonne higher on fund short-covering. However, by Friday the rally was crumbling, and we expect that before too long prices will once again be back in uncharted territory.

Within the next few weeks, much of the 60,000 tonnes per year of Western smelting capacity that has been temporarily off-lined for extended summer maintenance will be coming back on-stream. Even with this capacity off-line, LME stocks have remained at high levels, down just 3,100 tonnes from their peak of almost 649,000 tonnes in early August. With demand still only growing slowly, the market is likely to swing back into substantial surplus and LME inventory will resume its upward trend. We expect LME prices to move below US$700 per tonne over the next few weeks unless substantial and permanent Western smelter cutbacks are announced soon.

So far, Chinese producers have made the bulk of what few smelter cuts there have been in zinc. State statistics show China’s zinc metal production falling 7.4%, year over year, in the first seven months of 2002 to 1.1 million tonnes. However, recent data suggest the downtrend may be slowing. July production was 155,000 tonnes, only 3,600 tonnes less than the average monthly total so far this year. Lower Chinese production has contributed to a slower growth rate in global output so far this year, but the trend remains gradually upward.

The latest figures from the International Lead and Zinc Study Group show that total production of refined zinc rose 1.6% in the first six months of the year but that consumption contracted 1.1%.

Although the lull in activity over the past few days in the gold market has left prices positioned above the support level of US$312 per oz., bulls can draw some comfort from the relative stability they have found at this higher level given the strengthening seen in the Dow Jones.

The key factor that led to the latest move is renewed producer-based activity, which continues to make us view the US$300-plus-per-oz. gold price with some skepticism. Looking for gold price catalysts beyond the current US$316-per-oz. ceiling and beyond producer hedge activity still requires a leap of faith in gold’s investment fundamentals — a leap we’re reluctant to make.

We note that in the period since the last time the Dow traded at its current 8,800-point level, gold prices have averaged US$312 per oz. Based on the London morning fix, this is unchanged since the second quarter’s average of US$312 per oz. Such a muted reaction on gold’s part to an investment period that has been characterized by almost unprecedented uncertainty is disappointing, to say the least.

Gold market turnover data continue to paint a familiar picture for the yellow metal. Readers should not be surprised we are skeptical of the weak investment environment/stronger gold price argument, considering that the lowest Dow Jones reading (on July 11) since the 1990s coincides with a fall in London Bullion Market Association turnover. The number of gold ounces transferred in July fell by more than 17%, month over month, reducing turnover to half the levels seen five years ago. Average open interest on Comex was also down on the previous month.

It is difficult to reconcile this decline in the gold market’s activity with claims that turbulence in the investment sector is renewing interest in gold’s investment opportunities. Even if the kind of activity measured by Comex and the London Bullion Market Association were to have increased significantly, there is a problem associated with linking this to a long-term change in the gold price.

As with any commodity, investor interest in the “paper,” futures-based market can act as a price rudder on a day-to-day basis. However, the principal currents of price direction, over a prolonged period of time, are formed by the fundamentals — not the option to buy at a predetermined time. When investor interest in gold is considered, it should be remembered that the investor interest that can have most impact on price developments is the kind that affects physical demand.

Yet using the most readily available data series on physical investments in bullion is not encouraging. Sales figures from the Rand Refinery in South Africa show first-half sales of the Krugerrand reaching 25,000 oz. Sales figures from the U.S. Mint show sales of 1-oz. gold coin reaching 20,000 oz. in August and 109,000 oz. for the January-to-August period. Compare this to producer hedge activity and it is possible to see why we continue to view gold’s micro-economic factors exerting a greater influence on price. Estimations on the extent of producer buybacks so far this year are in the region of 10 million oz.

As we stated in the previous week’s commentary, there would appear to be emerging a hole in gold’s consumption outlook. Recent company reports have revealed the degree to which producers have continued to be active on the buy side of the market during the first half of 2002. The next quantitative gold demand figures are not due to be released until next month. When the World Gold Demand figures are released for the second quarter, they will probably show that consumer interest in gold has suffered from the producer activity of recent months.

But consumer interest aside, the key failure of gold prices recently has been their ability to attract levels of investor interest in the face of the weakening investor sentiment in other mainstream instruments. While producers remain active on the buy side of the gold market, price risks will remain on the upside. However, as the second half progresses, we expect producer hedge restructuring to exert a far less invasive influence in the price determination process, and, rather than altering our fundamental view of the medium-to-long-term outlook for the gold market, we continue to expect a drift away from current levels over the course of the second half.

— 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