Still too early for base metals

The outlook for base metals prices continues to be weighed down by the macro-economic environment, and recent comments from the Federal Open Market Committee (FOMC) did not provide any incentive for buying into base metal markets at this point in the cycle.

While short-run interest rates were kept unchanged, the easing bias remains in place. A cut does not look likely before the year-end, as the FOMC has stated that risk remains biased toward the downside.

Volatile equity markets and sideways-trading metal markets highlight the current uncertain environment, overshadowed by unusual negative circumstances such as risks of war and high oil prices — all of which will likely frustrate economic growth. Moreover, recent equity losses are expected to keep consumers (who account for two-thirds of the U.S. economy) depressed.

Developments in the manufacturing sector (the main focus of metal market participants) have been somewhat more positive, with activity in the U.S. expanding modestly. However, near-term prospects are relatively bleak, with expectations of muted data later this month, when the Chicago Purchasing Managers’ Index and the national manufacturers’ index of the Institute for Supply Management are due to be released.

A strong correlation exists between interest rates and base metal prices. Assuming that near-term economic data fail to impress, further pushing out the economic turning point, our view is that it is still too early to go long on base metals. However, given that speculators are already heavily short, any positive surprises or unexpected improvements could cause rapid reversals of the downtrends in base prices.

In the copper sector, key support levels for London Metal Exchange 3-month prices of US$1,465-1,470 per tonne came under pressure on Sept. 27.

However, we continue to view the downside for copper as relatively limited, since raw-materials markets remain extremely tight, constraining refined production growth, and exchange stocks are now drawing rapidly (combined, the LME, the Commodities Exchange of New York and the Shanghai Futures Exchange were down 25,400 tonnes during the report period). Economic data suggest there is risk of further slippage on the demand front, but, given the positive factors mentioned above, we anticipate good support from consumer and fund buying to emerge on any dips toward this year’s low of US$1,434 per tonne in January.

Another major supportive factor is China’s (at present) seemingly insatiable appetite for copper. Refined net imports so far this year are running at almost double last year’s levels, at more than 750,000 tonnes to August. At 154,000 tonnes, the August figure itself was the highest of the year so far. Chinese refined metal imports over the remainder of the year are likely to stay at extremely high levels and be supported by slower growth in local output.

The widening gap between China’s own mine output and its refined production suggests that the growth in Chinese refined production so far this year is unsustainable for much longer, given the high level of dependence on imported raw materials (mainly concentrate and scrap), which are in extremely limited supply at present.

Apparent consumption estimates for China suggest that demand is growing at around 20% so far this year, and we see no reason for this to slow substantially going into the fourth quarter. If, as we expect, local production contracts over the remainder of this year, there is every likelihood that strong Chinese demand for imported copper will continue over the rest of 2002.

Aluminum prices came under renewed pressure, pushing key support levels of US$1,290 per tonne as the FOMC predicted continually tough economic conditions ahead.

There was no halt to news reports of rising smelter production, and a sharp rise in Chinese exports of primary aluminum also dampened sentiment. According to the latest customs statistics, Chinese net exports totalled 238,000 tonnes during the first eight months of this year as a result of rising production in the region. Exports rose by 100.7% to 381,000 tonnes, while imports fell by 2.8% to 143,000 tonnes over the same period.

Meanwhile, the International Aluminum Institute reported that daily average production rates rose to their highest level since December 2000 at 58,300 tonnes per day in the IAI region (excluding China and Russia).

While we believe aluminum prices will improve in line with macroeconomic improvements, any rally is likely to be muted as a result of the oversupply situation.

The report period also saw the latest leading indicators on metal activity in the U.S. from the U.S. Geological Survey. The data suggest that recent growth in primary metals industry activity may slow in the next few months. The primary metals leading index decreased for the second consecutive month in August, and its 6-month, smoothed growth rate declined to 1% from a revised plus-3.2% in July. The primary aluminum mill products leading index decreased 0.7%, mainly because of sharp falls in average weekly hours in aluminum mills and the Purchasing Managers’ Index.

The declines were deep enough to offset rising sales of U.S. cars and light trucks. The fall in the leading indicator suggests continuous slow activity in downstream aluminum production and highlights the weak demand environment.

The 200-day moving average line finally gave way last week, leaving nickel prices to fall to their lowest levels since March this year. In hindsight, the fall should not come as too much of a surprise, though we had expected the US$6,600-per-tonne area to hold prices a little longer.

The weak LME complex, sharp equity falls and continued downgrading of demand prospects added to the pressures on nickel prices and led to the slide. However, with the 10-day moving average now below the 200-day for the first time since the start of 2002, the dip lower has weakened nickel’s technical picture, and unless substantial improvements occur to the broad demand environment in the fourth quarter (unlikely, given the state of current indicators), price targets for nickel may shift even lower. The next clear target on the downside is US$5,800-6,000 per tonne, where prices formed a trading range in the first quarter of this year. On the upside, the key target for nickel will be a return above the 200-day moving average.

In an otherwise thin news week for the nickel market, the decision by Russia’s Noril’sk to begin releasing quarterly production statistics of nickel and copper received much attention. On balance, this represents a positive move for the nickel market and its participants, increasing transparency and boosting the regular flow of key fundamental indicators.

The release of production data from 1996 (when the release of such statistics became illegal) delivered few surprises, showing production in 2001 increasing to 223,000 tonnes — a year-over-year rise of 2.8%. The release of production data is important given that the information allows for firmer estimates of stockpiled nickel. Based on these data, our estimates of a 60,000-tonne stock build in nickel over the past three years remain unchanged.

The immediate risk faced by LME zinc prices remains a re-test of the record lows reached in mid-August of around US$745 per tonne.

Despite a brief and mild recovery from the previous week’s lows of US$750 per tonne, zinc has shown that, even at these weak levels, it is not immune to sharp falls, as prices by the middle of the week had, at one point, shed US$20 per tonne. With the 10-day moving average now moving sharply lower, technical indicators favour additional price weakness as areas of initial price resistance also shift lower. In both the short and medium terms of course, it’s zinc’s fundamentals that remain the major handicap.

Although the latest Chinese export data reflect an attempt by Chinese refiners to rectify zinc’s fundamental imbalance, we suspect that the reduction seen in exports so far this year is insufficient to alter zinc’s price direction significantly.

After the previous week’s data showing falls in Chinese zinc production, figures for the report period showed the export volume also falling, to 44,057 tonnes (minus 2%, year over year), and 323,184 tonnes (minus 6.8%) for the January-to-August period. Although this leaves the 12-month moving average in Chinese zinc exports trending lower, the pace of fall required to put zinc prices on an upward pointing path has yet to be seen.

Uncertainties going into the weekend regarding the outcome of labour negotiations at Falconbridge’s Kidd Creek plant (140,000 tonnes per year) may keep immediate-term downside risks at bay, though supply news for zinc remains mixed.

London-based CRU International has reported irregularities in the reporting of U.S. Geological Survey zinc production data for the U.S., warning that previous data announcements are likely to have underestimated U.S. production by 30,000 to 35,000 tonnes per quarter since the start of 2001. Against these developments, the impact of lower Chinese exports is lessened even further.

Although gold ended the report period off its highs, the technical break earlier in the week above US$325 per oz. highlighted the extent to which prices are able to ignore weak fundamental data.

In the previous week, it was the World Gold Council that provided the weak data (regarding demand in the second quarter); in the period currently under review, it was Gold Fields Mineral Services, which released data covering the first half of 2002. The data showed world demand for gold falling by a sharp 15%, year over year, in the first half to an 8-year low of 1,537 tonnes. Jewelry fabrication fell by 17%, year over year, to 1,301 tonnes. The release of the data coincided with one of gold’s strongest performances for some weeks and the technically important move above US$325 per oz.

At first, this may at first seem strange, but it must be remembered that gold prices have rarely traded on their fundamentals this year, and despite the drift down toward the end of the week, we expect prices to continue bucking the trend of weak physical fundamentals — particularly if the weakness in the global equity market continues and meets some of the more bearish expectations that have emerged recently.

One of the key figures in the GFMS data was connected to the issue that, as we have consistently argued, has had the most impact on the gold price and gold market sentiment. The 232-tonne reduction in the level of producer hedging in the first half clearly reflects the extent to which producers have been active on the demand side of the gold market equation. GFMS itself has admitted that the issue of “unhedging” has had the biggest effect so far this year. With producers continuing to issue statements of ambitious hedge reduction programs, this is set to dominate the gold market for the next few months and into early 2003.

Furthermore, the decision by the Fed to leave U.S. rates at historically low levels and maintain an easing bias in comments following the recent FOMC meeting suggests that the financial incentive for producers to hedge is set to remain weak for some time, and it’s difficult to imagine the anti-hedging sentiment in the market dissipating in the short term.

The background to all of these developments also remains in place: equity markets continue to fall, the U.S. dollar is failing to recover ground against the euro, and corporate profit expectations remain uninspiring. Our latest in-house technical analysis of the Dow suggests that a fall towards 6,000 points is likely and that forecasts of even heavier losses below this level should not be thought of as alarmist. Clearly such weakness would increase gold price risks and could bring US$330 per oz. (possibly US$345 per oz.) into view.

As the GFMS has stated, however, the driving factor in gold prices this year has been producer-related hedge activity. However, it’s not clear that this key price determinant will continue to affect prices in the same way at this higher level.

— 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.

This is the last of Barclays Capital’s weekly metals reports. However, The Northern Miner intends to publish a monthly version, beginning later in October.

Sept. 23-27 at a Glance

– Copper prices were protected by a tighter raw materials market and strong Chinese demand.

– Aluminum prices remain weak as Chinese exports rise and U.S. demand indicators point lower.

– Prices for nickel slid to their lowest level since the first quarter of this year as key technical support gave way.

– Price risks for zinc continue to point toward a test of record lows.

– Gold prices trended higher despite additional data showing weak demand.