Strong year ahead for base metals

We expect all base metal prices to register double-digit growth from the last quarter of 2003 to the expected peak during 2004.

We have made new upward revisions to our base metal price forecasts (+15% aggregate) from our already fairly upbeat assumptions for 2004, and modest upgrades (+0.7%) to 2005 prices (see table on page 14). On an aggregate basis, we expect further gains of 37% this year, compared with a 17% rise in industrial metal prices last year, which would mark the strongest year for base metals since the late 1980s. We expect nickel and copper to be the best performers, supported by their exceptional fundamental strength.

Our view of a rising base metal price trend has not changed over the past couple of years. We also maintain our view that 2004 will represent the peak in the current cycle — producing the third and last leg higher in the current commodity price cycle, where physical business improves and where investment funds eventually exit the markets ahead of the cyclical downturn. We now see the first half of 2004 yielding stronger prices than the second half, though the second half will still be strong in a historical context.

Base metal market fundamentals are strong. Supply constraints are an important supportive feature resulting from under-investment in new projects in recent years, pressure from high non-U.S.-dollar production costs and from unexpected external events such as accidents (at the Grasberg copper mine, for example) and strikes (such as the ones looming at Falconbridge and Highland Valley). Overall supply will fail to meet growing demand this year, and the markets are moving deeper into deficit (or toward deficit in the case of aluminum). Rising physical premiums, falling inventories and tight scrap and concentrate markets are all firm evidence of base metal market strength.

While we believe that future demand improvements are already partly priced in, it is also our view that noncommercial (speculative) activity is not particularly extensive in relation to the strong price environment. London Metal Exchange (LME) open interest for all base metals has diverged from recent upward price trends, which we believe is the result of two factors: short LME positions being covered against physical deliveries to consumers who are re-stocking, and some systematic (Commodity Trading Advisor fund) profit-taking after a strong performance in 2003. The net long fund copper position on the Comex is not particularly large in relation to prices either, representing only about 60% of the all-time net long (recorded during the fourth quarter of 2003).

On the foundation of a strong fundamental platform, macro trends will continue to play a key role in guiding the direction of industrial metal prices. In this report, we summarize our assumptions.

— Currencies — The direction of the U.S. dollar will be crucial for future metal price performance, with the strong negative correlation between the two firmly intact. Our foreign-exchange strategists foresee further dollar weakness during the first half of 2004 but predict that the trend will reverse during the second half of the year. Our metal price forecasts are partly based on this assumption, and we emphasize that if the U.S. dollar continues to depreciate against key metal-consuming and -producing currencies beyond this period, the upward metal price trend may extend.

— Interest rates — The accommodative monetary (and fiscal) policy in the U.S. has played a key role in boosting metal-intensive manufacturing activity during the second half of 2003, and the combination of strong new orders and low consumer inventories continues to paint a strong picture for metal demand in 2004. Of central importance to metal prices will be the investment community’s reaction when the Federal Reserve starts raising interest rates. Our view is that the Fed Funds rate will start rising from 45-year lows of 1% by mid-year, which could well be taken as a signal to liquidate long metal positions.

— China — It is not a mere coincidence that base metals prices have surged higher since mid-2001, while Chinese exports and imports have grown three-fold over the same period. It is common for analysis of China’s impact on the commodities markets to concentrate on either its massive growth in exports, which is driven by both global demand for manufactured products and the relocation of production facilities to China, or on its surge in imports, which is fuelled by China’s thirst for raw materials and, generally, large-scale or higher value-added manufactured or consumer goods. However, we highlight that both sides of Chinese trade are hugely important for the commodities market. Given our forecast for strong global growth in 2004, we would expect the marked upward trend in Chinese exports and imports to continue this year and that this will again be a major positive influence for metal prices.

Forward price curves

— Aluminum — The prospects for the aluminum supply-and-demand balance are improving as capacity expansion plans are being postponed in China and as a high energy price environment in other geographical regions is likely to mute strong output growth going forward. In the meantime, tightness in the raw material market and strong spot alumina prices are supporting the upward trend in primary prices. Our initial technical price target of US$1,562 per tonne has now been surpassed, but we believe the upward trend will continue to see aluminum as an attractive investment. It has been an underperformer in this cycle, and it is the most liquid contract on the LME. Comparing our price forecasts with the forward curve also makes aluminum attractive for a consumer, while the producer could await higher numbers before selling forward.

— Copper — The key technical target for copper of US$2,400 per tonne is being tested, but we believe the current uptrend will be sustained beyond this level, helped by market specific strength (such as supply constraints) and a favourable evolution of macro trends (such as U.S.-dollar weakness). Because of its Comex and Shanghai contracts, copper is particularly attractive to the investment community, and as a result, the negative correlation with the U.S. dollar strengthened during the second half of 2003. Despite hefty drawdowns, copper inventories remain fairly sizable still; this is reflected in the small nearby backwardation, which is unusual in such a strong price environment. Producer selling activity has been limited as a result of the rising price environment, while consumers have been supporting prices in recent weeks when technically driven funds have taken some profits.

— Lead — The whole lead forward curve has shifted sharply higher over the past months, but, judging from our price forecasts, there is further upside potential for prices. Consequently, we recommend consumers take advantage of current attractive forward prices. But as prices are nearing their peaks this year, producers should also consider selling at least part of their production forward.

We expect the global lead market to register a deficit this year. However, supply will likely exceed demand again next year; hence prices should retrace beyond 2004.

— Nickel — The nickel forward curve was in full backwardation for most of 2003 and looks set to remain “backwardated” over the foreseeable future, owing to extreme supply tightness in a rising demand environment (driven by China). Inventories are being drawn down quickly, and as a strike action is looming at Falconbridge’s operation in Sudbury, Ont., upside price pressure is likely to persist at least during the first half of this year. Trading activity early this year has proved volatile, and because of extensive fund length and generally illiquid market conditions, price volatility is likely to persist.

— Tin — The shape of the tin forward curve has changed little over the past few months, whereas all forward prices have moved sharply higher over the same period. Rapidly rising prices are in line with a tighter marketplace as demand is picking up and as supply is constrained by the Indonesian export ban of raw materials. Our view is that consumers should take advantage of current forward prices, which are still below the price levels we anticipate.

— Zinc — Zinc forward price spreads have started to tighten over the past month as producers have finally started to hedge some of their production. Still, the zinc forward curve remains less steep than for some other base metals, and forward prices are still below our projections for the same period, which would suggest that consumers should take advantage of current forward prices and replenish their inventories as leading demand indicators also indicate that new orders are set to rise.

— 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 or ingrid.sternby@barcap.com