Base metals surprisingly buoyant as new year begins

Against most expectations, including our own, base metals have opened the year in buoyant mood. Early in the report period Jan. 7-11, they sparked sharply higher in response to fresh buying by commodity trading advisors and short-covering by brokers. Nickel continued its volatile trading pattern and emerged as the biggest gainer, with average cash prices rising almost 8% as nearby tightness intensified.

Despite the early strength, metals prices were looking fragile by Friday, Jan. 11, particularly aluminum and copper, which closed at important support levels. The late weakness illustrates the key problem with recent gains: they have been achieved almost solely on the back of speculative buying, with no consumer participation whatsoever. Unless industrial buyers emerge to maintain upward momentum, prices are likely to fall back quickly.

There were some persuasive signs of an upturn in the global economy, as U.S. jobless figures and falling business inventories supported the recent upturn in key indicators. European business and consumer confidence surveys were also better than expected. However, important parts of the metals-consuming industrial sector remained downbeat, notably the U.S. auto sector. Despite heralding a better outlook for 2002, General Motors forecast that total U.S. car sales will fall by about 10% in 2002 (though production is expected to decrease by only 4%, owing the low stock levels), adding that, in Europe, it expects a 5% decline in sales. Under such conditions, it’s unlikely consumers will take up the running for some time, leaving little to stop prices from drifting back down to end-of-December levels.

After closing weakly on Jan. 11, just above the key 20-day moving average at US$1,538 per tonne, copper appeared fragile, and a test of US$1,500 per tonne seemed imminent. Earlier in the week, London Metal Exchange (LME) 3-month prices hit a 6-week high of US$1,575 per tonne, pushed up by fresh fund-buying and broker short-covering. Consumers were notable by their absence, and fundamentals continued to deteriorate — a trend that was evident in another 17,000-tonne increase in exchange stocks, which pushed the total to a fresh all-time high of 1.1 million tonnes. As if further proof of copper’s oversupply were needed, the International Copper Study Group predicted a surplus of 434,000 tonnes in the global balance for the first 10 months of 2001.

But the upturn in copper prices owes more to hope than reality. Prices are trading at the top end of their fundamentally justified range, and the only buyers have been technical funds. Business sentiment and leading economic indicators are improving, and it is these factors, plus the simple weight of funds, that have pushed U.S. equities higher over the past few months. The market appears to be responding to the improvement in leading indicators and betting heavily on big falls in LME inventory over the next few months. However, unless consumers make a quick return to both paper and physical markets soon, this looks unlikely.

Movements in the aluminum were similar to those of copper: a bright start followed by steady declines to finish at key support just below the US$1,400-per-tonne level. At highs of around US$1,466 per tonne, small clips of producer selling were noted, suggesting aluminum may be hard-pressed to climb above this level on any upward moves. Nearby spreads remain tight, with the focus on the March-to-May period. Exchange stocks continued to climb (plus 19,000 tonnes), though the impact was softened by a steady downtrend in producer stocks. In the short term, we expect the focus to return to the downside, with key support pegged at US$1,375-1,380 per tonne, the location of the 10- and 30-day moving averages.

Zinc prices hit their highest level since August 2001, reaching a peak of US$860 per tonne. This represents a US$100-per-tonne increase in LME 3-month prices from the lows of mid-December 2001, with no fundamental developments to support the rise. On this basis, we expect the focus to return to the downside soon, particularly after the report period’s 34,400-tonne increase in LME stocks, which emphasized just how much excess zinc stock there is around at present. Once fund buying and broker short-covering draw to a close, prices will likely fall back again, with the first line of support at US$820 per tonne.

Recent developments in China suggest that there could be significantly lower exports of zinc to Western markets in 2002. In 2001, China’s zinc exports are estimated to have been close to the previous two years’ levels, at around 520,000 tonnes. Domestic mine production fell sharply in the second half of the year, after around 300,000 tonnes of mine production capacity were closed in the Guangxi and Shanxi provinces following a mining accident. Some of these mines may restart (as early as mid-2002, according to a local research company), but even so, lower domestic mine production looks likely in the current year. Add to this the difficulty that Chinese smelters may have in sourcing import requirements after recent mine production cuts, plus the likelihood of strong growth in China’s own zinc demand, and there appears to be a strong chance of a decline in exports this year.

Despite nickel‘s strength during the first full trading week of the year, we do not expect the gains to be sustainable. Moreover, we believe that, particularly during the first quarter, nickel will only find reliable support at lower price levels. As with all the base metals, nickel remains devoid of activity by producers and by consumers. In a market characterized by lack of liquidity, prices have been exposed to the technical actions of smaller speculative funds. The sudden price moves that such exposure can bring have been exaggerated by the thinness of trading conditions. This has been visible in the rapid increases in the cash-to-3-month backwardation, which flared out to more than US$270 per tonne during the middle of the report period. However, once the technically driven price rises have run out of steam, they will likely be unable to build on their gains.

The outlook for the next year in nickel prices looks less encouraging than it does for aluminum and copper. On both the supply and the demand side, nickel is set to remain handicapped over the next 12 months. Despite a construction sector that has remained strong throughout the downturn, nickel consumption shows little sign of improving while nascent signs of economic recovery from the U.S. remain premature. On the supply side, production cuts have so far been small, while Russian exports (from January to November 2001) show the decline that has taken place. However, the fall in Russian exports simply increases the risks of stock piling and is ultimately, therefore, a bearish policy.

The delayed reaction in gold prices to silver’s meteoric increase is typical of recent trading patterns in gold that have been characterized by thin markets and price sluggishness. Although the price increase to US$288 per oz. was impressive, given the expected strength of resistance at US$281 per oz., it has been slow in happening and has not been followed by additional buying by the funds.

The real focus in the gold market is still on the battle for control of Normandy Mining, and we associate much of the increase during the second half of the report period with competitive bidding by the companies involved. Although initial momentum was provided by fund short covering and the triggering of buy stops, we suspect that much of the second wave of buying can be closely linked to the current merger plans. Although the latter source of momentum may have influenced the outcome of the Jan. 16 Bank of England auction, we expect both sources of buying to be short-lived, particularly if, as expected, the spike in silver prices also proves temporary.

The real strength of the silver market will be assessed when the current tightness in lease rates eases. The massive jump in the 1-month lease rates in recent weeks clearly reflects increasing tight conditions in
the borrowing market, bringing many reminders of the Buffet-driven spike of 1998. The question regarding fundamental strength is, To what extent can prices avoid a sudden and rapid fall once the tightening in the borrowing market eases and lease rates fall?. Our opinion is that current supply-demand fundamentals will be unable to prevent such a fall, and we expect a test of US$4.20 per oz. before the end of the second quarter.

Where does this leave gold prices? Ahead of the penultimate Bank of England auction, they looked vulnerable. Meanwhile, the U.S. dollar looks strong and funds have been reticent buyers, and as soon as silver’s tightness ends, gold should look even more vulnerable.

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