Copper market poised to benefit from stronger demand

This article, the second of two instalments devoted to base metals, was culled from Barclays Capital’s monthly report The Commodity Refiner. Part 1 appeared in our Oct 14-20 issue.

Macroeconomic-driven demand developments will play a key role in directing base metal prices, while market specific features, primarily related to supply, will decide the extent of any price moves. Base metal prices are at a critical point in the cycle, trading close to key support levels on an aggregate basis.

Copper

The copper market is well-positioned to take advantage of improving demand conditions once the macroeconomic environment improves. This is due to its constrained supply side, resulting from price-related output cutbacks at the end of last year.

As macroeconomic factors remain biased toward the downside, short-selling has taken the upper hand. However, with speculators heavily short, we believe positive price reaction could be forceful in the event of any positive fundamental news.

Last year’s mine production cutbacks have caused a tight raw-material market. Low treatment and refining charges and a shortage of scrap are affecting smelters, with production declines seen in China. Consequently, import volumes are being pushed up further.

Chinese net refined imports amounted to 750,000 tonnes during the January-to-August period, with the August figure alone representing a record high at 154,000 tonnes. Apparent consumption estimates for China suggest that demand has been growing at around 20% so far this year, and we see no reason for this to slow substantially going into the fourth quarter. As a result, we expect Chinese net imports of about 940,000 tonnes this year, offsetting net exports from Russia.

Apart from the improvement registered in China, demand growth has, of late, been disappointing for the copper market. The outlook in the U.S. is uncertain: Demand for copper has suffered from a weak telecommunications sector, which has resulted in a decline in wire rod production of 7.5%, year over year, during the first half of 2002. At the same time, however, brass mill product demand has benefited from resilient auto and construction sectors.

We expect Western World demand to recover by a modest 1.5% this year (after the sharp 9.2% slide in 2001, enhanced by de-stocking) and to be followed by a couple of years of stronger demand growth (plus 4.5%).

The restart of any price-related idled capacity represents a key threat to improvement in the copper market. Although we believe BHP Billiton is keen to maintain its position as a leader of producer discipline, we do not think it likely that state-owned Corporacion Nacional del Cobre de Chile (Codelco) will be as market-conscious. Nonetheless, the Escondida Phase IV expansion is now in startup phase, and Freeport-McMoRan Copper & Gold’s Grasberg mine is raising output substantially after low output in the first half of 2002. In short, we expect global refined production to increase to 15.8 million tonnes in 2003 (plus 5%), following this year’s estimated decline (minus 2.3%).

q Outlook for prices — The speculative net short position in the Comex copper market increased further at the end of September to 20,608 lots, according to the latest available data, putting further pressure on prices.

The dominant reason for the increase was the rise in the number of short positions, which increased by another 5,204 lots in the last week of September. In contrast to recent times, some market participants also established fresh long positions (1,293 lots).

With copper speculators on Comex heavily short, we believe there is considerable scope for a short-covering rally once the economic outlook and demand conditions improve. As a result, any positive fundamental developments could cause a sharp and rapid reversal of the current downtrend in prices.

As with most of base metal markets (bar nickel), the whole forward curve is currently trading in a contango, reflecting good metal availability for all future dates.

Five-year forward contracts were traded for the first time on Oct. 1, attracting only a little business during the first few trading days. Meanwhile, prices for cash and all forward dates are trading at a lower level than the past couple of months. We believe current prices and the slope of the forward curve provide a good opportunity for consumers to lock in favourable forward prices.

Apart from Singapore, physical spot premiums in major copper producing regions have remained flat over the past month. Any improvements (or lack of decline in a soft demand environment) are the result of producer buying.

The potential for supply problems due to a possible strike at Kennecott has done little to spot premiums. Also, steady recovery in Asian demand has helped push premiums in Singapore sharply higher.

Following the decline evident in London Metal Exchange (LME) copper stocks during the second quarter, the total level has stabilized at around 870,000 tonnes.

U.S. stockpiles continue to represent the largest share by far, accounting for about 70% of the total. However, the U.S. has also seen inventory levels come down the most, with net outflows at Baltimore amounting to a little more than 10,000 tonnes during September.

Even if the total LME copper stockpile (as well as total commercial copper inventories) is at an all-time high, we think the start of a declining trend would have a positive impact on sentiment, enabling a price rise even if the stock surplus persists.

Declines in LME inventories have coincided with a sharp fall in cancelled LME copper warrants. Cancelled warrants have fallen from a peak of 89,000 tonnes (or 9.2% of the total) in mid-May, with about 30,000 tonnes (or 3.7% of the remaining total) now awaiting outward delivery. The level of cancelled warrants is still relatively higher than earlier this year, when the LME copper stockpile was growing.

In contrast to some other base metal markets, exchange stockpiles account for most of reported copper stockpiles, and so their decline is encouraging. Total commercial copper stocks stood at 2.3 million tonnes at the end of June, according to the latest available statistics. This is lower than the previous month (54,300 tonnes, or 2.3%) but sharply higher than a year ago (plus 794,000 tonnes, or 53.5%).

Meanwhile, of total exchange stocks, approximately 25% are held on Comex and 12% in Shanghai. While the Shanghai Futures Exchange’s stockpiles have been shrinking in recent times (by 30,000 tonnes to 161,700 tonnes during September), Comex stocks have risen marginally to 344,000 tonnes over the same period. We believe drawdowns in Shanghai reflect strong domestic demand.

The stock-to-consumption ratio has risen sharply, according to the International Copper Study Group, to 10 weeks at the end of the second quarter from 6.4 weeks a year earlier.

Aluminum

Despite prospects of improving demand, coupled with our view that prices will move higher once there are convincing signs that the economy is improving, any upside in aluminum is likely to be muted as a result of the large supply surplus.

Recent trading action has been relatively quiet, keeping prices in a narrow range, with short sellers occurring at the higher end of the range (US$1,320 per tonne), while light consumer buying has supported the lower end (US$1,290 per tonne). Aggressive selling of aluminum equities has highlighted market concerns of weak demand and surpluses; mining equities tend to lead metal prices.

China’s ability to produce and ship metal to the Western World is the largest threat to the outlook for aluminum. During the first eight months of this year, Chinese net exports amounted to 238,000 tonnes. Together with Russian exports, net trade from the former Eastern Bloc countries is likely to exceed 3 milliont tonnes this year, accounting for 17% of Western supply. Our predictions are based on the assumption that alumina will be available for aggressive Chinese expansion plans, and we expect China to remain a significant net exporter over the coming three years, enhancing the global surplus.

Production is also rising elsewhere: The International Aluminum Institute (IAI) reports that in August the daily operating rate rose to its highest level since December 2000, at 58,300 tonnes. Golden Northwest announced it would restart one of the three pot-lines at its Goldendale smelter in mid-September by purchasing power from the market rather than from the Bonneville Power Administration in the northwestern U.S., raising yearly output to 50,000 from only 12,000 tonnes.

Meanwhile, some concern has been expressed over capacity in the Gulf region (which represents about 6% of total Western capacity), owing to political tension. During the previous Gulf War, aluminum prices temporarily spiked, only to fall back on macroeconomic implications. We believe the impact of a war would be negative for the aluminum market outlook. In summary, we expect continued robust production growth over the next couple of years.

Aluminum order data remain weak. While improvements in the U.S. Aluminum Association’s index for aluminum mill product orders were evident in August, the index nonetheless fell 5.5%, year over year. The 3-month moving average is still pointing at a downward trend, and, given the volatile nature of this data series, it is still too early to say demand has bottomed. However, given aluminum demand’s relatively large exposure to the U.S. market, in comparison with other base metal markets, we think it will benefit from rising global economic growth, which should be led by the U.S.

The latest figures from Japan are encouraging: The Aluminum Association reported a 5.1% year-over-year rise in July, following 18 consecutive monthly year-over-year declines. Therefore, following heavy de-stocking last year, which caused a 7.1% decline in total Western aluminum demand, we expect a 2.1% rise this year, helped by a degree of restocking.

q Outlook for prices — Three-month aluminum prices received some support during September, trading marginally higher than in August (plus 0.5%), though the September average (of US$1,318 per tonne) was still 3.6% lower than in the year-earlier period. Pressure remains on the downside in the near term.

The average alumina spot price in September was US$138 per tonne (f.o.b.), or only 10.5% of the 3-month aluminum price. Australian alumina prices have fallen about US$5 per tonne (or 3.5%) over the past month in the absence of any significant spot-buying interest from China. While near-term direction of alumina prices will largely depend on Chinese demand, we’re confident they will be supported on the downside given the aggressive production plans at Chinese primary aluminum smelters.

Five-year forward contracts were traded for the first time on Oct. 1, attracting little business during the first few trading days. The whole forward curve remains in contango, with prices for all future dates trading at lower levels than previous months.

The level of cash prices compared with forward prices suggests the market believes there is sufficient aluminum available for prompt delivery, and also for all future forward contracts. Given prevailing low prices historically, we regard current price levels as a good opportunity to lock in forwards for consumers.

Physical aluminum spot premiums have been firming in Japan and Europe. While underlying demand remains soft, the rise of European premiums is attributed to the fact that consumers are returning from summer breaks, which is causing inventories to be rebuilt. Meanwhile, with exchange warehouses well-filled, we believe firmer premiums also reflect financing deals at LME warehouses.

In Japan, term premia for fourth-quarter delivery was set at US$60-65 per tonne, at the lower end of the expected range, reflecting continuous poor underlying demand. Prospects for a sharp fall in demand from the U.S. for Japanese manufactured goods are cause for concern.

Premiums in the U.S. have been volatile over the past couple of years, balanced between weak demand and metal shortage in the region during the power crisis. Lately, however, premiums have headed downwards, as demand has remained soft.

Sharp rises in LME aluminum stockpiles earlier in the year eased during September, and the net change over the month showed a decline of 6,500 tonnes, with the total registered at 1.3 million tonnes (the highest since February 1995).

European warehouses maintain their role as a major location for stockpiled metal, holding about 80% of the total. Sweden is a particularly convenient location for Russian produced material, the other prime location being the United Kingdom.

Meanwhile, Asia’s share of the total has risen (to 20% from 10%), owing to continuous deliveries into Singapore. Still, North American LME warehouses contain an insignificant amount of aluminum, despite being a key aluminum-consuming region.

Cancelled LME aluminum warrants have been rising since June this year, in line with net inflows slowing. The relatively high level of cancelled warrants (at 92,000 tonnes, or 7.1% of the total remaining LME aluminum stockpile) suggests there is a significant amount of metal waiting to be delivered, which may further halt the rising inventory trend.

Despite the high level of LME aluminum inventories, total commercial aluminum inventories (at 3.1 million tonnes in July) are not that high in a historical context. The latest monthly statistics from the IAI on producer inventories (accounting for the largest share of the total) show that unwrought inventories rose marginally (0.4%) to 1.6 million tonnes in July, compared with June, but they were lower (minus 12%) than in July 2001 (1.8 million tonnes). Drawdowns have been noted in all IAI regions apart from Africa (where production at Mozal presumably has helped maintain stock levels).

Even if the sector is plagued by a surplus, the inventory situation for aluminum is relatively better than for some other base metals; for example, total copper inventories are at all-time highs.

At the end of the second quarter, the stock-to-consumption ratio stood at 8 weeks, slightly lower than the 8.4 weeks at the end of the previous quarter, but higher than at the corresponding time in 2001 at 7.4 weeks.

Lead

In line with the rest of the base metals complex, lead prices fell during September, approaching the lows of November 2001 and 1993. Positive supply-side developments, in terms of reduced Chinese exports, are offset by concern over the global economic outlook (despite lead’s being less dependent on economic growth than other base metals). Moreover, the latest data pertaining to consumption and battery shipment have been mixed.

After a poor start to the year, there are signs that the starting-lighting-ignition sector has started to turn, with shipments of replacement car batteries rising by almost 7%, year over year, in May (the latest available data), whereas shipments of original-equipment batteries were still weak (minus 5.4%, year over year). For the January-to-May period, replacement shipments were 5.6% stronger, year over year, while total shipments rose by 3.3% during the period as original-equipment shipments registered a year-over-year fall of 4.6%.

Despite these relatively encouraging figures, helped by high temperatures in the U.S., continued poor performance of the industrial battery market has had a negative impact on the overall sector. Data from the U.S. Geological Survey (USGS) suggest that total battery demand in the U.S. fell by 8% in the first five months of this year. As a result, we expect Western World demand growth for lead to remain in negative territory this year at minus 2.5%, following a 4.8% decline last year, and to grow at about 2% to 2.5% per year for 2003-2006.

As with zinc, the concentrates market has tightened, while scrap supply is also extremely short. Nonetheless, Chinese producers increased refined output further in August by 15.3%, year over year. For the first eight months of this year, output was 7.6% higher, year over year, at 830,000 tonnes. However, reduced production growth rates in China, combined with continued domestic demand strength, should reduce net exports to below 400,000 tonnes by 2004. However, we believe the Western World lead market will remain in surplus during our active forecast period.

q Outlook for prices — Lead prices have been the worst-performing on the LME so far this year, declining by 15% since the beginning of January.

In fact, prices have been in a long-term downtrend since their peak in 1995.

Meanwhile, the nearby spread (cash to 3-month) remained in a steady contango of around US$10 per tonne in September, reflecting good availability of metal for prompt delivery.

Despite a small backwardation evident in 3-to-4-month forward prices in the past couple of months, the whole forward price curve for lead is trading in a contango, and so there is clearly little fear of insufficient metal being available for the coming 26 months.

Physical spot premiums have been mixed across different regions. In Singapore, they have risen sharply over the past few months (albeit from a low level), in light of firm Asian lead demand (albeit patchy on a regional basis). The strongest regions are China, Taiwan and South Korea, while a weak Japanese economy continues to limit consumer buying. U.S. lead demand is generally poor, and European lead demand is showing some signs of improving after a faltering summer period.

As with zinc, there has been an interesting pattern in LME warehouse flows recently, with U.S. stockpiles rising at much the same pace that Singapore stockpiles have been drawn down. This is consistent with movements in physical spot premiums, and reflects good demand in some parts of Asia and continuously ailing demand for lead in the U.S. Indeed, the U.S. LME lead stockpile has risen sharply over the past year and now accounts for more than half (or 92,000 tonnes) of all LME stockpiled lead.

The total LME lead stockpile amounted to 185,000 tonnes at the end of the third quarter, down from its recent peak of 196,500 tonnes in July. However, compared with last year, the inventory level is sharply higher (plus 82,000 tonnes).

Cancelled LME warrants have been rising for most of this year, and now account for 6% of the remaining total (or 11,000 tonnes). This is still not an impressive figure.

Looking at total reported stocks, the different categories account for similar shares, with LME stocks representing about 30% of the total.

In light of that, inventories held at producers and consumers amounted to 235,000 tonnes and 140,000 tonnes, respectively.

As a result, the total reported stockpile stood at 555,000 tonnes at the end of July. Although this is 115,000 tonnes higher from a year ago, we do not see the lead inventory situation as the major threat to outlook for the lead market, as stockpiles are still significantly lower than at their peak in the early 1990s.

The stock-to-consumption ratio, meanwhile, stood at 5.3 weeks at the end of the second quarter, compared with 4.3 weeks a year earlier. This is the lowest level of cover for all base metals.

Nickel

The nickel market is fundamentally sound, with prices having performed substantially better than other base metals this year. Heavily exposed to the stainless steel industry, nickel demand has benefited from restocking at various mills.

However, in late September, prices came under some pressure by speculative short selling, which was not relieved by any Russian buying. The 200-day moving average, representing a key technical level, was breached on the downside and fell below a short-term (10-day) moving average for the first time this year, weakening the technical picture.

On the supply side, Russia remains key: Noril’sk Nickel released production and export figures for the first time since 1996, and total Russian nickel exports have risen rapidly this year. According to Customs statistics, the country’s exports of nickel amounted to 191,700 tonnes during the first seven months of 2002, which was almost double (97.8% higher) the amount for the corresponding period last year. However, we understand that Noril’sk Nickel’s collateral loan of 60,000 tonnes (metal not currently available to the market) is included in this figure, so the rise is less alarming than it may appear. Nonetheless, the July exports of 29,600 tonnes represented a record high.

With base metals now removed from Russia’s secrecy list, Noril’sk will be able to report production and export figures on a quarterly basis. It reportedly produced 223,000 tonnes of nickel in 2001, which was 2.8% higher than in 2000. Meanwhile, its exports of nickel rose by 1.7% to 182,000 tonnes. Based on these data, which offered few surprises, our estimates of an approximate 60,000-tonne stock-build in nickel remain unchanged. While Russia’s ability to export is key to the supply side, we believe the Western World has the potential to produce 5% more refined nickel (to 890,000 tonnes) in 2003, mainly driven by output increases at Falconbridge. Inco’s 54,000 tonne-per-year Goro project is the only new fully integrated operation expected to come on-stream before 2006, with startup slated for 2005.

Western demand for nickel grew by about 4.5% during the first half of this year and is set to recover further in the second half, resulting in our expectations of demand growth of 6.1% for the full year. With stainless steel the key driver of growth, accounting for about 70% of total nickel demand, higher stainless output and reduced use of scrap help explain strong nickel demand growth figures. Demand from other end-use sectors (aerospace, for example) remains under pressure as a result of weak investment activity.

q Outlook for prices — Nickel prices have outperformed the other base metals this year, rising by 22% since the beginning of 2002. All other sectors (apart from tin) fell over the same period.

Not surprisingly, the nickel price is related closely to stainless steel prices, with nickel more volatile and often leading the way. In line with nickel, stainless steel prices have improved this year, positing gains of 10% since the beginning of January.

However, rises have come to a halt in recent months, owing to growing economic uncertainties, and future price direction will very much depend on macroeconomic conditions. We expect prices to bottom out during the current quarter and resume an upward trend on a more sustainable basis at the beginning of 2003.

The whole forward curve remains in backwardation, though all future prices are lower than in the previous month. Meanwhile, the curve has flattened compared with two months ago, reflecting some eased tightness for far-forward dates.

While tightness for nearby dates (cash-to-3-month) showed signs of easing during September, it was trading in an approximate US$100-per-tonne backwardation again in early October, with evidence of forward-borrowing activity. Despite the persisting backwardation, it’s encouraging that more metal has not occurred in LME warehouses.

Physical spot premiums for nickel have been relatively steady in recent times. Premiums across Europe are reportedly holding firm, with most stainless steel mills operating flat out with enquiries for nickel remaining solid.

Premiums for briquettes remain in the range US$30-50 per tonne, and some tightness may occur as less Russian material of that type has been emerging.

In China, nickel is now quoted at LME flat, and at a slight premium in some cases. This is in contrast to discounts of around US$300 per tonne recorded earlier in the year.

U.S. spot premiums have been relatively firm, with consumption reportedly strong, helped by restocking at stainless steel mills.

Again in contrast to most other base metal markets, LME nickel inventories are at relatively low levels.

Following a rise during the second quarter, reflecting inflows at Rotterdam warehouses, the trend is again downwards. We believe metal flows to and from Rotterdam warehouses could be related to changes in Russian warehousing arrangements, bearing in mind that Noril’sk Nickel has built warehousing facilities at its Dudinka port. Stockpiles in the other LME warehouse locations — Singapore and Baltimore — continue to decline at a steady rate, accounting for 29% and 8.5%, respectively, of the remaining total.

Cancelled LME warrants rose sharply in the last month of 2001, ahead of inventory drawdowns early in the year. Since the second quarter, cancelled nickel warrants have been subdued, amounting to only 1,000-2,000 tonnes (or about 5% of the remaining total).

Although we have no indication of incoming material, a low level of cancelled warrants at least suggests that there are no significant amounts awaiting outward shipments, which means inventories could start to rise modestly.

On a total commercial basis, nickel stocks are modest. While exchange (primarily LME) stockpiles represent a minor share of the reported total at present (unlike the situation in the early to mid-1990s), producer inventories account for the largest share.

The latest statistics from the International Nickel Study Group (INSG) suggest that inventories held at producers of 92,700 tonnes changed only marginally in July. However, the INSG reported that producer stockpiles are now 10,800 tonnes lower than at the same time last year.

The stock-to-consumption ratio has remained relatively steady, 6.1 weeks at the end of the second quarter, compared with 5.9 weeks a year earlier.

Zinc

Plagued by oversupply, zinc prices remain depressed and are not far from 20-year lows. Despite improving demand conditions, reflected in sharply improved galvanized prices so far this year, we expect the market surplus to remain large in 2003 as Western output continues to expand at a fast rate.

However, due to the oversupply situation and weak price environment, we believe there is potential for suppliers to respond by making output cutbacks in both the mining and smelting industries. Cost analysis suggests that with current low prices and treatment charges, more than half of the smelting industry is operating at a loss. If producers were to respond, the outlook for zinc prices would improve significantly.

As with most other base metal markets, China is playing a major role in the zinc market, with its net exports accounting for about 6% of global supply last year. However, as a result of concentrate shortages and low LME prices, reduced smelting output in the region (minus 7.4% in January-August) has caused a declining rate of Chinese net exports so far in 2002. The latest customs statistics show that China exported 323,200 tonnes of zinc during the first eight months of this year, which was 6.8% lower than in the corresponding period of 2001.

We forecast net exports of about 445,000 tonnes for the full year, compared with 521,000 tonnes in 2001. Reduced output in China leaves capacity utilization rates low, at less than 80%, providing potential for production increases if concentrates were released from smelter output reductions elsewhere.

Demand for zinc from the galvanized steel sector appears relatively strong, especially in the U.S. (where consumption of galvanized steel rose by about 5.8%, year over year, in the first half) and some Asian countries (in particular, South Korea and Taiwan). Meanwhile, the European and Japanese markets remain depressed. As a result, we expect zinc demand in the West to rise by a modest 2% this year, compared with a 3.6% reduction in 2001.

q Outlook for prices — Zinc prices have stayed at the low levels reached at the end of last year, having moved only marginally since the beginning of 2002 (minus 2%); they are currently close to 1993 lows.

Traditionally, zinc prices are strongly correlated with prices of galvanized steel. Galvanized prices have improved rapidly this year, with European prices rising by more than 50% since January. If, as we predict, this relationship is sustained, there is upside potential for zinc prices, especially if the zinc supply-side undergoes some restructuring.As with most other base metals, the zinc forward curve is trading in a full contango, with no metal scarcity expected over the next 26 months at present. Meanwhile, the nearby spread (cash to 3-month) remained in a steady contango of around US$20 per tonne in September.The last time there was any meaningful tightness in the zinc market was at the end of the third quarter in both 1997 and 2000. That did not occur again this year, with no apparent fear of metal availability for prompt delivery.However, despite the prevailing soft demand environment and the fact that metal warehouses are currently well-filled, physical spot premiums have risen in Rotterdam and particularly in Singapore in recent months. We believe rising Asian premiums are reflecting strong demand, particularly in China.In Europe on the other hand, premiums have firmed as some LME stockpiled material is tied up in financing deals and therefore unavailable to the market. Flows of zinc to and from LME warehouses have been mixed recently, though inflows have continued to exceed outflows.At the same time that the stockpile in New Orleans has been aggressively built up, inventories at the Trieste location have been heavily drawn down recently. In a soft demand environment, we think it is possible that some material has been transferred from European to U.S. locations.Inventories at the other major LME warehouse location, Singapore (accounting for 30% of the total), have been rising steadily over the past year, reflecting weak demand in most of Asia, other than China.The total LME zinc stockpile stood at 640,000 tonnes at the end of the third quarter, representing the highest level since January 1996. Another 43,000 tonnes were delivered during the third quarter (net), while the stock level is 274,000 tonnes higher than at the same time last year. Notably, cancelled LME zinc warrants have risen at the same time, suggesting that inflows have been fairly sizable in order to offset outflows.At the beginning of October, cancelled warrants had risen to 52,000 tonnes, or 8% of the remaining total. This follows a prolonged period when cancelled warrants accounted for only 0.5-3% of the remaining total. As a result, if the rate of inflow slows, the rising trend could be reversed quickly.Rising LME stocks have been the prime reason for total commercial zinc inventories rising, as stockpiles held at producers and consumers have been reduced, according to the latest statistics available.The International Lead and Zinc Study Group reported that producer and consumer stocks stood at 337,000 tonnes and 108,000 tonnes, respectively, at the end of July. While this was marginally down over the month, consumer stocks were 13,000 tonnes lower from July last year, whereas producer inventories were 15,000 tonnes higher. In a historical context, total zinc inventories are still well below their peak in the early 1990s.Meanwhile, the stock-to-consumption ratio had risen to 8.2 weeks by the end of the second quarter, compared with 5.4 weeks a year earlier.– 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