The following is the second of four instalments of The Commodity Refiner, published by London, U.K.-based Barclays Capital Research. This week we offer an overview of the base metals sector. Next week, a detailed report on copper and lead.
The base metals are faced with a tough marketplace in the near term. Our expectations of modestly higher base metal prices this year compared with last are not based on a rapid Western World economic recovery once the immediate negative effects from the war in Iraq are removed.
The U.S. economy is possibly in a much worse state than has been discounted for, and with extensive monetary and fiscal policies already in place, there is little ammunition left to help stimulate growth. Instead, a host of positive factors will be the key driving forces of base metal price support. Those factors relate to continuous strong Asian demand, currencies, and constrained supplies. In addition to this, there have been positive effects from low downstream inventory levels. These factors alone are not likely to be enough to drive sharp price rallies, but they will prevent them from falling much further.
If, on the other hand, an upswing in economic activity emerges much quicker than anticipated, we would call for a bull-run in base metal prices, especially as the existing positive factors would provide a strong platform. Expectations for the U.S. corporate quarterly reporting season do not warrant such a scenario, however, with companies now more gloomy about profits than they were well into the economic slowdown in the third quarter of 2001.
Recent macro-economic data point to weak economic growth ahead. While Chinese industrial production registered another impressive figure for March (+16.9% year over year), it was slightly lower than the February figure of +19.8%, and there are now increasing concerns regarding the impact the SARS virus will have on the Asian economies. While there is, as yet, no compelling evidence of a reduction in metal consumption in China (the world’s largest consumer of several metals), we are incorporating a slight slowdown in Chinese demand growth after this year’s leadership changes, which might partly lead to new banking reforms and a slowdown in the construction sector.
Economic growth numbers continue to be revised downward. The March report from Consensus Economics suggests economic forecasters now expect U.S. industrial production of +1.8% this year, compared with their previous combined forecast of +2.2%. Consensus forecasts for German IP have likewise been downwardly revised, from +0.5% to +0.2%, while Japan is likely to perform a little better than previously expected (+1.2% versus the initial forecast of +1%), primarily because of strong Chinese export growth. At the same time, the European Commission has trimmed its forecast of global economic growth from 3.6% to 3.2% for 2003, saying it could get far worse if oil prices remain high (which we do not expect). Meanwhile, the Organization for Economic Co-operation and Development (OECD) says the risk of a global recession has now diminished but that the chances of weak growth have increased.
In any event, it appears base-metal price floors are solid at present, especially as the categories of market participants taking advantage of price dips at present are widespread, with consumer business the most encouraging force.
And so, against a background of Western World economic malaise, the question becomes, Can base metal prices sustain downward pressure? There are several reasons to believe downside price risks are restricted. Including estimated data for the first quarter of this year, but excluding lead and tin, base metal consumption growth measured year over year has been in positive territory over the past four quarters. This follows four consecutive quarters of strong negative demand growth (and before that, eight consecutive quarters of positive year-over-year growth).
Based on calculations of deviations in metal demand growth rates from underlying economic growth (industrial production), it is clear that restocking helped boost metal consumption for most of last year. Despite this, end-user stockpiles are still low, and even if inventory management might have improved, modest economic growth is likely to keep metal consumption growth at least in positive territory.
However, according to preliminary data for the first quarter of this year, there are signs the pace of recent restocking of metals is slowing, a feature already evident in the previous quarter, especially for copper. As is clear from data provided by the U.S. Geological Survey, this would suggest end-user inventories remain at low levels, which would provide significant scope for restocking once underlying demand conditions start to advance.
However, the latest data for inventories at U.S. wholesalers, another indicator of the downstream inventory cycle, show a slightly different picture: inventories rose by a larger-than-expected 0.3% in February (after a flat reading in January). In fact, inventories of durable goods rose 0.7%, representing the biggest gain since mid-2000 and the biggest 45 Commodities Research fall-off of sales since September 2001. Auto inventories also rose, by 1.2%, after a 0.8% drop in the previous month. These numbers mirror poor data on U.S. retail sales and consumer confidence, and, along with many of the economic data released during the first quarter, reflect a deteriorating macroeconomic picture after the first month of the year.
Decent metal consumption growth numbers during the first few months of this year, compared with the same period last year, cannot be explained by restocking. Instead, we think metal consumption was boosted by a temporary revival in manufacturing activity, reflected in the spike of the U.S. Institute for Supply Management (ISM) manufacturing survey in January. This index has now moved back into contraction territory, sending a negative signal to the investment community, which has moved away from its recent extensive long exposure in the industrial metals markets.
The second key positive factor for base metal demand growth in recent months has been currency movements, with the depreciation of the U.S. dollar providing advantageous buying opportunities for non-U.S. consumers, in Europe and Japan in particular. In the past, base metal prices denominated in euros have rarely traded at a discount to U.S. dollar-denominated metal prices.
Speculative activity is especially intense in the copper market, partly because of its Comex contract, which possibly also explains its relatively strong negative correlation with the trade-weighted U.S. dollar (standard deviation of 0.63 for weekly data since 1993). This negative correlation naturally relates to the large amount of metal consumed and produced outside the U.S. Based on its negative correlation with the U.S. dollar, copper is currently undervalued, and any further depreciation would have the potential to underpin the price.
Thirdly, tight scrap supplies have helped prop up primary consumption rates in recent times, notably in nickel, copper and aluminum. In fact, aluminum alloy prices are trading at a premium to primary prices on the London Metal Exchange (LME), which is a rare feature and reflects a tight market for secondary aluminum in light of capacity closures in an overall low price environment. Meanwhile, the scrap ratio in stainless steel has continued to fall in recent quarters, raising the use of primary nickel in a strong demand environment.
Adverse supply conditions
Currency movements can also have a dramatic impact on production costs, especially when a low metal price environment already has pressuring effects on profitability. Because of this, we have analyzed current production cost curves and their sensitivity to changes in the U.S. dollar against key producer currencies.
Analyzing cost data from Brook Hunt, a substantial amount of current capacity is produced at a loss. The global copper refining and the zinc smelting businesses are in particular trouble, with 24% and 27% of total output (o
r 2.1 million tonnes and 2.3 million tonnes), respectively, in negative territory at present, measured on a cash basis. The situation would be worse taking total costs into account. The copper and zinc refineries are under particular strain as treatment and refining charges for both are around historic lows.
A lot (almost half) of the loss-making refined copper output is in Japan, so any announcement of production curtailments from that region would not be too surprising. In fact, there are already signs of adverse market conditions having an impact on smelting output, with Japanese (customs) smelters reducing output slightly during the first half of this fiscal year. China, too, has announced output reductions (most recently Daye Non-Ferrous Metals) because of low prices and tight concentrates. However, rising unit costs could eventually lead to larger closures if raw material continues to be difficult to source and the price environment remains low.
In zinc, there is also evidence that tough market conditions are starting to take a toll. In light of recent announcements of permanent and temporary closures, we estimate a total of 400,000 tonnes of smelting capacity will be taken out of production this year.
To highlight the impact of currency movements on production costs, we have looked at a scenario in which the U.S. dollar depreciates a further 20% against key producing currencies from last year’s level (keeping everything else unchanged) to see how that would change the supply landscape. While this might be a somewhat aggressive assumption, a further decline in the value of the U.S. currency cannot be ruled out. And with a substantial amount of production in certain industries already cash-negative, even a small move in this direction could prove pivotal.
The global zinc industry would be particularly vulnerable to a U.S. dollar depreciation, as an additional 24% of smelting output would be produced at a loss under these assumptions. Only about 12% is actually produced in North America. This is a much smaller share than for refined output of all other base metals (bar tin). Zinc mines would also move into a significantly less favourable positions, with an additional 1.2 million tonnes of capacity at risk. In light of this, one could also argue that the opposite would happen should the U.S. dollar regain strength against other currencies, as this would put the zinc smelting industry in a better position. The effect on total weighted average costs would be the greatest for the zinc smelting industry (+13%) under a dollar depreciation scenario, while the copper mining and smelting industries would also be faced with higher average costs in excess of 10%.
The primary aluminum industry, already under pressure from high power costs and alumina prices (with the latter primarily affecting the Chinese producers, as they are significant spot buyers), would also see a significant amount of capacity moving into cash-negative territory on a further U.S. dollar depreciation. In fact, an estimated additional 2.4 million tonnes would be operating at a loss — almost 10% more than is currently the case — and this would bring the total exposed tonnage to 21% of the total. However, given the costs involved in shutting an aluminum smelter, it is unlikely that a significant amount of aluminum smelting capacity will be shut — unless adverse market conditions remain for an extended period of time.
Price conclusions
Our Q1 price forecasts were not far from actual prices (bar aluminum, which performed substantially better than we had anticipated), and we are making few changes to our price projections going forward. We expect a relatively depressed Q2, but bottom ends of expected trading ranges should present good buying opportunities for the reasons discussed above. As prices are likely to remain highly volatile under current market conditions, this can provide interesting trading opportunities.
Key economic indicators
Again, base metals were unimpressed by the modest 0.1% month-over-month rise in U.S. industrial production for February, and prices reacted in a subdued fashion at the time of the release, in mid-March. Manufacturing production declined by 0.1%, but this was more than offset by a weather-related rise in utilities output and a 1% increase in mining. Slower auto sales and a build-up of auto inventories resulted in a decline in the assembly rate of autos and light trucks. Hi-tech production continues to gather strength. These numbers were close to expectations and did not change the outlook for growth in the first quarter; our economists continue to expect Q1 real GDP to rise by 2.5%.
The findings of the quarterly Bank of Japan Tankan survey came out mixed, with the headline figure declining to -10 for Q1 2003 from -9 in the previous quarter. This was the first decline in five quarters, but, taken as a whole, our economists predict a flat trend in the economy and business environment. As long as profits continue to trend upward, as they did during the last quarter of 2002, with recurring profits rising by 11.3% in spite of lower sales (which fell by 0.9%), our economists expect the cyclical expansion to resume if the outlook for Iraq and the post-war global economy turns even slightly more optimistic.
March ended two months of rises in the German IFO (Institute for Economic Research) business climate index: it fell to 88.1, from 88.9 in February. According to our economists, this completes the gloomy outlook already depicted by the fall of business confidence in several European countries, while there are no indications of a sustained turning point in German business sentiment, especially as the IFO data did not capture the start of the war. As a result, our economists expect a contraction in German first-quarter GDP (-0.2% quarter over quarter), and a flattish outcome for the eurozone as a whole.
To no great surprise, the downward trend in OECD leading indicators of economic growth resumed, according to the latest data for February, which is in contrast to more encouraging numbers reported in previous months.
The composite leading indicator (CLI), designed to provide early signals of turning points in economic activity, fell half a point in February for the whole OECD area, while its 6-month growth rate fell to +0.4%. The CLI for the U.S. dropped by 1.5 points, with its 6-month percentage change dropping sharply to -1%, while the European CLI has been contracting for nine consecutive months.
The Japanese number was unchanged, and has been relatively stable since September 2002.
The Conference Board leading indicator registered a fall of -0.4%, month over month, in February, compared with a month-over-month rise of 0.2% in January. Stock prices, initial jobless claims and consumer expectations caused the index to fall. The index slipped into negative territory for the first time since September last year (-0.4%, year over year). This indicator tends to lead U.S. industrial output, so it is a worrying trend for the economy and base metal demand.
The U.S. Institute for Supply Management (ISM) manufacturing index slipped below the expansion/contraction 50-mark to 46.2 in March. Almost all categories fell, with the most significant declines occurring in the new orders index, down to 46.2, and the production index, down to 46.3. The prices-paid index, however, continued its upward trend, jumping to 70 from 65.5 on the back of higher commodity prices.
The drop in the ISM Index puts it at a level that suggests growth has virtually ground to a halt. The ISM believes the war has slowed demand in a number of industries. Under most circumstances, a reading at this level would indicate that the Fed is likely to ease. However, the Federal Open Market Committee expects the economy to rebound after the war, in which case the Fed may be willing to continue its wait-and-see strategy.
Durable goods orders fell by 1.2%, month over month, in February, reversing most of the 1.9% month-over-month gain seen in January. There was a large increase in defence orders (28%), a big drop in civilian aircraft orders (56%), and small de
clines in most other categories. These numbers are consistent with another quarter of modest growth in equipment and software investment. Such investment has now been rising for four consecutive quarters after declining from late 2000 to early 2002.
The growth rate of the metal component of durable goods orders also slowed, from +5.4%, year over year, in January to +3.1%, year over year, in February, while it registered a 2.3% month-over-month decline after two consecutive months of positive numbers. These data also point to a depressed demand environment for metals.
The U.S. Geological Survey (USGS) metals price leading index gained 1.7% in January, the latest month for which figures are available. Its 6-month smoothed growth rate rose 1.4% from a revised -1.4% in December 2002. Notably, a big increase in the growth rate of the index measuring the trade-weighted average exchange value of the other major currencies against the U.S. dollar made the greatest contribution to the increase in the leading index.
The USGS data also show that the growth rate of the primary metals leading indices has slowed dramatically in the past year, suggesting weak growth in the overall U.S. metals industry in the short term.
Meanwhile, the growth rate of the inflation-adjusted value of inventories of U.S. non-ferrous metal products improved to -14.5% in January, from a revised -16.8% in the previous month. This indicator typically moves inversely with metal prices, according to the USGS. However, the actual level of these inventories decreased further, signaling further de-stocking.
U.S. retail sales fell by 1.6%, month over month, in February while non-auto sales declined by 1%. Gasoline stations saw a price-related rise of 2.7%, and sales at general merchandise stores rose by 1.2%. Almost all other categories reported declines. The sharp drop in the non-auto retail sales in February prompted our economists to lower their GDP forecast for the first quarter to 2.5% from 3.5%, and further, for Q2, to 2.5% from 4.5%.
Unsurprisingly, consumer confidence remains depressed. While metal prices have tended to trade in tandem with consumer confidence over the past three years (the consumer represents about two-thirds of the U.S. economy), the recent divergence of the two is unlikely to be maintained.
Bad economic news continued with U.S. auto sales for March, which fell by 0.4%, month over month — the third consecutive month of contraction. Even so, this performance was stronger than expected and certainly much better than in February, when vehicle sales fell to a seasonally adjusted annualized rate of 15.3 million, with equivalent data for March standing at 16.2 million. This performance may well have been motivated by the new round of incentives for April launched by the Big Three (GM, Ford and Daimler-Chrysler). With conditions already tight for vehicle manufacturers, the long-term viability of such offers must be questioned.
Meanwhile, automobile production in China is expected to reach 3.9 million vehicles in 2003, and could even pass the 4-million mark, compared with 3.25 million vehicles in 2002. The 2003 projection (by state sources) represents a rise of 38% from 2001, which would make China the fifth-largest auto manufacturer.
Plagued by severe weather, construction of new homes declined by 11% to 1.62 million (annualized rate) in February. However, building permits, which are not affected by weather-related events and provide a better insight into the housing sector, rose by 0.4% to 1.79 million (annualized). The onset of warmer weather and the fact that permits issued were more than the number of houses started suggest that construction of new homes is likely to rebound in the coming months.
The first quarter started with a bounce for equity markets, primarily related to developments in Iraq. Base metal prices moved in the opposite direction, as economic data continued to indicate tough market conditions.
In the past, mining equities have had the capacity to lead base metal prices, and we would generally regard firmer equities as positive for sentiment in the base metal markets. However, the sustainability of war-related equity market rallies is questionable, given concerns about the shape of the global economy in the aftermath of the conflict in Iraq. If these concerns persist, base metal prices are likely to remain pressured.
The recent unusual divergence in U.S. 10-year bond yields and metal prices is a result of money flowing into safe/real assets and away from equities in times of uncertainty. As the economic cycle, which seems to be turning for the worse, is likely to represent the main driver for metal prices, base metals are likely to face a period of weakness.
However, our rates strategists (bullish on the economic outlook) believe a bear market for bonds may now be developing, which would also provide a bull case for the base metal markets.
Dollar weakness has been a dominant theme over recent months and a key supportive factor for the base metal markets. In the longer term, dollar weakness in an environment of rising base metal prices will likely attract further European and Japanese consumer business.
On the producer side, a weak dollar would mean local currency strength and a rise in production costs (and vice versa), and this could eventually result in a curtailment of high-cost production outside the U.S.
— 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. Kevin Norrish is head of Commodities Research / Energy for Barclays and Ingrid Sternby is a base metals analyst with the company. E-mail: kevin.norrish@barcap.com and ingrid.sternby@barcap.com
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