Revisiting the bull market

The price performance of most of the base metals has been impressive so far this year, at least from a producer’s perspective. All metals made new highs for this cycle despite the rebound in the U.S. dollar. However, the recent correction that most metals have experienced raises the question: Have base metal prices peaked?

Before considering the price prospects for the individual base metals, we should first assess the factors that have driven the bull market so far: dollar weakness, investment funds, China, economic growth outside of China, declining inventory levels, and the lack of new capacity. We then must consider whether they are still relevant.

The dollar effect

The weakness of the dollar played an important role in triggering the bull market in 2003. However, we expect that the dollar will have less of an impact this year. For the purposes of our price projections, we have assumed the dollar will appreciate slightly from current levels during the remainder of 2004. The focus appears to be shifting away from the U.S. trade and fiscal deficits to the prospects of higher interest rates. There is more scope for dollar appreciation farther out in our forecast period. Accordingly, we have adopted a fairly cautious approach to its price forecasts over the next few years.

Investment funds

In our first quarterly report, we suggested that investment fund activity would continue to support higher prices. One reason for this view was that, with the possible exception of nickel, prices were below what are commonly perceived to be cyclical peaks. Although some funds have, no doubt, taken profits (encouraged by the strengthening of the dollar), given the tight nature of the fundamentals, we doubt that there will be much speculation from the short side.

Other factors that have supported the base metal bull market appear more sustainable. Chinese gross domestic product figures for the first quarter show growth at greater than 9.7%. The impact of China on base metals varies considerably from commodity to commodity. The common theme, however, is the country’s increasing reliance on raw materials. Although the latest production figures suggest that this is doing little to hold back output in China, the surge in raw material imports to support this growth is constraining production growth elsewhere. The increase in China’s raw material imports will far offset the increase to metal exports.

The biggest feature in 2004 (excluding China) is likely to be the sharp rebound in U.S. base metals consumption after what has been, in most cases, three consecutive years of decline. We are noting a marked recovery in activity in the non-ferrous semis sector, which is boosting metals demand. The increase for copper and aluminum has been particularly dramatic.

Elsewhere in Asia, we are seeing buoyant conditions. There are four different regional trends. In Japan, the largest consumer of base metals, excluding China, consumption is starting to recover. And after a relatively weak year of growth in 2003, activity in Taiwan and South Korea is picking up. The latter economy had been particularly affected by credit problems. Combined, these two countries consumed nearly as much base metals as Japan. The Association of Southeast Asian Nations countries is once again enjoying robust levels of base metal demand. The Thai and Malaysian economies are particularly buoyant. In Vietnam, we are seeing rapid demand growth, albeit from a low base. The final strand of base metal demand in Asia is India. The country is enjoying robust growth. Although the economic growth is not as metals-intensive as that in China, base metal demand is growing rapidly from an increasingly large base.

Supply tightness remains a feature

A number of factors suggest that the producers are still struggling to catch up with demand growth. The level of spot treatment charges and refining charges (and alumina spot prices) confirms the raw material tightness. For copper, there was even a report of a negative treatment charges and refining charges, while this year’s zinc treatment charge negotiations are even more protracted than usual. Strikes and technical problems have been a feature in 2004 as high utilization rates and increased union militancy raise the prospects for supply disruptions. Although high prices are starting to encourage new investment in the sector for most London Metal Exchange (LME) metals, we do not view the amount of new supply in the pipeline as being excessive.

Since the beginning of the year, there has been a significant stock drawdown for all the metals apart from zinc, prompting speculation that LME stocks may disappear. The experience of the aluminum market highlights how important LME stocks are in influencing prices. There was a massive increase in off-warrant primary aluminum stocks in Eastern Europe prior to the European Union accession of a number of states in May, in order to circumvent the 6% import tariff. This has more than matched the decline in LME inventories, yet prices have soared. For zinc, we have seen the opposite: large quantities of off-warrant material being shipped to LME warehouses, particularly in Dubai.

Aluminum

It is time for aluminum belatedly to join the bull market. Inventories have fallen dramatically on the LME, demand growth is picking up (particularly in North America), high spot alumina prices and power shortages are beginning to affect production in China, and prices are now performing better than most of the other base metals.

Although we expect inventories will be drawn down over the forecast period, we are cautious about price prospects, given the recent strong advance. We are forecasting an average annual cash price of US$1,675 per tonne this year, followed by what we believe will be a peak in this cycle of US$1,750 per tonne in 2005.

Copper

The market made new highs in April as terminal market inventories continued to shrink. We expect, in the second quarter, a further drawdown that could see copper make new highs. However, increased supply from the resumption of normal operations at Grasberg and Ok Tedi, the reactivation of the idled Phelps Dodge capacity, and the commissioning of greenfield projects such as Sossego and brownfield expansion elsewhere in Latin America should ease the market somewhat. This, combined with a likely negative impact of the dollar over the forecast period, suggests that average prices could peak in 2004 at US$2,760 per tonne. We are forecasting an average annual price of US$2,300 per tonne next year and US$2,050 per tonne in 2006.

Lead

Although the fundamentals of the lead market are still looking positive over the forecast period, such was the extent of the first-quarter rally that we believe the lead price has peaked. With Chinese exports of refined lead rising, we project only a modest drawdown of stocks. We forecast an average annual price of US$785 per tonne in 2004 followed by US$740 in 2005.

Nickel

Nickel provides an excellent example of the extreme volatility that occurs at this stage of a bull market. Although there has not been a dramatic change in LME inventories, prices have traded in the range of US$12,200-17,700 per tonne so far this year. High nickel prices have encouraged substitution away from austenitic grades, with a high nickel content, to steels with high manganese and low nickel content. This trend is particularly evident in the emerging markets of Asia. High prices have also increased the availability of nickel contained in scrap and encouraged producers to operate flat out. The final factor that has dampened the bull market sentiment is a reduction in Chinese purchasing following the buying spree that took place in 2003. On an average annual basis, we are projecting US$13,000 per tonne (US$5.90 per lb.) in 2004, followed by US$11,000 per tonne (US$5 per lb.) next year. Higher production in 2006 should bring about a further reduction in prices.

Tin

The tin market is displaying characteristics similar to those shown by nickel in 2003. Against a background of strong demand, producers are struggling to keep up, owing to a
concentrate shortage. Prior to the recent rally, tin prices had been depressed for so long that investment in new projects remains limited. Accordingly, the industry is not in a position to respond to the robust demand growth. The only area of significant production growth is China. However, higher output is being absorbed by domestic demand growth, and Chinese exports of tin continue to decline. Although tin prices are well below the recent peaks, we believe there is potential for prices to make new highs over the forecast period. On an average annual basis, we are forecasting a LME cash price of US$8,000 per tonne in 2004 and US$7,600 next year.

Zinc

A rally in the zinc price has come about without any discernible improvement in the fundamentals. In our earlier reports, we suggested that the uptrend in prices will remain heavily dependent on bullish trends within the rest of the base metals sector. This remains the case. We are now projecting an average annual price of US$1,025 per tonne in 2004. The slow improvement in the fundamentals should, however, allow higher prices in 2005 and 2006, when we are forecasting average annual cash prices of US$1,150 per tonne.

Gold

Gold prices are well off the recent highs and well down from the 15-year high of US$425.50 per oz.. Although the fortunes of the gold market remain inextricably linked to the value of the dollar, we are of the opinion that many other aspects of gold’s fundamentals are reasonably positive. Given uncertainties about the sustainability of the twin deficits in the U.S. (trade and fiscal), we expect investment interest in gold will remain high. Although we are not expecting much of a stimulus from gold fabricating demand, the supply side remains supportive.

Mine supply growth is low while de-hedging remains a positive feature of the market, with de-hedging likely to exceed last year’s levels. Greater investor interest in gold against a background of increasing political risk should support an average price of US$425 per oz. in 2004. A likely strengthening of the dollar over our forecast period may push average prices lower in 2005 to US$400 per oz.

Silver

Until recently, silver has outperformed gold. In some respects the performance of silver is similar to that of aluminum and zinc, where investor interest has been focused on markets that did not really participate in the early stages of the bull market. The recent correction in the price, however, highlights the lack of support from the underlying fundamentals.

We are projecting an average annual price of US$6 per oz. in 2004. Further, if mild, weakness in 2005 also cannot be ruled out, though a forecast of a return to the sub-US$5-per-oz. levels prevailing as recently as October/November 2003 seems unduly pessimistic. We are forecasting an average annual price of US$5.25 per oz. next year.

Natexis Metals is a ring-dealer member of the LME and an associate member of the London Bullion Market Association. The company is a subsidiary of Natexis Banques Populaires, based in London.

Base Metals Price Outlook to 2006

(average annual cash prices US$/tonne)

AlCuNiPbSnZn

20031,4321,7809,6405164,896828

20041,6752,76013,0007858,0001,025

20051,7502,30011,0007407,6001,150

20061,6752,0508,5006006,1751,150

% change

04/0317.0%55.1%34.9%52.1%63.4%23.8%

05/044.5%-16.7%-15.4%-5.7%-5.0%12.2%

06/05-4.3%-10.9%-22.7%-18.9%-18.8%0.0%