Base metal output is rising and demand has slowed. However, output growth is not happening quickly, whereas demand conditions are showing signs of improving. Given that all base metal markets remain in supply deficit, any positive surprises to demand or disappointments with regards to expected output additions could have dramatic price implications.
Trading conditions in the base metal markets have become more volatile, and market participants are increasingly uncertain about the outlook. Consumers have been reducing their stocks as a result, and hedge funds have been scaling back on their long positions. A logical conclusion is that prices should trend lower as global demand growth is slowing and as production is rising in response to high prices. However, this is not our conclusion. Notwithstanding a seasonally quieter period during the third quarter, we remain positive on the outlook for base metal prices for several reasons.
First, because inventories remain very low and are unlikely to build significantly for the remainder of this year, this should mean that total reported stocks, measured as weeks of consumption, will remain below “critical” levels up to at least year-end.
London Metal Exchange copper stocks are currently the lowest since 1974, while aggregate weighted base metal stocks have fallen to their lowest level in 16 years. This, together with a continued high price environment despite slowing demand and rising production, has heightened market speculation over potentially large unreported metal stockholdings. One could argue that in the current market place, a larger buffer of material is justified. We believe a certain build-up in stocks outside official warehouses has occurred, but given the cost of financing off-warrant material, this amount should be limited. Stock building in the world’s largest copper producing nation, Chile, is also nothing out of the ordinary. Solid fundamental reasons underpin today’s high metal prices and market talk of “manipulation” is overdone.
The second factor behind our positive outlook is that there are signs that the slowdown in demand is stabilizing. In the U.S., our economists expect a pickup in business investment spending, which will help support above-trend growth in the second half of 2005 and through 2006. We expect global gross-domestic-product growth at 3.9% and 4.1% in 2005 and 2006, respectively, compared with the trend of around 3.7%. In the current tight base metal markets, even sustained growth around current levels will be enough to keep the base metals prices moving upward.
The oil price is the biggest risk factor for global growth, and the 50% rise in 2005 appears responsible for at least some of the weakness in industrial production. Base metals prices have suffered little from high energy prices, however, and we would argue they have even benefited, because of the negative impact on metal production costs. While we do expect oil prices to gain further, the percentage gain should be easier to take. Furthermore, we would argue that slow European demand conditions are already largely factored into prices and that there is even scope for improvement should the European Central Bank lower rates, while the weaker euro has also helped stop busi- ness sentiment from deteriorating further.
A third reason why we remain positive is because consumers are under-hedged. Statistics show metal consumption slowed much faster than economic growth levels during the first half of the year, suggesting consumers have been destocking. If economic conditions improve, then consumers will likely be forced to buy even if prices are high. In China, where underlying economic activity has remained strong, high price levels have been a key factor discouraging new metal purchases. If prices fail to ease significantly, then Chinese consumers are also likely to be forced to enter at higher-than-desired price levels, supporting our view of a higher floor for metals prices compared with previous cycles. Some substitution away from base metals has also occurred where possible; for example copper tubes in plumbing have been replaced with plastics and the nickel content in stainless steel has been reduced. Still, substitution opportunities are being limited by both quality issues and higher prices of other commodities — plastics prices are also at least 60% higher over the previous year.
China is, of course, increasingly important for the outlook of base metals demand and prices. Indeed, Chinese demand, coupled with low global metal inventories, has been the key supporting factor in the wake of the recent “soft-patch” in Western demand. China’s aluminum semis production continues to show annual growth well above 20%. Growth in copper semis output has been less impressive, due to the dual effects of high copper prices and limited power supply, but showed encouraging signs of improving in June (up 13% year-over-year). Chinese physical spot premia have eased, reflecting better metal availability. What’s more, demand shows no signs of collapsing, while greater domestic availability is due to a recovery in Chinese imports which, in turn, serves to tighten up the Western market balance.
Supply additions?
While we see strong potential for demand conditions to surprise on the upside, we also see the risk for supply additions to disappoint. History suggests that supply growth is often overestimated. Naturally, in a rising price environment, companies have high hopes and ambitions to raise output fast. However, rising output costs, and other constraints are making output additions slow.
There are also great expectations in the market for new production to fill the current supply gaps soon. This scenario would materialize only if demand slowed significantly, which we do not expect. Several of the base metals markets will remain in deficit next year, in our view, including aluminum, zinc, nickel and tin. Not until 2007 do we expect sufficient new production to move these markets into surplus. The copper and lead markets will move into only modest surplus next year, according to our assumptions, with supply and demand remaining finely balanced through the first half of 2006.
Base metal production costs are higher for several reasons. Only exchange rates have been a major drag for producers outside the U.S. over the past year. And even if the dollar has recovered, we expect it to remain weak in a historical context for the next year at least. For example, forecasts from our foreign-exchange strategists currently suggest the euro and the yen will reach 1.25 and 108, respectively, against the U.S. dollar on a 12-month view.
In the industrial metal markets, high energy prices are normally discussed in the context of potential negative implications for demand. However, even with crude oil trading around US$60 per barrel, there are still few signs of price-related demand destruction.
Instead, it is becoming increasingly evident that high energy prices are putting substantial amounts of metal production at risk. Among the base metals, aluminum is most energy-intense in its production. Given a sharp rise in German power prices, the European aluminum smelting industry is vulnerable, while production in both the U.S. and New Zealand is also at risk.
Long-term European power contracts ending this year and next will expose a number of European aluminum smelters to considerably higher power prices and this will have a big impact on profitability. The energy component of total production costs has risen dramatically, from a typical 25-30% to more than 50% in some cases, leaving as much as 900,000 tonnes of annual capacity (or up to 25% of the region’s total) at risk of closure. Norsk Hydro has already announced it will be shutting its 70,000-tonne-per-year Stade and 134,000-tonne-per-year Hamburg smelters in Germany by the end of this year, while other aluminum smelters, such as Norf (220,000 tonnes annually), and Voerde (86,000 tonnes) are negotiating new contracts.
As if high power prices and adverse currency
moves were not painful enough, high alumina prices and freight rates are also adding to costs. The chances of near-term relief in high energy prices are nil. Oil markets are getting tighter, natural gas prices are on the rise, and European power prices have joined the commodities bull-run.
Aluminum and energy prices generally have a positive relationship. However, the performance of German electricity prices has sharply outperformed aluminum over the past three months, owing to weakness in U.S. and European aluminum demand and a general sell-off in metals markets over the same period. High energy prices will lend support to aluminum prices, but are only likely to drive them higher, if demand conditions stay positive. Recall the power crisis in the U.S. Pacific Northwest in 2000, when 10% of global aluminum capacity ceased because of rising costs, but aluminum prices fell because demand was the weakest in about 20 years. In any event, we are becoming more positive on prices further out the aluminum forward price curve, and believe they are undervalued in relation to the current high energy price environment.
Over the nearer term, what could have an immediate impact on availability and prices is insufficient supply of mining equipment and replacement parts. In light of this, we note how the share-price of
In light of this, and despite metal prices trading around multi-year highs, mine output of both zinc and nickel has grown by less than 1% so far this year.
Labour disputes
In the current market place, base metal prices are extremely sensitive to any supply or demand side shocks. For sure, speculators, producers and consumers are not the only interested parties in the trends of metal prices, with mining unions also clearly carefully watching their dramatic increase. Last year saw a raft of labour disputes across the global metals markets, with more this year and at present.
Such a push from mining unions should not be such a surprise — historical labour costs clearly demonstrate a strong correlation between changes in annual mine labour costs and metal prices. This also provides another example of how the trend in real production costs is now being pressured higher.
Labour disputes tend to have a firming impact on metal prices, particularly during periods of supply tightness; however, not necessarily on production. In Chile, for example, strike threats at large copper operations have tended to be short-lived, but given their large sizes, copper prices have found strong support even if only from the threat of strike. Early in the third quarter, a workers’ strike at
— 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 www.barclayscapital.com.
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