The outlook for base metals in 2006

In the base metals complex, we remain most positive on zinc for 2006, followed by nickel, copper, aluminum, tin and lead, respectively. We see aggregate upside potential of a further 10-15% in the first half of 2006 from current cash price levels, when we also assume the cyclical peak will occur. Far forward contracts also continue to offer value, in our view, especially in zinc. In nickel, we expect a nearby backwardation to return as the market starts to tighten from its current surplus.

Base metal prices have risen for four consecutive years. Copper continues to hit new all-time highs, while aluminum and zinc are around their highest levels in about 17 years. Against general expectations, high prices have failed to rapidly attract new production. At the same time, the global demand environment has remained strong. This powerful combination, as well as extremely low global metals inventories, will generate even higher prices in 2006, in our view. This environment has forced us to reassess our already bullish outlook, and as a result, we have once more raised our 2006-07 price forecasts for most base metals.

The broader macroeconomic backdrop remains extremely positive for the industrial metals, with a low interest rate environment, robust global growth and prospects of a weaker dollar. The skeptics continue to cite rising interest rates, downside risk to the U.S. economy and subsequent risk to China’s economy.

However, we see these fears as overdone; we believe China’s metals demand will continue to grow strongly even in the event of an external economic slowdown, due to domestic infrastructure-led investment. Strong demand from other emerging markets — for example, India — is also becoming increasingly important.

In a strong demand and price environment, production should grow. But serious short and long-term supply constraints persist, and production costs are on the rise. We believe the risk of a sudden near-term flow of new production causing a correction in prices is therefore small.

Fund involvement is also widely regarded as a threat to the sustainability of high base metals prices. Indeed, long-term investment money continues to flow into commodity markets, including the base metals. This trend shows no signs of abating, and investment into structured products (often including more base metals than the broad-based indices, partly due to attractive shapes of the forward curves) is increasing.

Shorter-term fund involvement, however, is generally not excessive on the long side. As a result, we see little risk of substantial fund-driven corrections in prices. In the event of downside price pressure, it is likely to be shallow and brief once again, given the amount of buying interest from consumers and funds on lower numbers.

Aluminum

We see the entire forward curve continuing to shift higher due to ongoing cost pressures at smelters, and structurally strong demand. High alumina costs are the key factor slowing growth in China’s aluminum smelting, while high energy prices are the key constraining factor in the western world.

We expect further drawdowns in exchange inventories on strong cyclical demand, boosted by consumer restocking, and lower aluminum shipments from China. Chinese exports have picked up recently, in response to rising London Metal Exchange (LME) prices, but we believe this is unlikely to be a sustained trend as the government seems committed to reducing exports of energy-intense production, and is likely to raise export taxes further if necessary. Our target for 3-month prices in the first half is US$2,500 per tonne.

Copper

Far forward prices have moved up faster than the more actively traded contracts at the front end of the curve. This is the result of a reduction in producer forward sales, consumers moving out on the curve, and buying of commodity baskets by long-term investors. Fundamentals remain strong. Consumer inventories are low, global demand robust, while producers continue to struggle from depleting ore grades (at major mines in Chile and Indonesia, for example) and new projects tend to take longer to launch due to rising production costs (related to energy, water, labour and currencies). More workers’ strikes in 2006 cannot be ruled out in response to record high prices. Any output disruptions (especially at smelters/refineries) would feed straight through to prices, in the absence of “shock absorbers” such as spare capacity and stockpiles. For 3-month prices, we see US$5,000 per tonne as a distinct possibility.

Lead

We believe lead prices are near peak levels. Prices will remain strongly supported because of low inventories, but lack the upside price drive seen in other base metals, in our view. Key reasons for this view include the fact that China remains a solid net supplier of refined lead to the West, while global output growth has picked up. We see 3-month prices trading in a band of US$1,000-US$1,150 per tonne over the nearer term.

Nickel

Nickel faced very poor demand conditions during the second half of 2005, driven by cutbacks in stainless steel production and consumer de-stocking. While prices eased some 30% during the period, even the low occurred around a historical high level of US$11,500 per tonne. Supply disruptions, with some 45,000 tonnes of production lost (partly due to the lack of feed), halted the downside in prices, and even though LME inventories have been rising, they remain relatively low in a historical context. We are positive on the nickel price outlook. We see the existing surplus diminishing going forward, driven by a rising trend in Chinese refined imports, a pickup in buying from European stainless steel mills, and low growth in mine output. This should also cause a steepening of the curve. Our near-term 3-month price target is US$15,500 per tonne.

Tin

Along with nickel, tin was a distinct underperformer in the second half of 2005. However, prices have stabilized after a brief test below US$6,000 per tonne (the 200-day moving average). And fundamental prospects are looking up. In the near term, the outlook for output in key Asian tin-producing regions is dampened by the monsoon season. A generally higher production cost environment also means that prices around US$6,000 per tonne are generating unattractive returns for producers. While prices have suffered from short selling by funds on a negative price trend, consumption of tin has remained robust, driven by China’s electronics sector, and by a move away from lead-free solders. We are looking for a move above US$7,000 per tonne for tin prices again in the near term.

Zinc

Having caught up with strong performance in copper prices in the second half of 2005, zinc remains one of our favoured base metals for 2006. LME inventories are in a steady decline in response to strong demand from the galvanized steel sector, and the lack of sufficient supply growth. The absence of new mine capacity will remain a key market feature over the next couple of years, and together with rising refined zinc imports into China, is a key reason for our bullish stance. The risk of larger-than-expected mine output from China is relatively muted, in our view, as China’s zinc mines are generally small, and are now quickly being depleted. And any technical price correction, given extensive Barclays CTA fund length, should only provide a good buying opportunity as we see a large deficit again in 2006, and have a 3-month price target of US$2,200 per tonne. Far forwards also offer value, in our view.

— The preceding represents the opinions of the authors and does not necessarily represent those of the Barclays group. For access to all of Barclays’ economic, foreign-exchange and fixed-income research, go to the website at www.barclayscapital.com.