Base Metals: The Last Leg Higher

Since the latest consensus metal price forecast survey conducted by Reuters in mid-January, in which we were the most bullish forecaster for 2004 on an aggregate basis, analysts have been busy making upward price revisions for the years ahead.

We expect base metal prices to continue to perform strongly over the near term, even though we have already seen multi-year highs. We also believe the rising price cycle will turn after this year. In the Reuters poll, our 2005 price projections were toward the bottom end of consensus forecasts, and recent upward revisions by the market make our 2005 forecast look even more pessimistic.

What happens after 2004?

After a strong 2004, which is likely to produce the strongest London Metal Exchange metal prices since the late 1980s, we see the metal price cycle turning. By that time, the metal consumer will be fully stocked. The producer will have started selling forward on a larger scale, while the speculative investor will be exiting on the first signs of slowing economic activity. We believe there are several reasons for a trend reversal:

— Slowing economic activity in the U.S. as the consumer is faced with tighter fiscal and monetary policy after the U.S. presidential election in November amid large budget deficits. Our economists see the U.S. Fed Fund rate rising from 1% to 2% by the end of this year. Although this in itself is not enough for a trend reversal, as there is a historical positive relationship between metal prices and interest rates, we believe a hike could well be taken as a first signal among funds to liquidate long metal positions.

— A reversal of the falling U.S. dollar trend, with a strong negative correlation with base metal prices intact. Our foreign-exchange strategists foresee further dollar weakness during the first half of 2004 but believe that the trend will reverse during the second half of the year.

— A slowdown in Chinese economic activity, amid softening growth rates already evident in bank lending, fixed asset investment and foreign direct investment. Because of extensive exports of manufactured goods from China, lower demand from the U.S. consumer will enhance the slowdown.

— Supply will catch up while new operating capacity comes on stream in most base metal markets in 2005.

The fact that LME 3-month prices are trading sharply higher does not necessarily mean that future prices along the curve are performing as well, or are even moving in the same direction. Aluminum and copper 3-month prices are about 5% and 11% higher, respectively, since the beginning of the year. Their respective 63-month prices are only 2.6% and 1.2% higher over the same period. Our analysis shows that the backwardation expands as the cash price moves higher. As a result, we believe producers risk little at present when they hedge production forward.

Less impressive metal price performance outside the U.S. due to currency effects has had a clear impact on producer hedging decisions. But our expectation that the falling U.S. dollar trend will reverse by mid-year serves as an additional incentive to sell sooner rather than later, before large-volume forward selling hits the market.

With relatively limited producer selling pressure so far, consumers are perhaps better off awaiting lower forward prices, if they can (especially in the U.S., owing to exchange-rate effects), though aluminum is an exception. Metal investors should focus on liquid nearby contracts, where we see strong price performance, especially during the first half of 2004.

Above-trend growth is likely to yield the strongest metal price performance since the late 1980s this year, and we expect the cycle peak (cash average) to occur in the second quarter. The quarterly trend thereafter is based on a seasonal slowdown in demand in the third quarter and on the likelihood that macroeconomic indicators will signal that profits should be taken. But as we expect underlying physical demand to remain strong at the time, we see another strong fourth quarter, before the upward trend turns and the last leg higher in this cycle is over.

— 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. Queries may be submitted to the authors at kevin.norrish@barcap.com and ingrid.sterbny@barcap.com