Demand outlook positive for metals markets

Although prices managed to recover by Friday, June 21, the overall performance, especially by base metals, was poor during the week under review.

The precious metals complex continued to fare slightly better, though here too there was some disappointment as gold failed to respond fully to the looming prospect of euro/U.S. dollar parity. The London Metal Exchange (LME) complex now looks set to enter the seasonally quiet summer period on a low note, as downtrends become more established. Indicators suggest that price movements are likely to remain either on the downside (in the case of copper, aluminum and zinc) or, at best, capped (in the case of nickel).

The underlying trend of recovery in the U.S. manufacturing sector remains in place. This is confirmed by the higher-than-expected increase in the leading indicator and by the highest level of manufacturing activity in the Philadelphia Reserve Bank’s monthly survey since mid-1998. Of course, in the current environment, the fundamental states of economies are not calling the shots.

Sentiment clearly is not with the U.S. dollar, following the increase in the U.S. current account deficit to its highest level on record. For metals markets, this means that, on balance, the demand outlook is still positive. However, as we saw in the first quarter, launching a recovery on expectations of demand alone can deliver short-lived results. Given this, short-term prices are likely to follow the course of the U.S. dollar — lower.

The week at a glance

– Copper has recently seen the highest level of speculative buying since data began to be collected. This is unlikely to have been all liquidated, and short-term price risks continue to point lower.

– Aluminum markets received a stream of bad news as stocks rose strongly and global production registered fresh increases. Given this situation, another test of critical support at US$1,340 per tonne looks possible.

– Nickel was the best performer, rising to test US$7,500 per tonne for the first time in more than 12 months. However, as with the last test of this level, prices are likely to meet resistance.

– Zinc delivered few surprises as prices consolidated in a US$760-to-780-per-tonne range. The latest fundamental data clearly highlight the market’s weakness, and a test of recent, historical lows cannot be ruled out.

– Gold and the rest of the precious metals complex performed better again, but given the extent of the weakness of the U.S. dollar, gold’s overall performance was disappointing, and more buying from speculative funds is now needed.

After forming a downtrend for most of the report period, copper prices now appear to be unwinding the speculative buying that recently pushed the metal to the highest level of the recovery cycle. The latest data from the Commodity Futures Trading Commission had not been released at presstime. After funds amassed the largest net speculative long position on record, it will almost certainly show a reduction in the degree of long exposure. With prices on June 21 still registering closes in London above the US$,1640-per-tonne level, it would seem that only part of the speculative overhang in copper has been liquidated. If more follows over the short term, US$1,600 per tonne could quickly become the price target, ushering copper into the seasonally quiet third quarter on a downbeat note.

The contradiction between market sentiment and manufacturing conditions has persisted. Which is most important for copper’s fundamental outlook: the record U.S. deficit or the highest U.S. manufacturing indicator since mid-1998? The current of recovery in the US manufacturing sector is still in place, which is a clear positive for demand later this year. However, as we have pointed out, demand has not yet played a pivotal role in the process of price determination. Right now, expectations of demand increases are insufficient to sustain an ongoing rally, and while the latest manufacturing figures augur well for buying levels in the fourth quarter, the pessimism caused by the uncertainties of U.S. assets is providing more of a guide to potential price movements. Furthermore, the pace of LME stock withdrawals also looks set to fall, based on the large drop in cancelled LME warrants.

For the second time in the current quarter, the US$1,340-per-tonne level of support in aluminum is at risk of being tested. What has been a little surprising (not to say indicative of current conditions) is the lack of non-U.S.-based buying on the back of the weakness in the U.S. dollar. Although there are several reasons why aluminum prices have weakened, the lack of consumer buying is a key factor in their sharp decline below US$1,360 per tonne. When prices last tested US$1,340 per tonne, this level was able to provide support. Back then, however, the outlook for copper was improving, owing to expectations of Chinese buying. Now, copper is expected to weaken, LME stocks are heading higher (having gained 27,875 tonnes during the report period), and the latest production data continue to climb — all of which suggests that US$1,340 per tonne may prove a less reliable source of support the second time around.

The latest data from the International Aluminum Institute show that output in May was up 2%, year over year. This illustrates the extent to which primary aluminum production continues to rise in the West, boosted by strong gains in both Latin America and North America as output recovers from power-related production cuts. Meanwhile, Chinese output is rising at levels of more than 20% ahead of year-ago levels, owing to a bubble in the development of new capacity. The result is that, despite a healthy recovery in apparent global consumption so far this year, supply continues to run considerably ahead of demand. A levelling out of demand is inevitable in the third quarter, but production is likely to continue rising, suggesting that a substantial rebound will be required in the fourth quarter if the market is not to register an extremely large surplus this year.

Over the past few days, nickel prices have amply displayed their tendency towards volatility. The latest price movements have not been able to retain all the gains made, but neither have they given them all back. Support at US$7,200 per tonne prevented a full price reversal as the extent of recent volatility deterred speculative short-selling and slowed the pace of any price descent. However, before prices are able to test and break resistance at US$7,500 per tonne, demand fundamentals will need to improve significantly. So far, there have been only pockets of improvement, most notably in some areas of the steel market. However, we suspect that these are not yet considerable enough to provide another fillip to prices, and our short-term price view in nickel remains a return to the US$7,000-7,200-per-tonne area in line with the direction in the rest of the complex.

The US$7,500-per-tonne area is a key one for nickel, and there are several similarities between this latest move and the last time prices stalled here, a little more than 12 months ago. Then, as now, the market faced a seasonally quiet period, the move was against the grain of the metals complex, the Russian port of Dudinka was closed as a result of seasonal flooding, much of the rally was fuelled by short-covering, and, at the higher levels, consumer-based buying dried up. These are all familiar facets of the current nickel rally, and they all point to temporary and unsuccessful attempts to break resistance.

Zinc prices delivered few surprises during the report period, having largely consolidated in the lower range of US$760-780 per tonne. Given the likely direction of the LME complex, combined with the zinc market’s fundamentals, the disappointing reaction of producers to the physical surplus, and the technical vulnerability of prices at current levels, we expect the historical lows of US$748 per tonne to be tested over the summer. Although price targets still exist on the downside, we do not expect to see sharp falls in the zinc market. With prices close
to historical lows, the risk/reward ratio to speculative funds of building short exposure at these sorts of levels is low. The low level of potential profits is therefore a deterrent to aggressive, fresh short selling. Price moves may be sluggish on the downside, but even as the year progresses, upside prospects are limited as fundamentals remain poor.

The zinc market is used to temporary shutdowns by producers over the seasonally quiet summer months, as maintenance work is carried out. Consequently, the latest closure by Big River Zinc at its Illinois plant was never likely to set the zinc market alight. In fact, given the onerous size of the supply overhang in zinc, none of the output cuts so far in zinc is likely to generate any price momentum in the medium term. The consequence was clearly highlighted by the latest figures from the International Lead and Zinc Study Group, which show the clear growth trend in production and the comparatively sluggish moves in consumption.

The precious metals complex has remained the stronger performer over the past week, though it can be argued that gold prices failed to live up to their full potential. With the euro taking further steps forward in its move toward parity with the U.S. dollar, the response of gold prices has been surprisingly poor, particularly during the week that the U.S. current account deficit (the lightening rod of U.S. dollar weakness) reached record high levels.

When the broader market needs to find reasons for gold price movements, it tends to experience the same swings in fashions and trends as the metal’s ultimate end-use in the jewelry industry. It is de rigueur, at the moment, to associate gold price strength with weakness in the U.S. dollar. Only a few weeks ago, the trend was to ascribe gold’s strength to Palestinian terrorists, and around a month ago, it was tensions between Pakistan and India. Amid such shifting sands, we are cautious about blithely isolating greenback weakness as the driver of gold prices.

A weaker dollar does not lead to safe-haven buying. The concept of safe-haven buying is an intellectually bankrupt one, for a start. What dollar weakness does encourage is greater levels of opportunistic, speculative activity, as is clearly illustrated by the large jump in Comex open interest (due mainly to speculative funds). However, the current level of speculative activity can be judged to be close to the saturation point, given that the net speculative long position has remained at historically high levels on the Comex for several weeks. If speculative funds have already bought into gold on the back of U.S. dollar weakness, who else in this shrinking market is left to buy it? We already know that because of hedge buybacks, producers have taken the place of consumers, and the level of small, private and retail investment in gold is derisory. Could it be that speculative funds have now already factored in the spectre of U.S. dollar weakness?

If the gold rally is to avoid running out of oxygen at these higher levels, fresh impetus is required, followed by a clear break of US$330 per oz. This has to come from the speculative funds — at higher price levels, producers will be unwilling to buy back hedges, and consumers will be bullied further toward the periphery. Even though the euro is close to parity with the U.S. dollar, speculative funds have so far been reticent about making the next move.

— The opinions presented are the author’s and do not necessarily represent those of the Barclays group.