Price volatility expected for copper

Although copper recently lost its upside momentum, we believe downside risk to prices is limited beyond technical support targets because of sheer physical shortages and modest speculative length. However, high price volatility is likely to persist through the quieter summer months when seasonal demand slows, and while investment fund activity becomes more diverse after pushing prices largely in the same direction through the first quarter.

U.S. dollar strength, slowing growth in some leading demand indicators, and expectations of tightening monetary policies were the key macro themes that triggered long liquidation among some funds — fuelled by technically driven commodity-trading-advisor profit taking and short selling. However, other funds still appreciate the potential effect on prices of acute inventory shortages in a period that we expect to be the strongest global growth phase in almost 30 years. At the same time, longer-term investors remain attracted to metal markets, benefiting from the “roll yield” in a backwardated market like copper.

Similar to most other base metal markets, signs of slowing Chinese activity were a major factor behind the copper price correction in the second quarter. Sharp falls in physical premiums and freight rates are firm evidence of better metal availability in China. This follows a period of record imports of refined copper and sales of an estimated 200,000 tonnes by the Strategic Reserve Bureau (SRB), which we believe have pushed bonded warehouse stocks up to an estimated 400,000 tonnes. As with nickel in the first quarter, a period of de-stocking has been occurring in China. As a result, we see lower copper imports and softer prices through the third quarter, before physical shortages take copper to a fresh peak later this year through to the first quarter of 2005.

We believe Chinese demand could surprise on the upside beyond near-term softness. While Chinese officials are determined to slow overall growth, it is important to consider the implications for copper consumption of greater investment in certain sectors, such as power, which is (in contrast to the Western World) the largest end-use sector of copper in China (accounting for about 30% of total demand).

Against an extremely tight U.S. market, a robust Japanese market, and only the first signs of improving demand in Europe, we believe the copper market will remain in a large deficit next year. Scrap availability has improved, and we expect copper mine output to rise through the second half, but it will take time for this material to relieve a refined market with low, and still falling, inventories. Although upwardly revised, our average price forecast for 2005 is lower than that for this year, which reflects extreme supply shortages in 2004 following the unexpected output disruptions at the Grasberg mine in Indonesia.

Data from the Commodity Futures Trading Commisssion reveal that investors in the Comex copper market have been active taking profits from long positions and selling fresh shorts in recent times. As a result, the net long copper position has fallen below 10,000 contracts, compared with a peak of 48,000 contracts in October last year. We believe fund length (what is left), will continue to erode over the nearer term on likely prospects of a firmer U.S. dollar and signs that strong leading demand indicators are topping out. However, the net Comex fund copper position is unlikely to move into short territory, at least on a sustainable basis, as low inventory levels are likely to keep forward price spreads in backwardation, which we expect will push prices higher again as seasonal demand picks up later this year.

London Metal Exchange (LME) copper futures open interest has been falling steadily since November 2003, in contrast with the price for the majority of time. This relationship suggests short-covering against physical deliveries. Since the beginning of the second quarter, however, simultaneously falling open interest and prices suggest long contracts have been liquidated, in line with a slowdown in certain leading metal indicators.

As prices fell back toward US$2,500 per tonne, however, fresh exposure to the metal began to build, as market-specific fundamentals remain supportive. In May, 1.3 million lots of copper futures were traded on the LME. This represented a fall of 13% on the month and 14% on the year. More than this, the volume of copper turnover was the lightest since December 2002. In spite of this reduction in turnover, copper remained comfortably the second most actively traded metal on the LME, with more than 500,000 more lots traded than the next most active metal — zinc.

Despite the recent profit taking and increased price volatility, the shape of the forward copper curve has been rather stable and in a full backwardation in the second quarter. Prices for all traded future contracts have eased during this period, reflecting a combination of nearby fund profit taking and producer sales of far-forward contracts.

However, because of low global refined copper stockpiles, we expect the nearby backwardation to firm again in a strong demand environment, while we also expect far- forward prices to stay supported on a high underlying level of demand.

Physical spot premiums in China have continued to ease since the beginning of the second quarter, reflecting record imports of refined copper and sales from strategic stockpiles. Accumulation of copper ahead of an expected renminbi revaluation this year and subsequent selloff as the peg appeared likely to persist for longer are also believed to have been factors behind lower domestic copper prices. As a result, Chinese spot premiums have fallen to only about US$50 per tonne compared with a recent peak of US$150 per tonne.

In the U.S., spot premiums have continued to move sharply higher as that market remains particularly tight. And in Europe, there are now signs of copper demand finally improving, which has also translated to somewhat firmer physical premiums. Although the copper concentrates market remains extremely tight, there is now evidence that historically low spot treatment and refining charges (TC/RCs) are starting to bottom out. Better scrap availability and the first material from CVRD’s Sossego mine have helped this development. It appears most merchants are now reluctant to buy concentrates for prompt delivery much below US$20 per tonne (US2 per lb.).

Japanese copper smelters expect higher mid-year TC/RCs, looking for US$60 per tonne and US6 per lb. for the July 2004-June 2005 period, as the first round of talks with miners starts. Contract treatment charges for 2004 were settled around US$42-46 per tonne, compared with mid-2003 terms at US$47 per tonne.

LME stocks have continued to fall sharply through the second quarter, with European and Asian LME stocks largely depleted, while the U.S. has only about 100,000 tonnes left; down by about 70,000 tonnes since the start of the second quarter.

With China having absorbed much of the world’s copper, the U.S. market is particularly tight, as domestic demand has picked up sharply. LME stocks are set to remain low, as any material held off-warrant outside China is insignificant, in our view.

Taking into account the amount of cancelled warrants, only about 70,000 tonnes of LME copper is now available. In mid-June, cancelled warrants were almost 30,000 tonnes, or about 23% of the remaining total. Because of low copper inventories, price spreads are likely to remain well bid, with the nearby backwardation likely to flare out to attract any excess material.

Total reported copper stockpiles (including inventories at exchanges, producers, consumers and merchants) have fallen away rapidly from the all-time highs of the second quarter of 2002, and stood at an estimated 1.3 million tonnes at the end of May. This is more than 600,000 tonnes lower compared with the start of the year.

According to data collected by the International Copper Study Group, stocks held at Western World consumers and producers stood at 156,000 tonnes and 661,000 tonnes, respectively, at th
e end of March (latest data available). Although difficult to estimate, anecdotal data suggest refined copper stockpiles in bonded warehouses in China could amount to about 400,000 tonnes.

In line with falling inventories and improved demand conditions, the historically high stock-to-consumption ratio has also declined rapidly. We estimate total stocks measured as weeks of consumption now stand at only five weeks — the lowest since the third quarter of 2000. This is less than half the recent peak of 10.3 weeks, recorded in the second quarter of 2002.

Chinese refined copper imports remained high in April, at 136,100 tonnes, while exports were, as expected, larger than usual at 11,600 tonnes, leaving net imports at 124,500 tonnes. For the period January-April, imports were 45% higher at 524,900 tonnes, while exports were 3% higher at 22,500 tonnes. Scrap imports were also stronger: +9.5%, year over year, at 1.1 million tonnes in January-April. However, imports are expected to have slowed in more recent months.

Imports of concentrates were 8.4% lower, year over year, in January-April at 791,000 tonnes. This has helped ease the tight concentrate market, and slightly higher spot TC/RCs have been registered recently as a result.

The global refined copper deficit widened further in March — to 180,000 tonnes from a 120-tonne deficit in the previous month, and a 86,000-tonne deficit in the same month a year earlier. The deficit stood at 379,000 tonnes in the first quarter, compared with a 143,000-tonne deficit in the first quarter of 2003.

Global copper usage rose a further 10%, month over month, and 9%, year over year, in March, while first-quarter year-over-year growth was 8.7%. European copper demand growth showed the first signs of improving: +1.3%, year over year, in the first quarter. Demand growth in most other regions remained strong through the first quarter, year over year: +25% in China, +12.9% in Japan, and +8.3% in the U.S.

The availability of scrap increased +19% in the first quarter. Mine output, on the other hand, remains constrained, having fallen 2.1%, year over year, in the first quarter, while total refined output rose 2.7% over the same period.

Nickel

Movements in the nickel price were a precursor to price falls in other base metals during the first half of this year. Multi-year high nickel prices led to substitution, de-stocking and higher production, which brought the price down by about 40% from its peak in January. However, as the de-stocking process in the Chinese stainless steel industry comes to an end, refined inventories continue to fall from already-low levels, and given limited scope for further price-driven production increases, we believe US$10,000 per tonne represents a solid floor for nickel. Prices should rise again in the second half as a result of sheer inventory shortages and a structural supply shortfall.

Sharp falls in Chinese imports of refined nickel in recent months are showing signs of bottoming out. Despite news of smaller stainless steel plants closing in China in response to measures against overcapacity, large projects are still proceeding, which will require large intakes of nickel. China’s largest stainless steel maker, Shanxi Taigang Stainless Steel, is set to proceed with plans to boost output by a third this year to 900,000 tonnes, from 670,000 tonnes in 2003 (of which 85% is the nickel-richer 300-series), and is also planning to build another plant that would add 1.5 million tonnes by 2006.

Meanwhile, the Shanghai Baosteel Group plans to triple its purchases of nickel this year from about 6,000 tonnes last year in order to supply two new stainless steel plants. In addition, Chinese nickel demand outside the stainless steel sector is rising. We expect demand from the battery sector to rise by more than 30% this year to about 16,000 tonnes, though this partly reflects a shift in production from Japan. And the International Stainless Steel Forum suggests global melt output will rise 6.8% this year. Japanese melt production is strong, up 4% to 1.1 million tonnes in the first quarter.

Although the nickel scrap market remains tight, falling nickel prices have attracted some secondary material to the market. According to industry consultant Brook Hunt, this means the Western World scrap ratio is likely to rise from 42% to 44% this year, removing some 20,000 tonnes from the demand side in the refined market. However, high primary price volatility is also likely to keep the scrap ratio unstable.

Also on the supply side, it now appears the first output from Inco’s 60,000-tonne-per-year Goro project will be delayed until 2008, after the company outlined changes to the project — changes that indicated startup before mid-2007 is unlikely. Although Inco’s Voisey’s Bay project in Labrador is scheduled for mid-2006, this highlights the risk that the structural under-supply in the nickel market may persist, which would keep long-term prices high. Although consumers are likely to reduce their dependency on nickel as much as possible, there is limited scope for substitution (so far primarily seen in emerging markets) because of superior quality of high nickel grade stainless steel.

Arcelor, the world’s largest steelmaker, recently stated that Chinese steel demand is weakening and the steel price boom is to end. And South Korean producer Posco announced it would reduce domestic prices for nickel-containing stainless hot bands and cold-rolled coils by 8% with immediate effect. This is also in line with softer demand for stainless steel in the domestic market.

In Europe, however, stainless steel producers such as ThyssenKrupp, TK Stainless and Acerinox say they are not planning to shut down plants for maintenance or holidays this summer, owing to robust demand.

Activity has been dominated by long liquidation, while short selling (primarily by commodity trading advisor funds) fuelled the downward move in prices at one point in the second quarter. More lately, however, prices have bounced back, while open interest has stabilized, suggesting shorts have been covered and that some fresh long exposure has been established.

Nickel remained the second least actively traded contract in May, and with only 219,300 lots traded, only tin saw less turnover. The gap between nickel and the next most actively contract, lead, actually grew in May to 56,594 lots from 34,102 in April. The turnover reduction amounted to a fall of 27% on the month and an even larger 40% reduction, compared with the corresponding month last year. The fall in turnover has been accompanied by a fall in the price from record levels, indicating that overall exposure to the metal is being reduced.

Despite price falls along the whole forward curve during most of the first half of this year, the curve remains in a full backwardation, reflecting deficit market conditions. Lately, however, prices have started climbing again, especially for nearby contracts, causing a tightening of spreads across the curve.

Three factors — a move away in prices from 14-year highs; signs that the de-stocking phase in the Chinese stainless steel sector is nearing an end; and further falls in LME inventories — have prompted fresh purchases to secure metal for prompt delivery. As a result, the cash-to-3-month price spread has started to widen again.

A reduction in U.S. premiums has been evident in recent months, which we believe could reflect better availability of scrap, while demand conditions remain robust.

In Europe, we believe Russian full plate cathode is available for US$80 per tonne, in warehouse Rotterdam, while physical premiums in Singapore are also steady.

LME nickel inventories are low at most major locations. Although Rotterdam (a convenient destination for Russian material) remains the largest location for LME nickel, its stockpile has been in a declining trend since the beginning of the year. As a result, total LME stocks now stand at 9,000 tonnes, with available stocks at only 7,500 tonnes, taking cancelled warrants (about 17% of the remaining total) into account. And on a total reported basis (including stockpiles h
eld at exchanges and producers), nickel stocks stand at an estimated 109,000 tonnes — their lowest since April 1991 in absolute terms.

According to the International Nickel Study Group, producer stocks were about 100,000 tonnes at the end of March.

Continuous sharp falls in nickel stocks mean total stocks measured as weeks of consumption now stand at only 5.2 weeks, compared with a recent peak of 9 weeks at the end of 2002.

There are now signs that sharp falls in Chinese imports of refined nickel are bottoming out. Although still at much lower levels compared with last year, gross refined imports showed a third monthly rise in April (to 4,200 tonnes), while net imports were 3,600 tonnes for the month.

Statistics from the International Nickel Study Group for March show mined and refined nickel output were rising, while improvements in global refined consumption were more modest as Chinese stainless steel mills continued to de-stock. Global nickel mine output was 7.1% higher, year over year, in March, while 5.8% higher, year over year, in the first quarter. Refined output was 2.8% and 5% higher, respectively. Total refined consumption was only 0.3% higher, year over year, in March, and 2.5% higher in the first quarter, compared with the same period last year. As a result, the global nickel market showed a 4,700-tonne surplus in the first quarter, compared with a 2,800-tonne deficit in the corresponding period of 2003.

Lead

After aggressive price gains since the second half of last year, upside price pressure in the lead market is now less intense. This is so not only because of the trend in other base metal markets, but also because the second quarter is typically a slower period for lead demand. Physical tightness has eased somewhat, primarily in the U.S., as evident from lower physical spot premiums.

However, the US$700-per-tonne level for 3-month LME lead is set to remain a solid floor, for reported inventories continue to fall and the market remains in deficit. A degree of producer discipline also provides underlying price support; Teck Cominco’s Lennard Shelf mine in Australia remains shut, which is withholding about 75,000 tonnes of lead-in concentrates from the global market.

Unlike other base metals, however, we expect the lead market to move into a modest surplus next year. We believe seasonal demand will bring lead prices to their cyclical peak in the last quarter of this year, which is earlier compared with the rest of the base metal complex.

In line with LME prices, Chinese lead prices have also eased, and local reports suggest most of the large lead producers are holding large stocks of refined lead. As a result, the trend in international trade has not favoured lead to the same extent as it is has for some of the other base metal markets. Chinese refined exports have held up despite reductions in export tax rebates and an overall tight concentrates market, owing to low mine output growth.

There is little evidence that the Chinese have had difficulties in sourcing raw material feed, with concentrate imports approximately 30% higher, year over year, in the first four months of 2004 (at 186,000 tonnes, which is equivalent to about 112,000 tonnes of refined lead). While this enabled a 20% rise in Chinese refined lead output over the same period (to 382,000 tonnes), it also keeps spot treatment charges low, at around US$50 per tonne. Term contracts in Europe, meanwhile, have been concluded around US$120 per tonne, in line with the 2004 benchmark.

We forecast 10% growth in refined Chinese lead consumption this year. However, as auto battery producers will have to pass higher input costs on to their consumers, we expect demand growth will moderate in line with an overall slowdown in domestic economic activity. In the U.S., however, the latest data for auto batteries (lead’s largest end-use sector) from the Battery Council International show strong year-over-year growth in both replacement and original equipment automotive batteries, growing by 7% (to 21.5 million units) and by 7.5% (to 5.5 million units), respectively, in March. This reflects a rise in U.S. car sales over the same period, while higher-than-average temperatures also spurred growth in replacement batteries.

Chinese smelters continue to dominate the spot concentrates market, with high levels of imports showing no signs of abating despite low availability of global concentrates. Strong Chinese import demand means spot treatment charges (TCs) continue to fall, with the Chinese accepting US$50 per tonne.

Term contracts in Europe, meanwhile, have been concluded around US$120 per tonne, in line with the 2004 benchmark. LME open interest for lead futures fell steadily between October of last year and mid-May — at a time when the price was moving largely in the opposite direction. This relationship suggests short-covering against physical deliveries, and was a dominant theme in most base metal market.

More recently, however, the relationship between lead open interest and prices has been more diverse, reflecting a short period of short selling — likely by commodity trading advisor funds. As the market is trading in backwardation, however, these shorts were soon covered, and there were also signs of fresh long exposure being established.

With just 275,900 lots traded on the LME in May, this was the most lightly traded month for lead since September 2002. The reduction in turnover of 17%, month over month, continued the trend for falling lead turnover that has been in place since the start of this year. In year-over-year terms, lead turnover fell by 21% in May.

The whole lead forward price curve remains in full backwardation, and despite recent profit taking, nearby prices are trading well above those registered two months ago.

The backwardation has steepened, reflecting the fact that producers have taken advantage of prevailing price levels to sell production forward, while it also suggests availability of metal for prompt delivery is scarce. We expect the forward curve will remain in backwardation through large parts of this year, until the market gradually moves back to surplus next year.

As the market was moving deeper into deficit through the first part of this year, the nearby backwardation (cash to 3 months) also widened, suggesting market participants were willing to pay a large premium for spot material.

During a seasonally weaker period for lead demand in the second quarter, physical spot premiums in the U.S. eased substantially from their recent peak. However, because of current tight market conditions, they remain high in a historical context — around US$130 per tonne. Premiums in other geographical regions have remained steady.

While European and Asian LME lead inventories are largely depleted, stocks in the U.S. have continued to fall sharply. In fact, U.S. stocks have more than halved since the beginning of the year, and, at June, were at less than 40,000 tonnes. In absolute terms, LME lead stocks are now at their lowest since 1990, at 60,000 tonnes.

Indeed, rising cancelled warrants through the second quarter were accompanied by net outflows. Still, about 8,000 tonnes (or almost 15% of the remaining total) is awaiting outward delivery, which suggests the downward inventory trend will continue over the nearer term.

As a result, total reported lead stockpiles (including those at exchanges, producers, consumers and merchants) are now at their lowest levels we have on record (dating back to 1984), at an estimated 320,000 tonnes. The International Lead and Zinc Study Group reported producer and consumer stockpiles stood at 117,000 tonnes and 126,000 tonnes, respectively, at the end of April. Because of sharply falling inventories, stocks measured as weeks of consumption have now fallen to only 3.2 weeks; this compares with its recent peak of 5.2 weeks in the second quarter of 2002.

Chinese monthly trade statistics show net exports of refined lead were stable in April, at 36,600 tonnes, compared with 37,500 tonnes in the previous month. Despite modest growth in domestic concentrate production (only +1.5% higher at 17
2,000 tonnes in January-April), China’s output of refined lead was 18.3% higher at 541,500 tonnes over the same period, helped by a 30% rise in imports of concentrates.

Data from the International Lead and Zinc Study Group show the global lead market was in deficit during the four months of this year, at 93,000 tonnes.

Data for April show healthy growth in mine supply, of about +16%, year over year, and +4%, month over month, though refined output growth remains depressed. Refined consumption was down over the month, however.

Aluminum

The combination of buoyant demand and constrained supply will move the global aluminum market into deficit this year and next, and keep prices well underpinned. Decisive signs from the Chinese government to slow growth helped trigger the largest daily price fall ever in the second quarter, but we believe fund-driven profit taking based on developments in China (and elsewhere) will represent an attractive buying opportunity for other market participants after a period of high price volatility over the quieter summer months.

Indeed, overheating has been identified in some of aluminum’s key end-use sectors (such as real estate and autos), but also in primary aluminum production. In fact, projects to build a total of 1.5 million tonnes of aluminum capacity have been stopped, and a further 900,000 tonnes of new expansion have been delayed since mid-2003. Also, smelters still using environmentally unfriendly Soderberg technology (an estimated 600,000 tonnes) will be phased out through this year.

Chinese credit controls, together with high spot alumina prices and a lack of power, help reduce China’s supply overhang rapidly. This is already evident from sharply slower exports of primary aluminum. This alone, however, would not drive prices higher, in our view — recall the demand-driven price decline in 2001 despite substantial power related capacity closures (11% of the world total) in the U.S. Pacific Northwest. In a strong demand environment, however, we believe Chinese capacity closures will have a positive impact on prices; consequently, we have revised higher our price forecasts for 2005 in line with the widening global aluminum supply deficit.

We believe power constraints in China will get worse during the remaining summer months, and in mid-June power rates were hiked (with particular focus on aluminum smelting) for a third time this year. China’s power shortages (estimated at -30 million kilowatt hours in the third quarter) are unlikely to ease structurally until 2006. There are also talks of removing the 8% export tax rebate for aluminum, which would leave Chinese smelters further vulnerable to high costs, though we understand a full removal of this rebate is unlikely.Construction (and real estate) is the largest end-user of aluminum in China, and we expect Chinese aluminum demand growth to moderate this year, from +25% to +15%. However, we believe strong demand in other geographical regions this year will offset this trend, most notably in the U.S. (which remains the largest region for aluminum demand), but also in Japan and Europe. Scrap shortages are also helping boost global primary demand growth (by an estimated 1%), which we expect to be +7.2% this year.Spot alumina prices are down sharply from their peak in April. This is in response to lower Chinese imports, as aggressive primary metal production plans are being deferred as a result of tighter credits and poor power availability. A reduction of the 8% export tax rebate is being discussed and, if implemented, could lead to further capacity closures and reduced demand for alumina.However, a tight alumina market through to 2006 means further alumina price falls will be restricted. At present, spot material is trading around US$435 per tonne (f.o.b.), compared with the recent spot peak above US$550 per tonne.– 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 the web site at barclayscapital.com. Queries may be submitted to the author at ingrid.sternby@barcap.com