Remarkable growth in base metals' performance

Base metals have put in a remarkable performance over the past few years and much of this has, one way or another, been linked to China. The global economy ex-China has been relatively subdued with Europe and the US putting in a disappointing performance, especially when one considers the record low interest rates over the past few years. Admittedly, many Asian economies have been performing well, but much of this is again linked to China as it set its sights on catching up the developed world. As buildings and industrial plants shoot up and infrastructure is rolled out, China has entered the global market for commodities in a big way, to the extent that in some cases, notably in zinc and aluminium it switched from being a net exporter to a net importer, although this may be only a temporary change.
China’s growth acceleration was a much needed boost for the base metals markets as recently in November 2001 the metal prices were on their knees and supply surpluses were leading to an excessive build up of inventories. The turnaround in China has seen a steady change in the fundamentals for the metals with stocks for most metals now approaching critical levels. The question now is whether China’s growth can be sustained or whether it will be choked off by commodity shortages and inflation. China’s growth has had wide reaching consequences, Japan and S.Korea’s industrial output grew in the January to September 2004 period by 7.7% and 11.7% year on year respectively. Much of this has been boosted by strong export demand from China. Demand for commodities from China has had a far reaching bullish impact on commodity producing countries, particularly in Australia, South America and Africa.
With China generating widespread growth and signs that industrial activity in the US and Europe may be about to pick up again, there is a real danger that demand for metals will outstrip supply and with stocks already low, there may be a sustained rise in commodity prices. So far higher commodity prices have largely been absorbed by manufacturers who have found it difficult to raise prices to consumers as there is so much competition and over capacity in the global economy. However, in mid-October base metal prices started to correct as some investment and hedge funds liquidated their base metals positions. The trigger for this move was concern that China’s demand for metals may slow. The move lower was a much needed break as metal prices were becoming overstretched.
The 2003 to 2004, base metals rally has already out-stripped the previous three rallies, raising the question whether there room for further gains. Anecdotal evidence suggests some parts of the world’s trading infrastructure are already at their limits and are constraining economic activity, notably shipping, power generation and financial debt. These constrains may be a sign that there is not much more room for further growth, until more investment has been made in the areas of these shortages. The situation in each of the metals, as discussed below, paints a similar picture.

Copper
Copper’s outlook for the next six months is generally positive and although the supply / demand deficit is expected to move towards a small surplus in the second half of 2005, the market will likely remain tight. With low levels of exchange stocks and with western world stock to consumption ratio at 3-6 weeks, the market will remain vulnerable to supply disruptions or any pick-up in economic activity. The copper supply / demand deficit is projected to return to being balanced in 2005 before seeing a surplus develop in 2006. The swing from deficit to surplus is forecasted as a result of a significant pick up in mine and refined output. Although mine output is already increasing with the restarting of Grasberg and with new capacity coming on stream, refined output may take longer to gear up as smelters will need to replenish their concentrate stocks after the heavily drawn downs in 2003 and in the first half of 2004. The pick up in mine output can be seen by the rapid rise in treatment and refining charges which have moved from $25/dmt and 2.5c/lb in May to $90/dmt and 9c/lb. Supply is forecast to rise by 6.5% in 2005 to 15.45 million tonnes, from 14.50 million tonnes in 2004.

Aluminium
The aluminium market has been particularly strong in the past few years with world demand rising 6.7% in 2002, 8.1% in 2003 and set to rise closer to 9% in 2004. After such a strong period of demand, it is not surprising that demand growth is expected to moderate in 2005 to around 5.5%. Production has also been strong, with supply surpluses seen in both 2002 and 2003, however 2004 and 2005 are expected to be deficit years as shortages of alumina and power supplies restrict smelter output. China’s rapid expansion of late has left it short of power and aluminium smelters are one of the industries that have suffered. Aluminium demand has been particularly strong in the US construction and transport industries. Although car production is weakening in the US, the truck and trailer market is very strong (a sign of broader economic expansion). In Europe, demand is good with construction and general engineering leading the way and in Japan demand is strong in all areas except the construction industry. Although on the surface the fundamentals for aluminium look strong, the exceptionally strong growth in demand in 2004 suggests that consumers have been re-stocking. This means demand going forward may suffer as consumers stop restocking and run on a hand-to-mouth basis.

Zinc
The zinc market is emerging from many years of supply surplus, but 2004 saw the swing from supply surplus to deficit and this should last into 2006. A combination of stronger demand and a slowdown in production growth will lead to the market moving from a 210,000 tonne surplus in 2003 to a 230,000 tonne deficit in 2004 and 2005. The turnaround in zinc’s fundamentals has taken time to come about, especially as producers started to make production cutbacks three years ago. However abundant smelter capacity and the willingness of smelters to run down concentrate stocks meant that despite a fall in Western mine production in 2002, refined out continued to rise. The earlier cutbacks in mine production and the drawdown of concentrate stocks have however tightened the concentrate market. Although new mine output is expected to pick-up this year, it is likely that smelters will first need to rebuild concentrate stocks. Therefore world refined output is expected to rise only marginally this year, before recovering later in 2005. The slowdown in refined output growth in 2004 has started to have an impact on stocks. The outlook for zinc is constructive as 2005 is likely to see further tightness in mine output which is expected to constrain refined output and see the drawdown in LME stocks gain momentum. In turn, this should support LME prices, but as the stock situation is unlikely to get critical, prices may find the upside capped.

Lead
The lead market is fundamentally tight with primary and secondary supply unable to keep up with consumption. The tightness in the market is mainly a supply issue as lead demand is not particularly strong with world growth at around 2% per annum. Mine production is expected to rise 2% in 2004, before picking up further in 2005. This should start to ease the tightness in the market and return the market to a more balanced position. The impact of the deficit can be seen in the LME stocks, which have fallen from 185,000 tonnes in September 2002, to 32,425 tonnes in September 2004. Stocks were then boosted by a one off delivery of 20,000 tonnes in Singapore, which took the total to 52,525 tonnes. Since mid-September, stocks have fallen slightly to 49,200 tonnes. Producer and consumer stocks have also been falling, to the extent that the stock to weeks’ consumption ratio has fallen from 5 weeks at the start of 2003 to around 3-4 weeks.
One of the main hindrances for lead supply has been the cutbacks made to zinc mine output. From late 2001 various mine cutbacks in zinc have impacted lead concentrate supplies as lead is mined as a coproduct of zinc. Lead mine output is now picking up albeit slowly, but as it does and if China’s rapid pace of growth slows, then the tightness in the lead market should be relieved.

Nickel
Nickel has had a phenomenal run, since reaching lows of $4,290/tonne in late 2001, price have rallied to $17,700/tonne in early 2004 and have spent the rest of 2004 trading in a volatile fashion either side of $14,000/tonne. The strength of the market has been the result of a combination of factors, notably supply disruptions caused by strikes, delayed production expansions and the massive investment in China’s stainless steel capacity. The result has been two years of supply / demand deficit.
However, the market is now changing, strong demand, restocking and fund buying, forced prices to extremes, which encouraged some stainless steel users to look for substitutes . High prices also enticed more scrap on to the market. Higher production of low-nickel stainless steel (the 200 series) has cut primary nickel demand and has also freed up more stainless steel scrap. The high prices seen over the past few years are unlikely to be seen again for some time. Part of the problem that led to the high price was failure of new technology. In the late 1990’s the promise of cheap new supply via pressure acid leaching, meant that other more traditional production projects were put on hold. When the new productions facilities failed to produce the scheduled quantities of metal, the market found itself in a supply deficit situation. The worst of the deficit has now passed and as new production projects are on course, production should start to pick up significantly over the next three years.

Tin
The outlook for tin has been transformed over the past few years after being in a depressed state for much of the late 1980’s and 1990’s. During this time the market suffered from falling demand and excess production. However, extended periods of low prices meant low levels of investment in the industry which eventually led to structural changes . The tin market is once again fundamentally sound as the overhanging stocks have now eroded. In 2001, LME stocks stood at over 30,000 tonnes, these fell to a low of 3,000 tonnes in June 2004. Production cutbacks in China, lower production in Australia and the ban on exporting concentrates from Indonesia since June 2002 have been important factors in tightening up the supply side of the tin market. Shortage of concentrates led to an almost halving of refined tin production in Malaysia in 2003 to 18,250 tonnes from 30,000 tonnes in 2002. However small independent miners in Indonesia have now set up crude smelters so some pick up in exports of tin are expected, especially with these higher prices.
Perhaps the balanced nature of the market is best depicted by the lack of price gyrations since May 2004. After recovering from lows in 2001 and 2002 at around $3,600/tonne, prices climbed steadily to $5,000/tonne in December 2003 and then raced up to $9,650/tonne in May 2004. Since then prices have traded within a sideways band between $9,250/tonne and $8,380/tonne. The rapid change in the fortune of the tin market is thought to be both cyclical and the result of structural changes.

The future outlook
There is a controlled slowdown in China which takes the pressure off oil and demand for metals and allows for stronger US growth without raising inflationary concerns. In this scenario base metal prices would remain strong for the next three to six months before better supply leads to lower prices. During this time the metals will remain vulnerable to price spikes, but the funds are less likely to get aggressively involved as better supply is on the cards. This best scenario has a good chance being seen, but it is important to be aware of what else could happen if other situations develop. A hard landing in China that impacts metal demand significantly is seen as the least likely scenario to unfold as China and many of its Asian neighbours have built up large reserves of US dollars which should enable them to withstand various shocks should they materialise. However, a correction to the imbalances in the US financial markets seems long overdue, so a scenario of further dollar weakness and slow down in western economies is quite possible. If this scenario is seen then hopefully it is played out in a controlled manor, otherwise the financial markets may undergo a sharp correction, which is likely to drag base metals down too.