Base metals withstand US corporate scandal

Don’t panic.

On the morning of Wednesday, June 26, in the wake of the latest example of gross U.S. corporate misgovernance, it would have taken a brave person to bet on base metals markets ending the week on an upbeat note. Since early 2000, LME metals have tended to take their cue from U.S. equity markets, and speculative shorting of metals in anticipation of a further slide in share values began as soon as the markets opened. However, as equity indices dipped but then regained their poise, base metals prices recovered, then moved sharply higher. A strong close on Friday, June 28, suggests further gains are possible in the period immediately following the report period June 24-28.

Then again, equity market turmoil may not be over yet. Corporate profit expectations in the U.S. are still downbeat, and there is no guarantee that we have seen the last of U.S. financial scandals. However, there are growing signs that industrial metals markets are de-coupling from a panicky share sector and beginning to take their cue from the wide range of leading indicators that are signaling a strong upturn in global metals demand. In each of the past three major bull markets for base metals, the bulk of the price gains were made shortly after a big fall in U.S. equity markets, and we may be on the verge of another illustration of this pattern.

n Copper prices closed strongly on June 28 and look capable of testing the US$1,700-per-tonne level in the week ahead, as tight concentrate availability constrains supply in the face of gradually improving demand.

n Aluminum prices look set to test the US$1,400-per-tonne level again, but fundamentals are not as positive as for copper and forward selling looks likely to emerge in the region of US$1,400-1,420 per tonne.

n Nickel failed to respond to rallies elsewhere in the base metals complex, and price prospects appear limited for the next few months at least.

n Zinc’s strong performance (gaining US$50 per tonne) has opened up the possibility of a return to recent highs at US$840 per tonne, though, given the poor state of market fundamentals, any spike is likely to be short-lived.

n Gold prices fared poorly considering the constellation of apparently positive factors during the report period. Dollar weakness is now acting to encourage selling by non-U.S. investors and may be a sign that the rally has finally run out of steam.

After their strong performance in the second half of the week under review, copper prices are expected to move back into the US$1,680-1,700-per-tonne range.

Low treatment and refining charges reflect a tight concentrate market. As an illustration of just how tight the copper concentrates market is becoming, consider that negotiations between Japanese smelters and three copper miners for July 2002-to-June 2003 treatment and refining charges have been settled at US$64 per tonne and US6.4 per lb., respectively. The deal represents a significant step down from last year’s mid-year terms of US$76 per tonne and 7.6 per lb. The fall reflects a growing shortage of copper concentrate, where benchmark terms in the spot market have fallen to previous cyclical lows of US$30-35 per tonne and 3-3.5 per lb.

This shortage of concentrate is likely to contribute to a further tightening in the Far East regional copper market. Although production in the region grew in the first half of 2002, a 10% decline in China’s copper concentrate imports so far this year suggests that that country’s production growth is likely to slow, and probably contract, over the second half. Meanwhile, regional demand is likely to continue growing strongly as a rebound in export-related demand in Japan and Taiwan (where copper imports in May climbed 34%, year over year) supplements the domestically driven appetites of Korea and China. Regional premiums are already on the rise (with Singapore witnessing an increase of US$10 per tonne, to US$58 per tonne), and this will likely continue.

Aluminum prices broke convincingly out of their 3-week downtrend and performed strongly on June 28. They now look capable of moving up to challenge US$1,400 per tonne. However, the US$1,400-to-$1,420-per-tonne level is likely to prove the limit of any upside move in the weeks ahead, since the factors that are encouraging persistent forward selling at this level are unlikely to change much.

There are now promising signs of a concerted demand upturn in the U.S., where sheet and plate orders have picked up strongly, and extruders are stretching out their lead times as order levels improve. However, the main concern for the aluminum market remains supply. The 215,000-tonne increase in London Metal Exchange (LME) stocks during the second quarter (normally the strongest for consumption) suggests that the market is still in substantial surplus. Recent Chinese aluminum trade data underline one of the contributory factors to this position, showing net exports climbing to 116,000 tonnes in January-to-May from just 5,000 tonnes in the year-earlier period. Consumption growth is climbing quickly in China, where apparent consumption was up by 15% in May, year over year, but supply growth is far outstripping it.

During the third quarter, aluminum stocks will likely climb higher, with the rate of increase probably accelerating for seasonal reasons. Nevertheless, as long as aluminum demand continues to pick up, the prospects of a break above the US$1,420-per-tonne level will increase as the busier fourth quarter approaches.

Nickel appears to have suffered from burn-out. The week’s spike to US$7,500 per tonne deprived prices of the opportunity of benefiting from gains in the rest of the complex. Despite higher prices in copper, aluminum and zinc, nickel’s main emphasis has been on maintaining support at US$7,000 per tonne rather than testing recent highs. This tendency toward sluggishness is likely due to the fact that, earlier in the month, nickel prices had already moved higher, ahead of the LME complex.

The test of resistance at US$7,500 per tonne had effectively already removed any short positions and denied nickel the short-covering potential experienced by other markets during the report period. With resistance at US$7,500 per tonne now established, upside price risks are limited, lowering the risk/reward ratio and lowering the attractiveness of nickel prices at current levels for both funds and consumers.

This scenario is likely to continue over the summer months, when we expect nickel to move in a broad range of US$6,600-7,400 per tonne. Thereafter, prices should begin to launch a more sustainable recovery than that seen in early June, and by the final quarter this year, we expect average LME 3-month prices to move toward the US$7,500-per-tonne area. Not only should nickel be supported by further progress in the industrial recovery; its own micro-economic developments are also finally starting to move in the market’s favour. After climbing strongly for most of the past year, production data, according to the International Nickel Study Group, has started to move into balance. Although this still leaves the nickel market with a supply overhang dating from last year, the trend is supportive of a gradual price recovery later in the year and into 2003.

Zinc prices put in their best performance so far this year, gaining almost US$50 per tonne, or 6%. However, the fact that fund short-covering was the key factor behind the price rally does not bode well for the future. The steady price downtrend since early June sucked in plenty of short-selling from the trend-following commodity trading advisors, but macro fund buying on the lows provided the catalyst for a break of some key levels. Technical patterns and the weight of fund-covering still to be completed suggest that a move up to the recent high at US$840 per tonne is possible, but given zinc’s truly awful fundamentals, any spike is likely to be short-lived.

That is not to say that fundamentals will not improve over the next few months. The closure of substantial amounts of Western smelting capacity for extended mainte
nance programs during the Northern Hemisphere summer months may well mean that zinc metal is in shorter supply than it has been for some time, and this, in turn, would result in much needed withdrawals from LME warehouses.

However, before a real turning point for the zinc market is reached, some permanent smelter closures are required, a trend that may be helped by the steadily weakening U.S. dollar. Lower Chinese exports would also help. January-to-May data show a 3% (year over year) fall in exports, but a broader perspective shows that they nonetheless remain at historically high levels. Our concern is that a general recovery in base metals prices will drag zinc higher with it and that this, combined with the reactivation of the Tara mine in September, will dilute the pressure for much-needed production cuts, leaving the zinc market in limbo for some time to come.

The lacklustre close to the gold market on June 28 brought to an end a week of trading that had seen the most disappointing price developments in bullion since prices began climbing higher in May 2001. Set against the context of several major factors — near euro/greenback parity, the largest case of fraud in U.S. corporate history, and some of the lowest measures of equity strength since the post-Sept. 11 collapse — gold price gains were both small and brief. Furthermore, the end of the second-quarter financial reporting period might have pushed prices higher as bullion holding funds valued open positions based on the quarter-end prices.

Is this it for the rally? Certainly the extent to which short-term risks to gold prices have increased should not be underestimated. What gold’s price failure over the report period shows is that mixing the broad, macroeconomic environment with gold price developments provides nothing more than excuses as to why gold might be higher — rather than reasons why it is higher.

The question remains: What effect does the macro environment actually have on contemporary gold markets? Historically, the two have been interlinked but, for very different reasons (exchange limits, gold-linked exchange rates, etc.), were once standard procedures. Another question: In a liberalized economic environment, are the links between gold prices and the broader macroeconomic environment as close as they used to be?

And yet another: Is the gold market now too small to act as a conduit for disaffected foreign-exchange/equity funds? The obvious answer is no, and they never can be, given the size of the gold market in comparison with the other markets to which it is supposed to relate inversely, namely foreign exchange and equities. Even gold equities cannot compete; remember that the market capitalization of gold market equity is smaller than the Coca Cola market. Recent events confirm to us that the key drivers of gold price direction are the internal, microeconomic factors of the market. It was these that propelled gold above US$300 per oz., leaving recent macroeconomic developments unable to maintain the trend.

Will Japanese investors turn from buyers to sellers as local gold prices weaken and the Japanese yen strengthens? Corporate scandals weakening investor confidence in U.S. assets are not wholly irrelevant, and they maintain an ability to affect gold prices — but only, it seems, at lower prices. With much of the upside momentum in gold having already been expended, macro developments have so far lacked the potency to push prices into a higher gear and break resistance at US$330 per oz. Short-term price risk has therefore shifted quickly to the downside, and a test of key support at US$315 per oz. should now be considered imminent.

Not only have speculative funds amassed one of the largest net long positions on record, but Japanese-based selling is now a risk. Since Japanese investors turned more friendly toward bullion in the first quarter of 2002, on the back of a weaker Japanese yen, weakness in the U.S. dollar has pushed yen gold prices lower. Although the level of Japanese gold buying in the first quarter was not as high as was implied by some reports, it did form one of the factors of gold’s rally.

With the yen now much stronger and local prices lower, liquidation from Comex funds may not be the only source of selling. Japanese funds have already pushed platinum prices sharply lower. Is gold next?

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


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