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Base Metals: Supply Side Crucial

Commodities | Feb 07 2007

By Greg Peel

The prevailing theme in commodity price forecasts for the last three or so years has been “stronger for longer”, otherwise referred to as a “super-cycle”. The super part is mostly a reflection of the Japanese experience through the sixties and seventies and the comparisons made with a much bigger China.

Those metal price forecasters who were hanging onto a “reversion to the mean” or historical cycle model a while back have since been trampled in the stampede. Even super-cycle proponents were forced to shake their heads in disbelief as spot prices for metals just kept on going up. Even last year’s recovery from the May correction lows have left the odd analyst bewildered.

Nevertheless, a “reversion to the mean” belief is still in place – the problem is there’s not a lot of consensus on what that mean is. It is generally agreed to be at some level lower than here, but higher than the old, pre-China mean. Analysts are still backing the supply side to catch up with demand, even though it has been very slow out of the blocks. What has frustrated analysts, however, is constant delays and disruptions to new or expanded supply along the way.

So how are we left in 2007? Last month Reuters conducted its annual price forecast poll. The consensus was that supply would catch up, but not until 2008. 2007 would likely see some weakness in copper and aluminium, but further strength in nickel and zinc. Polling 40 analysts resulted in the following price move averages:

Aluminium down 7% in 2007 and down 8% in 2008. Copper down 9% and down 15%. Nickel up 9% and down 19%. Zinc up 14% and down 21%.

The Red Kite debacle last week may have altered prices somewhat, but it only serves to highlight the other important factor in the market – fund investment. Whether or not a 10% overnight fall in zinc was justified is by the by. Red Kite made its unit holders very rich last year, and then had a bad month. They just didn’t want everyone to bail out all at once in a panic. Hence the market panicked.

But metal prices are traditionally volatile, and lately even more so. The addition of fund investment into the mix has seen to this, as it is not the miners, smelters and fabricators who buy/sell as if the world is about to end. Heady down-days can easily be matched by up-days. It’s just that down is a little more slippery (elevator versus stairs).

What funds will do in 2007 is largely unknown. It is a given that global liquidity is still abundant and money has to go somewhere. It is also possible that funds are already moving onto the Next Big Thing, believing metals to be yesterday’s story now. But then those punters who missed out might think now’s a good time to get in.

So that brings us back to fundamentals. There is little disagreement that demand will remain robust due to a strong global economy in general, and more specifically a rethink on weakness in either the US or China. Thus supply must be the key, and the Reuters poll would tend to suggest the long-awaited supply side catch up begins next year.

Take it all with a grain of salt, says ABN Amro. For example, while the average copper price forecast for 2007 was US$2.77/lb the range was US$2.04-3.50/lb. Hardly what one might consider “consensus”.

Copper is largely the bellwether for all base metals and the reality is stocks are slowly beginning to build. A supply side response is under way. It should have been under way last year, or even the year before, but there were those frustrating disruptions. As ABN puts it:

“Both 2005 and 2006 were years characterised by above-average levels of supply disruption. These included labour strikes, earthquakes, pit-wall failures, truck-tyre limitations, labour shortages and, in some cases, deliberate targeting of molybdenum-rich areas of ore bodies at the expense of copper.”

You could also add to this equation that large miners have deliberately reduced their output. This is not manipulation. Miners have taken the opportunity of high prices to extract metal from low-grade ore bodies that were previously uneconomic.

Not only does supply of metal need to catch up, but so does supply of infrastructure, equipment, spare parts, and labour force. And the weather? Well there’s not much we can do about that. The catch-up process is a slow one, which is probably reflected in the general feeling that 2008 will be it. But then, analysts have been made to look foolish a lot lately, even though it’s a bit hard to blame them.

UK-based Natexis Commodity Markets suggests that the price performance of copper this year is a sign of things to come. While the rebound in late 2006 was “extraordinary”, this month’s prices are around 35% lower than the May 2006 peak. Says Natexis:

“The performance of copper reinforces the point that given the incredibly high starting point, with prices far in excess of the marginal cost of production, a constant stream of bullish news is required to keep prices at inflated levels and once this news flow dries up the downside potential is significant.”

Nevertheless, says Natexis, “buffer stocks” are still low and tightness at the concentrate stage (except aluminium) ensures any supply disruption or demand surge has a material effect on prices.

If you had to find some anecdotal consensus among a plethora of recent analyst reports it would be this:

Aluminium is not suffering supply tightness and has thus underperformed. More weakness is expected. Copper supply is building, and provided disruptions are minimal we should see lower prices ahead. Nickel will remain tight as demand is strong and supply slow, but today’s prices will have to give way eventually. Zinc is the tightest and the supply side catch-up is the furthest off.

How does this play out in listed mining stocks? Consensus is the big diversifieds are cheap even if metal prices fall. Some pure-plays, however, are starting to look like their day in the sun might be coming to an end. But then the fortunes of pure-plays are inexorably tied to spot prices. Analysts have not predicted spot prices at all well for about three years.

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