Base metals: Temporary profit taking weighs on prices

Base metal prices had a bumpy ride this week. While prices had initially been trending higher in line with the entire commodity complex, profit-taking set in toward mid-week when macroeconomic concerns resurfaced following the publication of higher-than-expected Chinese CPI data.

At the moment, aluminum prices are trading at USD 3,150. Copper and nickel prices stand at USD 8,450 and USD 33,000 respectively. Zinc and lead were hit particularly hard and are now trading at USD 2,600 and USD 3,100.

Despite the setback in prices this week, we are becoming more positive toward the sector. For most of the second half of 2007 our outlook for base metal prices was negative because China was selling off domestic stockpiles and because registered inventories were increasing. Back then we noted that it would take a turnaround in two indicators before we would become more positive again – Chinese imports and inventories. During the last couple of weeks, this has happened.

Chinese trade data for January showed a decisive increase in net imports of copper and nickel. Also on an aggregate basis, Chinese base metal net imports in January were roughly 10% above the values in December. At the same time, aggregate base metal inventories have also started to decline. Consequently, we are upgrading our outlook for the sector. In our view, aluminum, copper and nickel have the most upside potential.

While the turnaround in Chinese imports and registered inventories confirms our initial expectation, there are also some surprises. Initially we would have expected this to reflect a strong recovery in demand, which starts pushing inventories lower and forces China to import more. Instead, as it turns out now, it is rather a series of supply disruptions which is causing a deterioration in availability.

Nevertheless, the effects are the same. In the current environment of rising volatility, we would say that supply disruptions are even a more powerful price driver than a gradual recovery in demand. However, because it is more problems on the supply side and less a demand recovery across the board, investors should be selective with new exposure to the sector. Some markets are more affected by disruptions than others. Moreover, while for some markets such as zinc, the supply problematic is probably only a shortterm, temporary phenomenon, in other markets, such as aluminum, the supply situation is tightening longer term.

Aluminum, copper and nickel are most affected by the supply problems. In China, the administration is actively trying to curb energy-intensive aluminum production in light of rising coal prices and electricity shortages. Production in South Africa faces similar problems. In the copper market too, the main problem is electricity supply in major producer countries. In Chile, which is the world’s largest copper producer, a severe drought is reducing hydroelectricity generation. Moreover, there is a natural gas shortage emerging due to reduced supplies from Argentina. Apart from energy problems, there are also problems with falling ore grades and access to sulphuric acid, which is also necessary for producing copper.

source: CS