Metal Matters: Copper, Nickel And Iron Ore

This story features RIO TINTO LIMITED. For more info SHARE ANALYSIS: RIO

-Copper bearishness unwarranted
-Nickel production cuts needed
-Iron ore price forecasts may be too low
 

By Eva Brocklehurst

CIMB believes the bearishness that has befallen the copper market is unwarranted. Commodity investors are now as bearish as they were at the height of the GFC. The fall in prices has highlighted the issue of cost support and the market looks right for a rally, in the analysts' opinion. Growth in mine supply has been steady for some months, along with a fall in copper prices, and this suggests supply should continue to grow. It may not. CIMB thinks the biggest impact will come from the pit failure at Rio Tinto's ((RIO)) mine in Bingham Canyon in the US. Most observers expect supply disruptions for six months. CIMB suspects production will be curtailed for more like 12 months and estimates this could take at least 100,000 tonnes out of the market in 2013. 

The lack of cost support is the key argument from the bears, CIMB maintains. The analysts believe more than 100,000 tonnes of copper production is now uneconomic. Producers are not expected to close down supply as a result of the current weakness but CIMB thinks the market will eventually view price levels as well supported. The next month or two will be critical to measure demand, as the northern hemisphere's industrial production increases over the summer months.

Despite concerns about China because of some weak data recently, CIMB expects growth there will stay supportive of commodity markets in 2013. The size of the country's manufacturing industry means it has dominated the metal markets and been the major driver of world growth. CIMB suspects this has overshadowed the importance of the US. US housing investment is now contributing to GDP growth and productivity has picked up. The recovery in US construction activity should benefit copper most of all the industrial metals. US housing consumes more than 44% of US refined copper. This compares with just 13% in the case of aluminium.

Copper is facing a challenging future, in Deutsche Bank's view. After attending the CESCO conference in Chile, the analysts highlight the potential for industrial action, given the choice by Chilean mine workers to stage a strike while the conference was going on. Despite the broad expectations for surplus in the copper market over the next several years, such risks to supply remain in Deutsche Bank's view. The analysts note the deceleration in demand from China appears to have caught some by surprise. Imports of copper cathode are expected to stay elevated but few expect growth of any consequence. Demand in Brazil has also been disappointing, as that country is set to host the Olympics and World Cup in the coming years.

Some producers are increasingly reluctant to ship cathode to China for fear it will simply go into inventory and maybe they are attracted to superior LME premiums. Either way, sentiment for copper seems to have genuinely turned and the analysts suspect producers are being threatened by both lower revenues and higher costs, creating a narrowing of future profitability. This, combined with the formation of a contango in the copper market, could make copper miners examine the attractiveness in hedging production. Deutsche Bank thinks the challenge to copper supply is sufficient to affect the outlook over the next several years. The analysts suspect that deferrals of projects will become more common and thus the prospect for lower-than-expected supply growth could be quite high.

Turning to another base metal, nickel, and Macquarie finds an oversupplied market. Large production cuts are needed and unless those happen, prices are expected to remain weak. Nickel prices resumed a downtrend over the past month as exchange-traded commodities in general have sold off. Meanwhile, LME nickel stocks are still rising. Despite the ongoing surplus, prices have lost their typical relationship to stocks, in Macquarie's view, with prices still higher than in August 2012, when LME stocks were 50,000 tonnes lower. The general rise in open interest levels suggests another factor at work in the nickel market, which is an increase in the use of LME stocks for financial purposes.

The weakness in the nickel market is due to weak stainless steel production outside China, Macquarie maintains, as production is estimated to have fallen year-on-year in Japan, Europe, Korea and Taiwan in the first three months of 2013. One indicator of the oversupply is the growing discount between Chinese domestic nickel prices and the LME nickel price. Almost all of the older electric furnaces producing nickel pig iron in China are not profitable.

Macquarie finds no reason for optimism about the nickel price in 2013. Apart from Chinese nickel pig iron, producers in Australia and Canada are also suffering from a high exchange rates against the US dollar, and further cuts to production seem likely. The role of financial players must also be considered in limiting the downside, while Macquarie notes another wild card is a potential ban on exports of nickel-bearing ores from Indonesia, starting in 2014.

In terms of iron ore, Macquarie thinks expectations for average prices over the rest of the year are too low and, while there is more supply coming to market in the second half of the year, there is a case for expecting higher levels of steel demand this year. Moreover, it's the trajectory of prices that is more important, with a real risk of another large de-stocking event that causes a short-term collapse in prices. This presents the potential, from an equity market view, to sustain a major overhang and, in Macquarie's opinion, the sooner it occurs the better.

Steel inventory is being drawn down at a good pace but the analysts do not think the volume is the problem, it's the value of the steel that's a concern. Steel prices have fallen consistently since inventory peaked in early March and this suggests to Macquarie that traders must be losing money on the volumes they are holding. Should the traders start to liquidate this inventory then it won't matter if demand still holds up.

The steel mills will be forced to cut production and reduce inventory as the traders de-stock and this will create a similar situation to the third quarter last year. Macquarie is not sure just what might trigger the trader liquidation but one driver could be if the spread between the SHFE rebar contract and the current spot price were to go into backwardation. So far the spread is positive but it's a key indicator to watch, in the analysts' view.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms