Commodities | Apr 27 2006
By Greg Peel
The emerging school of thought amongst commodity analysts, as has become apparent in reports that have been rapidly crossing the FN Arena desk recently, is that the most recent red hot price hikes in commodities indicate speculative momentum that has moved beyond fundamentals. The warning here is that an outside shock could trigger a pullback and a period of extended volatility. However, this does not change the view that fundamental evidence is still extremely bullish.
This school is not saying crash – it is saying keep on your toes and look for opportunities to buy in again at lower levels if a pullback occurs.
My colleague Chris Shaw has been attending the Commodity Investment World Conference in Tokyo and reports the mood was set by Barclays Capital’s head of commodity research who stated emphatically that fundamentals make the market look very, very bullish (Fundamentals Still Driving Commodity Prices: Commodities, 27/04/06).
National Australia Bank analysts subscribe to the view as well. While acknowledging that speculation has also triggered large price increases, they note that fundamentals have also played their part and that the first quarter has only seen a tightening.
We all now acknowledge the supply side. A decade of underinvestment in capacity coupled with rising input costs and shortages of skilled labour and equipment have hamstrung desirable production increases. What has been in contention is the demand side. How much more could demand grow at these prices?
China, along with the US, has led industrial production in the last three years. The general expectation was that China would have to slow down, and there have been similar expectations for the US economy. However, NAB notes the demand picture has strengthened significantly in the past few months.
Driving this firstly is China. Slow down? You’re kidding! China’s industrial production has continued unabated, notes NAB, at 16% in 2005 and maintaining this level into 2006. Joining the team has been East Asia, which has also outperformed production expectations. US production has not yet waned, but even if it does we see Japan and Europe picking up the ball now. The demand side is far more globally balanced than it was.
Having said that, NAB acknowledges even this solid demand picture does not justify all of the price hikes in the first quarter. Speculation is definitely part of the picture. But with supply side disruptions becoming a constant threat NAB suggests speculators are likely to be rewarded.
Labour is the biggest problem. Soaring prices have not been lost on mine workers, and they do not intend to be left out of the equation. Mine accidents have also contributed, but labour disputes began in 2005 and are continuing the trend in 2006. Mexico has been a focus, with disputes at Grupo Mexico’s massive copper and zinc/silver mines leading to lost output and low stock levels.
2006 will see the expiry of existing labour contracts for various mines and smelters across the globe. Most of the contracts are related to the North and South American copper and aluminium industries. Strikes during negotiation periods are a very good chance.
NAB has fundamentally changed its view on copper and zinc. The analysts predict their own base metal index will see an average 50% increase from 2005 to 2006. There is always a risk, however, that fast moving speculators (hedge funds, not index funds) can switch suddenly in the search for better return potential. This is where volatility could become significant.
Let’s now have a look at metals on an individual basis.
NAB notes aluminium price increases have been constrained by comparison to copper/zinc largely due to rising stock levels in 2005, but suggests this rise is due to hidden inventories being lured to the surface through higher prices. Producer stocks actually fell during the period.
NAB expects global aluminium demand to grow by 5.4% in 2006, led by China with 15%. Production is also expected to rise, but production faces the spectre of higher energy costs and, in China’s case, energy shortages (aluminium smelting uses exorbitant amounts of electricity) despite an expected 14% increase in China’s electricity output in 2006. NAB is forecasting a record production deficit and an average price of US$2550/t (34% up on 2005).
The price of lead rose 26% year-on-year to the first quarter of 2006. NAB expects China’s growth in consumption to be 15% as its battery manufacturing industry grows rapidly, not only to service its fledgling auto market, but to export batteries to the world. NAB expects global consumption to grow by 3.0% and production to grow by 3.3%, which will serve to move lead supplies out of deficit into 2007. NAB forecasts an average price of US$1230/t in 2006.
Nickel has actually bucked the trend, falling year-on-year by 3.8% in the first quarter. However, demand conditions have improved dramatically since the second half of 2005, notes NAB. Increased stainless steel production and inventory restocking will see an 8.1% increase in consumption, while increased smelter capacity is forecast to boost production by 5.4%.
NAB has the nickel price rising 1.6% in 2006 to average US$14947/t, but there is upside risk to this price from potential increased stainless steel demand.
Zinc – what can you say? The first quarter registered a year-on-year price rise of 70%. NAB notes zinc has the tightest short term fundamental position featuring sharply declining stockpiles on persistent production deficits. The supply response has lagged other metals.
Consumption is forecast to increase by 3.5% in 2006, again driven by China, but supported by a turnaround in the US and Europe in galvanised steel production. Refined output is expected to grow 3.5% as well, but the deficit remains. NAB expects zinc to average US$2775/t in 2006, a rise of 100% on 2005.
Copper is the metal most affected by supply disruptions. The first quarter saw a price increase of 51% year-on-year. Copper markets remain elevated by a combination of market fundamentals, says NAB, which will only tighten in 2006, and speculative pressure will continue.
In short, NAB suggests copper stocks are critically low, with the downward trend set to return. In 2005, consumption fell dramatically in Europe, Japan and the US due largely to destocking, but increased dramatically in China, India and Russia. NAB expects consumption to grow by 5.5% in 2006, and production by 5.8%, but production may well yet be set for major disruptions. An average price of US$5650 is forecast for 2006.