Commodities | Sep 15 2011
– Metals and marginal costs
– A number of factors supportive for copper
– Natural gas and oil price linkages
– Positives for thermal coal
– Chinese steel demand stagnating
By Chris Shaw
When the pricing environment is negative for base metals, marginal costs are often used as a way of determining the potential downside for prices. But as Barclays Capital points out, prices can fall below the marginal cost as markets often experience a delay between when margins become negative and supply falls.
As well, Barclays notes costs are not static, so the extent by which prices can fall depends on the level of oversupply in a particular market. For markets in deficit, such as the case with copper at present, Barclays suggests marginal prices are not particularly useful as prices need to trade high enough to give incentive to consumers to commit to enough capex to grow output.
While the 2008/09 downturn saw prices falling further into the cost curve than was needed to balance the market, the current environment sees risks better known and lower speculative positions in markets. As well, Barclays points out that as operating costs have continued to increase, the cost support level is now higher.
For nickel this suggests prices don't need to fall further, as prices are already eating into the markets of high cost nickel pig iron producers. The market surplus and high stocks suggest zinc prices could fall further according to Barclays, though the downside appears to be somewhat limited.
For both aluminium and copper Barclays suggests production doesn't need to be cut further because there are already unintended supply cuts, as Chinese aluminium output is falling due to tight supply and lower power availability and copper inventories globally are low and refined copper output continues to fall.
Further on copper, UBS notes Codelco, the world's largest producer, has reported some of its European and US clients have asked to cancel orders due to concerns over less demand given the current uncertain global economy.
Having checked with other sources UBS notes other copper producers have experienced something similar, suggesting a de-stocking event this year. UBS sees a repeat of the cancellations experienced in 2008 as unlikely.
UBS expects a sizable copper market deficit in 2011 and a smaller deficit in 2012, after which the market should trade closer to balance. Under such a scenario copper prices are forecast to average US$4.14 per pound in 2011, with prices to be stronger in the first half of the year. For 2012 prices are expected to average US$3.70 per pound.
In the view of ANZ Banking Group, moves by the Chinese government to curb growth through interest rate rises and increased Reserve Ratio Requirements is likely to shift copper trade back to global merchants.
This is because smaller firms that rely on the alternative market for funds are now facing greater competition, which is pushing up lending costs and in some cases causing lending to dry up altogether.
As the big international players can extend their balance sheets to customers there is likely to be a shift in trade, reflecting decreased reliance on the LME warehouse system and a relocation of material from visible to more opaque storage facilities.
ANZ also expects a faster opening and closing in arbitrage windows as the Chinese market changes. As well, there would also likely be an increase in stockpiles, something the bank expects would be highly supportive of prices in the copper market.
Global macro hedge fund manager Covenant Financial Services suggests copper has the potential to soon rival gold as the world's most sought-after metal. This is due to the metal's key role in China's electrification efforts.
The key, according to Covenant chief investment officer Steve Shafer, is copper is being driven by demand whereas gold is being driven by fear on the part of investors. This should prove supportive for prices for many years.
Shafer expects the supercycle for copper to extend until 2030 or longer, because Chinese growth depends on electrification and copper is a key to this at every point of the process. The need is clear, as China experienced a 1500 gigawatt power deficit this summer.
To meet the likely electricity needs of its population in coming years, Shafer notes analysts have suggested China needs to each year add twice the total amount of coal-fired utility power presently used in all of Britain.
Shafer notes the copper market is already supportive for prices, as the market deficit of 250,000 tonnes in 2010 is likely to grow to a deficit of 377,000 tonnes this year. If the current rate of consumption continues, Shafer notes more copper will be consumed in the next 27 years than has been consumed over the past 106 years.
Reinforcing this view, Shafer estimates that if worldwide demand for copper was to grow at 3% annually over the next 10 years a further 44 mines producing at least 150,000 tonnes per year would be required. There are currently only 26 mines of this size in the world.
To Shafer this suggests copper prices should be appreciably higher over the next 3-5 years. This implies any price dips should be seen as opportunities to acquire the metal.
Turning to the oil and gas markets, Deutsche Bank notes an extended period in which natural gas prices in Europe have remained at a discount to oil-indexed contract prices implies long-term contract buyers remain burdened by carry-over obligations from previous years. This is limiting the extent to which these buyers can access the spot market.
This has meant it is only extreme weather events that have been able to push spot prices above contract prices. Even in such an environment Deutsche doesn't expect a complete de-linking of gas prices from oil prices, though there is scope for some reduction in volume obligations.
Any such change would allow for more spot market buying, something Deutsche suggests would likely lift prices.
In the bulks, Macquarie attended the McCloskey Beijing Coal Conference and notes feedback from the event was quite upbeat with respect to the outlook for thermal coal prices. Market expectations are for a re-stocking in China over the winter, especially given concerns over drought conditions in part of the country and some maintenance work potentially impacting on the transportation of material in coming months.
The drought means less hydro power is available, something Macquarie expects will support Chinese thermal coal prices leading into the end of this year. This expectation of higher prices has seen increased competition among Chinese buyers for Indonesian coal, which suggests imports will remain high in the December quarter and so offer support to prices.
Further on coal, Citi points out the Indonesian government has announced plans to ban the export of coal with a calorific value less than 5700kcal by 2014. If this was implemented Citi sees a significant impact on the thermal coal market, a Indonesia is expected to be the main supplier of thermal coal to both China and India.
As much as 70% of Indonesia's exports could be caught up in this ban, Citi estimating this could remove more than 220Mt from the global market in 2014. While it is possible to upgrade the coal Citi notes such a move has many risks, so either way there is likely to be higher costs and higher prices in the market.
Assuming coal upgrading is not feasible, and the technology is yet to be proven on such a scale, Citi notes major customers in both India and China would be forced to look elsewhere for supply. There are limited options however, as South African exports are constrained by rail infrastructure issues and increasing domestic demand.
At the same time Canadian thermal coal exports are likely to be muted until 2013 due to high costs and weak demand, while the potential for Columbia to boost imports is threatened by potential delays in developing rail and port infrastructure.
Given these factors impacting on alternative markets, Citi expects the end result will be higher costs and higher prices in global thermal coal markets in coming years.
Turning to steel, a review by Macquarie suggests China's steel production and trade numbers show demand is stagnating at present. While China produced 58mt of steel in August, an increase of 10.7% in year-on-year terms, net exports also declined by 10% in month-on-month terms to 36.6Mtpa. This implies export orders fell rapidly in June and July as ex-China demand softened.
The arbitrage between China and Europe has now shut in Macquarie's view, while the uncertain demand outlook means traders are now less interested in booking material. The data for August suggests real Chinese steel demand slowed by more than apparent demand for the month. But as prices were flat rather than fell as a result, Macquarie's view is demand is stagnating rather than collapsing.
