Post-recession growth in manufacturing has been lackluster in 2002, and so has the consumption of commodity metals, whether steel or nonferrous. "Certainly, the consumer seems to have gone in hiding and, as a result, demand has rapidly faded away," says Nick Moore, one of the 30 analysts worldwide who comprise the Global Metals & Mining Equity Research Group of J.P. Morgan Securities Inc. On the London Metals Exchange (LME), the key indicator for the nonferrous industry, stubbornly high inventories have weighed down summertime prices to levels at or near the lowest levels in three years.

In fact, various J.P. Morgan analyses find that excess supply has been the most obvious market force "conspiring against upward price progression" for the nonferrous metals. In fact, research notes from Moore continue to cite:

• High inventories, since commodity market stocks remain at high and burdening levels. "For example, London Metal Exchange inventories have risen to levels last seen in early 1995."
• Slack stock ratios, since overall inventories—not just on the commodity exchanges but also reported by end users, producers and merchants—are in many cases double what we would consider critical. "Worse, the stock ratios are building rather than eroding."
• Chinese exports. "At a time of fully supplied Western markets, Chinese shipments of aluminum, lead, zinc and tin are an added burden to global stocks. On a positive note, China remains structurally short of iron ore, copper and nickel."
• Substantial capacity. "Despite substantial idled capacity in the copper, zinc, and aluminum markets, other nonferrous supplies remain in surplus. Premature reactivation in aluminum potlines—and plans for new mines and smelters—bode ill."

As a rule, nonferrous commodity pricing decisions are made at the margin. "So, the tone of a market often depends on a thin sliver," says Moore. "That sliver, for many of the markets, is the difference between millions of metric tons of supply and millions of metric tons of demand. The swing factor between gloom and boom may be a few tens of thousands of metric tons. As such, commodity markets robbed of the oxygen of demand growth need immediate and significant supply-side redress." That's why, at this stage of the economic year, J.P. Morgan has relatively modest nonferrous commodity price assumptions for 2003.

Moore says the key to the direction of nonferrous prices is the progression of a nation's industrial production activity rather than overall gross domestic product. In other words, metalworking trends have more impact on pricing than general economic trends. And there is a feeling among the analysts that more nonferrous capacity cutbacks are needed to bring the market into supply-demand equilibrium.

"Although obvious candidates for another round of capacity cuts are elusive, since some producers have already done their part, we believe more cuts are necessary," says Moore. "If none are forthcoming, then the price will have to be the common denominator, sliding lower until industry capitulation is achieved." Markets need fresh cutbacks, not reactivation and new projects. An added issue is the LME contract negotiation season, which typically begins during LME Week in October. "As we saw last year with the copper cutbacks, producers often wait until this period before making headline-grabbing cutback announcements in order to garner the maximum impact," says Moore.

But, for steel, price determinations are more regional in nature—even though the issue of excess capacity also overhangs that global marketplace. For example, in North America this year, flat-rolled prices have risen dramatically because of tariffs and other geopolitical factors as well as local supply constraints. Spot-market prices are at lofty levels despite the global oversupply—and the weaker-than-expected demand is in such key regions as North America, continental Europe and Japan.

U.S. steel companies have been enjoying one of the highest-priced domestic markets in years. Prices on some sheet products have risen as much as 75%, and operating mills are all running flat-out to meet surging demand, in part because of the tariffs, but also because 32 steel companies have filed either Chapter 11 or Chapter 7 bankruptcy-court protection since 1997, resulting in less steel on the market. Still, Michael Gambardella, global metals team coordinator for J.P. Morgan, forecasts that steel prices will start declining in the U.S. market around the end of this year owing to the resumption of operations at former LTV Steel operations in Ohio, Indiana and Alabama.

"Weaker macroeconomic data lately, and recent surges in monthly steel import volumes, suggest price weakness could arrive sooner than expected," says Gambardella.

He points out that the overcapacity problem has been a supply-side issue for many years, and was a key factor for the record-setting pricing collapse of 1999 and 2000. "The U.S. is the most fragmented steel industry in the world, and that is probably the biggest problem facing the U.S. steel mills today," he says. And it has become a big issue when trying to gauge 2003 steel pricing trends. President Bush now is expected to relegate his controversial steel tariffs to the scrap heap by mid-2003, after the World Trade Organization declares them illegal and U.S. steelmakers come up short in their efforts to convince him they need import protection so they can regroup.

Steelmakers have argued that restructuring can't occur without unions granting major concessions and without Uncle Sam assuming $20 billion in pension and health insurance costs for current and retired steelworkers. Chances of either occurring are nonexistent; making it unlikely that steelmakers will be able to keep their consolidation pledge.

An end to tariffs will lead to lower steel prices in 2003—because imports will increase and some idled U.S. mills will be back in operation, raising U.S. output. Hot-rolled sheet steel coil prices in Asia and the U.S. have already risen beyond the highs seen in the last cyclical peak in early 2000. At such high prices, it seems inevitable that global production will rise until markets once again become oversupplied and prices begin to fall, suggests metals team member Graham Cunningham in Taipei.

Gambardella says the Section 201 trade case is proving less of a barrier than previously thought because of increasing product exclusions by Bush as well as the substantial price premium in the U.S. market, which is attracting imports. He also expects rising domestic production and rising imports coupled with stagnant domestic consumption to reduce spot-market pricing.

Some mini-mill sheet producers have reported that flat-rolled steel prices have continued to strengthen and that their fourth quarter order books were filled with the strongest per-ton price seen this year (averaging around $400 per ton). Some other mills booked orders but not at such high prices. So, the market's projected fourth quarter hot-rolled.steel pricing is around $380, as it was in September. "However, we continue to believe that flat-rolled steel pricing is at or near its peak," says Gambardella. "We believe the strength in steel pricing has been supply-side driven, and is at significant risk as nearly all of the 2001 idled capacity has been or is about to be restarted." Upshot: Buyers may see the price of bellwether hot-rolled sheet slide as low as $300-320/ton by the end of 2003.

The J.P. Morgan metals team's expectations for nonferrous pricing in 2003 suggests that annual averages will be somewhat higher than in 2002. "Perhaps this represents the optimistic nature of commodity forecasters," says analyst Moore, "although the forecasts do factor in an improving business cycle." However, he also notes that most of these 2003 forecasts actually are less optimistic than earlier versions. Aluminum, lead, zinc, and tin all are marked lower than before for 2003, while copper is unchanged. The key upgrade is nickel—and that's mostly because of a reduction in the Russian nickel stockpile overhang and not because of an expected surge in demand from stainless steelmakers.

LME spot copper has averaged 75¢/lb for the past five years. "The principal restraining factor for prices in this recent period has been the high level of exchange inventory and the production capacity overhang," says J.P. Morgan analyst Martin Squires in London. The J.P. Morgan metals team expects to see improved supply/demand fundamentals for copper in 2003, so their average price forecast for next year of 84¢/lb compares with the 74¢ projected for 2002. But that's still a long way from the early-to-mid 1990s, what suppliers refer to as "those halcyon days" when LME copper costs in excess of $1/lb.

Automotive, plumbing, building products and ammunition markets for copper and its alloys have been healthy this year, but demand has soured so severely in the electronics, telecommunications, factory automation, fabricated products and coinage sectors that world purchasing is expected to fall at least 12%. (Note that in the U.S., purchasing of coppermetals is on track to drop 15% to 7.1 billion lb.) A high level of production in 2001 and early 2002 has created an inventory overhang worldwide. And that's why the bellwether price for LME copper in 2002 has been stuck at the same 72¢/lb average as 2001.

Housing has remained strong within the global economy this year, but a vibrant turnaround still is being awaited for manufacturing. So, market prices for copper can't increase very much, says Squires, until it's obvious demand is rising—because U.S. and global industrial production is improving—and stocks are falling—because producers are maintaining the discipline to keep idled capacity idle.

Still, looking ahead, "the copper price risk is skewed towards the upside," he suggests, "because of an expected return to synchronized growth by the major industrialized nations in 2003, led by a revival in the U.S. business investment cycle." The mavens project that Western mine and refined production will decline this year because of the announced mine cuts and closures and a decline in secondary (scrap-based) output. In 2003, they reckon output will rebound as new and idled capacity is in operation and scrap availability rises to bolster secondary output. Despite that, world copper inventories are in balance and supply should begin to move towards deficit next year, Squires says.

Reason: He expects that the continued production discipline shown by producers—who idled mine capacity over the past year in response to weak market conditions— will lead to a fall in refined output in 2003 when world demand is rising 3%. "Despite our expectation that some idle capacity would be reintroduced towards the year-end, Phelps Dodge and BHP Billiton have continued to reiterate their commitment to keeping this capacity off-line until market conditions dictate its reintroduction," Squires says. So, he adds, the return to demand growth and producer restraint—when combined with expanded Chinese buying activity—is bound to create a supply deficit next year "and underpin copper's price recovery."

As for aluminum, analysts Moore and Squires are reluctant to boost the 2003 forecast of the LME price much higher than the 64¢/lb average of the past nine years. They say that one of the reasons that daily aluminum tags slipped under 60¢ in late-summer for the first time in three years was because "aluminum producers have prematurely brought idled capacity back on line." There are low prices and high inventories simply because world aluminum consumption grew 3%, but production grew at a rate of 4%.

In the U.S., production has been scaled back. Indeed, Alcoa has shut down permanently 197,000 metric tons of aluminum at two plants and has idled 90,000 tons at another. The company has reduced its aluminum capacity close to 6%, since 2000. Other smaller aluminum companies located in the Pacific Northwest have also idled their aluminum production. Even as those plants are being closed, however, Alcoa, Alcan and other suppliers are announcing plans to build new smelter plants in countries such as Iceland, South Africa, Canada and Brazil. Lower energy and labor costs at these locales would be enough to offset the higher cost of shipping the aluminum to fabrication plants in the U.S.

The U.S. is the world's largest aluminum consumer and the light metal serves such diverse markets as aerospace, automotive, machinery and consumer products. However, the manufacturing recovery remains anemic and aluminum demand is pallid. "Orders for U.S. aluminum mill products have been dropping lately, and that is a concern," says maven Gambardella. Available first-half data shows that while overall aluminum mill product purchasing is on pace to improve 3% this year, even that small growth could evaporate in a second-half demand slide.

As a result of this year's pallid buying worldwide, inventories aren't falling as fast as expected. In the past year, China has increased its production of aluminum by about 25%, India by 11%, and Canada by 7%. So, a sizable global surplus of aluminum has built up and is expected to stay high in 2003. In the U.S., the mid-summer surplus was at an annualized 9.4 weeks worth of supply, which would be the biggest regional glut since the 9.5 weeks of supply posted in 1999.

Looking at the alloying and plating metals, there's little market evidence to support much improvement in lead, zinc or tin prices in 2003. "The last thing the zinc market needs right now is more supply," says analyst Moore. "Yet, LME zinc inventories at the start of September had risen to the equivalent of 3.5% of Western World demand." The LME zinc price has languished at 36¢/lb, just around the average cash cost of production, for the past year, and not at the 42¢ that had been forecast. So, "with the zinc market's economic outlook uncertain," even he now wonders if the 2003 price forecast of 44¢ may be too optimistic.

However, metals team colleague Atsushi Yamaguchi at J.P. Morgan's Tokyo office notes "the next general meeting of the LME is scheduled for November, and production cuts for zinc, copper and other metals will be announced around that time." And it may also take some large cutbacks in the mining and smelting of lead for that metal to reach the 26¢/lb projected for 2003. LME lead is selling this year right at the forecast level of 22¢.

Demand for nickel worldwide increased 5% in the first half of 2002 because of growing demand from stainless steel mills. LME spot nickel started the year at $2.66/lb, but ended June with a price of $3.24, a six-month gain of 22%. "During the first half of 2002, nickel proved to be the best performing base metal," says metals team analyst Curtis Woodworth, "an increase in price fueled primarily by three things: speculative trading based on a general recovery in the manufacturing sector (particularly in the fabrication of stainless steel), controlled exports of Russian primary nickel and a tight market for nickel scrap."

By early September, the annual average for LME nickel was sliding back toward $3.10/lb mainly because such other key end-use markets as commercial aerospace and power generation equipment have remained quite weak. "As a result, we do not believe that nickel prices will average above our current commodity team's forecasts of $3.10/lb for 2002 and $3.40/lb for 2003," says Woodworth. Further pressure could be exerted on the price of nickel if Norilsk, the Russian producer, begins to export its massive nickel stocks (of which 60,000 metric tons are currently in warehouse as collateral for a loan) or if the nickel scrap market loosens.