Seeking Balance

Output will struggle to match consumption. That's why insiders see price growth staying above long-term averages.

Tom Stundza -- Purchasing, 10/7/2004

Metals buyers should prepare for another be-wildering and disordered year in 2005. That's because metals is a bull market fueled by strong demand, especially from economies such as China, and a global underinvestment in efficient production capacity in the past dozen years.

Prices—already at or near record highs—are expected to rise further, although the rate of growth is unclear. The supply base—which has undergone capacity cutbacks—is expected to mutate further, making the ultimate sources of some materials uncertain.

China's demand surge has been cited as the key factor in the disruptive 2005 metals marketplace, but other significant dynamics influencing commodity prices include the long-awaited demand pickup in industrialized nations and serious under capitalization of the mining and smelting sector since the late 1980s. "The metals industry has been ignored and undercapitalized for 10 to 15 years," says Robert Cohen, Toronto-based manager of the Dynamic Global Resource Fund, "and that continues to constrain supply and boost pricing."

Upshot: Trying to gauge next year's trend in commodity prices is going to be challenging because there are many other uncertainties still affecting the global economic outlook for 2005. Prices can be affected by conditions ranging from geopolitical tensions to volatile energy prices, from erratic regional industrial activity to sliding, inconsistent construction behavior, from tentative monetary and fiscal policies to unsettled trade deficits/surpluses.

"Demand for metals and minerals may be coming off its cyclical peak, but the emerging perspective is for a slowing of growth rather than a brake on it," says David Humphreys, chief economist for Rio Tinto in London. "For some commodities, the full price effects of the demand cycle still have to work their way through the supply chain. Nonferrous supply will continue to be constrained by the legacy of low investment in the mining industry during the late 1990s and early 2000s and this will leave the market vulnerable to supply disruptions."

Humphreys summarizes other events that appear to be roiling the nonferrous metals marketplace: "First, concerns about the possibility of slower economic growth in China, which would lower Chinese demand for base metals. Second, worries about the negative impact of high crude oil prices on the world economy. And, third, speculation that rising interest rates in the coming months might temper world economic growth and curtail industrial demand for metals."

Also looking ahead, steel market analyst Peter Marcus at World Steel Dynamics in Englewood Cliffs, N.J., says: "The odds have grown for steel prices bottoming out, but not until the summer of 2005." He explains that won't occur this year because world steel demand has yet to slow and steel production capacity has yet to expand. "World commodity metals' prices probably have peaked, and will likely fall under downward pressure in 2005 as supply begins to expand," agrees economist Craig Alexander at TD Bank in Toronto. "Still, in an environment of strong global growth, declines are likely to offset only a small portion of the gains racked up in recent months."

Imports are growing and buyers are getting more offers from offshore suppliers, "which could become a factor in the metals market—next year," says the purchasing director of a metal parts manufacturing firm. Analysts agree: "This year, European and Asian steelmakers have been focusing on supplying their traditional customers and have had relatively little interest in increasing their exports to the U.S.," says Charles Bradford at Bradford Research in New York. "But, with projected 2005 prices continued strong, the foreign steelmakers may expand shipments to the U.S."

The fact is that so-called prompt supply has been a problem all this year. "Business conditions are extremely good right now, but many of our suppliers are unable to keep up with today's demand," says a buyer at a major agricultural equipment plant in the Midwest. "In fact, steel mill leadtimes continue to grow. Virtually all mills have implemented allocations based on last year's buys." What bothers analysts is that leadtimes from steel mills and nonferrous metals plants could become even more extended in 2005. "The world's steel markets remain robust," says Bradford, "so with worldwide steel demand so robust, there has been a strain on productive capacity."

Although the precise timing of expanded steel and nonferrous metals supply will depend on the rhythms of the world economy and will vary by commodity, economist Humphreys at Rio Tinto, says "higher prices are triggering the investment that will eventually lead to a convergence between global supply and demand in metal and mineral markets."

A variety of factors have led to a global spike in steel prices in 2004, including manufacturing recovery in the U.S., parts of Europe and Japan; the unexpected and overheated demand surge from China; sudden shortages of such raw materials as scrap and iron ore, and the weaker dollar that has disrupted traditional trade patterns. Since steel production and processing industries often are slow to respond to changes in demand, there's little surprise among the analysts that supply has been disrupted—leading to the sharp upward swing in pricing.

In fact, after three years of declines, metalworking end users are boosting actual steel use in the U.S. by better than 7% this year. Nachiket Moghe, an analyst at Zacks Investment Research in Chicago says the world steel sector also is experiencing a solid recovery in demand—driven by growth in the manufacturing sector in the U.S. and Europe, strong consumption growth from China and the start of a demand pickup in Japan. Moreover, improved demand combined with raw material surcharge levied by steel producers has been driving up transaction prices to record highs. But, the future of the global steel-consuming sector for the rest of 2004 and 2005 is decidedly uncertain.

The North American outlook for car sales, for example, which held up during recent periods of economic softness largely because of low-cost financing and sales incentives, now is described as muddy at best. In coming months, Big Three-dependent companies could face a production disaster if car dealers aren't able to clear their lots and the automakers are forced to slow their assembly. The last time that happened, in 2001, suppliers were pummeled; several notable names, like Visteon and Delphi, were forced to lay off workers.

Domestic demand for machinery and equipment has been running 18% ahead of last year. Sales of commercial trucks, trailers, railcars and, even, ships also has been gaining ground, as the improvement in freight activity has spurred replacement demand for transportation equipment. Looking at 2005, growth in these and other metalworking sectors is still expected in North America—but at a lower rate than in 2004. Moghe suggests that "domestic steel producers, having increased prices of late, might be reluctant to initiate further price increases—especially as it may make them uncompetitive vis à vis imported steel producers." However, further increases in steel prices are likely to be caused by further increases in scrap costs. "In our view, tight U.S. supplies and an insatiable appetite for scrap from Chinese steel producers are expected to lead to a supply shortfall for scrap," he says.

That's why there is no price downturn in sight for international steel prices; in fact, transaction prices in Europe and the U.S. are likely to increase further, according to most analysts. One reason: Prices of such key raw materials as iron ore and scrap will only increase in the 2005 market. Note that multinational miners BHP Billiton and Rio Tinto are working on a 15% hike in iron ore prices over the price of the previous contract, which was around $20 per metric ton. So, European steel manufacturing groups Corus, LNM and Arcelor, the world's largest, already have announced their intentions to raise prices 20% further in the coming months of 2004 above the summertime average price of around $660 per metric ton.

Still market analysts such as Peter Fish at MEPS International in Sheffield, England, believe that the price-boom conditions in the U.S. steel sector will last only until the end of the year. "Slow but steady transaction price reductions are anticipated through the first half of 2005," he says, "because elevated energy prices are reducing sentiment for a continued vibrant manufacturing recovery." Analyst John Anton at Global Insight's Washington offices says there were signs of increased supply this past summer, "although significant relief for buyers will not be seen this year." In fact, most analysts now say that, even if regional production rises slightly and shipments from foreign mills increase somewhat, supply shortages won't ease until next year at the earliest.

Contract prices with automakers and auto parts firms are another story. Arcelor already sees a price hike of 20% as a realistic target for its 2005 contracts with the European auto industry. Analysts also see substantial price gains for U.S. and Canadian steelmakers' 2005 contracts with the Big Three automakers and their parts suppliers. "World Steel Dynamics believes that U.S. automotive sheet prices should rise sharply $100 per ton on average in 2005," says Peter Marcus.

Base metal prices have moved up sharply worldwide this year, an environment largely unfavorable to commodity purchasers. "Demand growth has accelerated and inventoried stocks have trended lower, so prices have risen," says analyst Neil Buxton at GFMS Metals Consulting in London. In North America, improved manufacturing activity bolstered commodity metal markets during the second half of 2003 and through the first half of 2004. Upshot: After seven consecutive annual declines, Purchasingdata.com's Nonferrous Price Index rose 22% in 2003 and has risen another 79% to an annualized 2004 reading of 148.7 through August.

The worldwide nonferrous price surge was boosted by growing demand from China's rapidly growing economy, a supply deficit in some major metals and signs of a global economic recovery. Global demand for these commodities grew as strongly as at any time in the last 20 years, putting acute pressure on supplies. Reflecting this pressure, inventories of all the major nonferrous metals except zinc fell sharply during the first half of 2004. Copper stocks dropped 67% from their end-2003 levels while aluminum stocks fell a more modest 28%.

Mick Davis, chief executive of London-based mining firm Xstrata, expects price growth for copper, aluminum, zinc and lead to cool in 2005, although he expects sales prices to maintain higher-than-average levels. "I would be surprised if metal prices showed the same level of growth in 2005 as they did in 2004," he tells the Reuters News Service. "The big issue is what level do prices settle at. Our judgment, based on the current demand/supply environment, is that the level in 2005 is going to be somewhat higher than long-term average prices."

Analyst Moghe of Zacks Investment Research also sees possible supply shortage—and higher prices—ahead among some nonferrous metals over the next 2-3 years "driven by expanded demand from improved consumption in Western countries as well as lower growth in capacity additions." Metal and mineral markets remain generally supply constrained and accordingly vulnerable to supply disruptions. These conditions are likely to persist through the balance of this year and into 2005.

Aluminum demand was exceptionally strong in the first half of 2004, rising 10% above the tonnage used in the first half of 2003. At the same time, production has been high enough that global stocks of aluminum inched up 0.33% to three million metric tons at the end of the July from 2.99 million metric tons at the end of July 2003.

Still, between the first half of 2003 and the first half of 2004, the world aluminum price rose nearly 20%. Moghe says high alumina prices, global power shortages (especially in China) and the Chinese government's policy to clamp down on inefficient capacities will cause supply-side disruptions for aluminum in 2005. "As a result, expect aluminum to be in deficit by around 300,000 tons in 2005, which should support higher prices," he says, forecasting world primary aluminum prices to average 85¢/lb during 2005 from the current levels of 77¢/lb.

Although new production capacity is being added for all mineral commodities, this will take time to have an impact on the supply-demand balance for such metals as copper, says economist Humphreys at Rio Tinto. The copper market experienced a shortfall of well over half a million metric tons in the first half of 2004—at a time when world copper tags were rising 67%. Although mine production is now rising steeply in Latin America and Indonesia, it will take time for this to affect the market for metal. "The market overall still looks likely to remain in deficit for months to come," he says.

Copper inventories monitored by the London Metals Exchange, the world's largest metals bourse, have declined 75% this year to about 108,000 tons in early September. In fact, LME copper inventories have slumped from a record 980,075 tons in May 2002, a year when production exceeded demand by 211,000 tons, according to Bloomsbury Minerals Economics Ltd. Global consumption this year will rise 7.6% to 16.8 million tons, widening the deficit to 950,000 tons, because supply is growing by less than 3%, according to analyst Jim Lennon at Macquarie Bank in London. "The general tendency at the moment is maybe for copper prices to be a little lower in 2005 than in 2004,'' says Lennon.

However, "prices have been supported by tight world supply," notes London-based analyst Ingrid Sternby at Barclays Capital, who says the global market will remain very tight in 2005. Copper mining and smelting is notorious for strikes and other production slowdowns. "Any disruption to supplies is going to be price supportive,'' she adds.

There are reasons why copper's price outlook remains high. "The outlook for the second half and into the first quarter of 2005 calls for a modest improvement in the overall world economic scenario and the resulting demand for copper,'' says William O'Neill, a partner at the Logic Advisors commodity consulting company in Upper Saddle River, N.J. Demand from China, the world's largest copper user, will jump 15% to 3.5 million tons, forecasts Donald Coxe, global portfolio strategist for BMO Financial Group in Chicago. He points out that China doesn't have enough domestic supply of aluminum, copper, lead and nickel, but does have zinc. So, Coxe reckons aluminum, copper, nickel and even lead prices may be volatile in 2005.

The lead market has been dull for some time but it has been re-energized this year, with average monthly prices reaching 14-year highs. Major producers reacted to years of low prices, scarce primary lead concentrate feed, declining North American demand and their own financial difficulties by closing or idling smelting capacity. Global consumption continues to grow for lead, though, which is mainly used in batteries—due to booming demand for new cars in China, India, Southeast Asia and Eastern Europe—causing a supply deficit.

This trend is expected to continue through 2005, says Australian consultancy group AME Mineral Economics. "This year's LME forecast average price is a 24-year high of 39¢/lb and it won't return to a lower trendline until 2006," AME forecasts, mostly because of an expected continuation of this year's world refined lead supply deficit of 130,000 metric tons. AME reckons metal inventories have been drawn down to very low levels, with LME stocks down to below 40,000 metric tons, compared to 150,000 metric tons in November 2003. AME forecasts that the refined lead market will record only a small supply deficit in 2005, and although prices will ease from the current peak, the LME cash price again will average this year's 38¢/lb.

Current lead demand growth is now focused in Asia on the back of increased lead-acid battery manufacturing, with consumption growth greatest in China. Asia now accounts for 39% of annual lead use, up from 30% in 1996. Despite growing concerns over the environmental impacts of global lead use and the long-term substitution threat to the lead-acid battery market, consumption is forecast to continue growing.

Western refined lead production, however, declined in each of the years from 2001 to 2003 and will fall again this year, AME expects, owing to a series of smelter and refinery closures and suspensions. "Major producers have cut production because of years of low lead prices, the difficulty in obtaining lead concentrate feed, a decline in demand growth away from the traditional European and North American markets, and producer companies' financial difficulties," AME adds.

The main use of zinc is to coat steel against corrosion. Consumption is barely moving this year, with midyear use annualized at 7,198,000 metric tons, as compared with the 2003 total of 7,127,000 metric tons. Climbing global zinc stocks caused by China's economic restructuring woes have caused monthly world prices to fall off to 46¢ in recent months from 51¢ late in the first quarter. While there are signs zinc demand has started to outstrip newly smelted supply, stockpiled zinc is making its way onto the market. Since annual zinc production has been stuck at 6,660,000 metric tons since 2002, it isn't known how large the zinc stockpiles really are. Some analysts believe excessive stocks will be depleted by the end of this year.

Marketing executives at producing firm Horsehead Corp. say there appears to be some uncertainty among forecasters as to whether or not the market is truly in surplus—"news that has further dampened the near-term outlook for zinc pricing." The producer believes that strong demand and low exports will keep the zinc market in deficit through 2006—and prices well above historical averages.

"And, we believe 2005 zinc prices should be less hit by the mid-2004 manufacturing slowdown in China since zinc is typically used for high quality steel products, which should continue to show superior demand growth," says analyst Sung Mee Park at Goodmorning Shinhan Securities in Seoul. That's why he and other analysts forecast zinc prices to continue to be somewhat strong through 2005—rising from the forecast of 48¢ in 2004 to 52¢ in 2005.

Driven by a recovering global economy and soaring demand in Asia, particularly China, nickel supply has come close to allocation levels and prices have risen rapidly, resulting in higher prices for stainless steel. The economic boom in China has seen that country increase its consumption of nickel from 200,000 metric tons in 1990 to an estimated 4.5 million metric tons this year.

But there actually has been an increase in global consumption of primary nickel in 2003 and 2004 for two reason beyond China's appetite: There has been growth in stainless steel production, which accounts for almost two thirds of nickel use, and there has been limited supply of nickel from recycling of stainless steel. The sharp increase in consumption, combined with the fact that production remained relatively stable, has resulted in a deficit on the global nickel market. In fact, supplies are estimated to be about 6% behind demand.

Already bolstered by the vitality of Chinese demand, the primary nickel market continues to benefit from increased consumption in industrialized countries. World production of stainless steel has grown substantially. This will result in a sharp rise in demand for nickel, which is translating into a market deficit. In fact, supply will be hampered by the lack of significant new production capacity, a situation that should even last into 2006. In addition, the Québec Mineral Exploration Association says supply of recycled nickel should remain limited. "Therefore, everything is set for the average annual price of nickel to increase significantly again in 2005," says the research group

So, with the strongest fundamentals of all the base metals, the price of nickel soared in 2003, reaching its highest levels since 1989 at year's end. (The average annual cash price of nickel on the LME rose from $3.26/lb in 2002 to $4.37/lb in 2003.) The price is even higher in 2004 (and now is expected to average $6.26/lb) because of high end-user demand and renewed interest in commodity metals from investment funds.

The only supply relief in sight is the promise of new sources coming on stream in the second half of 2006. That's when Toronto's Inco, which currently meets one-fifth of world demand, is scheduled to start production, about eight years behind its original target, at its Voisey's Bay project in Labrador. Voisey's Bay was once designed to yield 122,000 metric tons of nickel annually, or 14% of global supply, but a series of environmental issues and planning delays have scaled down the project to 50,000 metric tons/year.