Base metals turn the corner

Base metals have had a solid run-up over recent weeks, or even over the last few months in some cases, as chart 1 shows.

Since early June, lead is up about 11%, zinc is up 19%, and aluminium is 11% higher. Copper meanwhile is nearly 7% higher. Perhaps, more importantly, many of these commodities have either broken through key areas of resistance or trading ranges which they had held for most of the year.

Many investors attribute no importance to these ‘technical’ considerations – they are the realm of chartists – and while that may be true, and I’m certainly no technical analyst, I don’t think it pays to ignore these price signals. They are breaking out of trading ranges or key levels of resistance for a reason, and that reason needs to be investigated.

Two questions arise: Whether this price action can be sustained, and whether it could herald the start of a broader break-out in commodity prices.

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Analysts thus far appear to have mixed views. Some suggest the move in base metals is simply a technical break-out, with no bearing to fundamentals. At best, they say it’s maybe driven by a temporary blip in stocks levels. Weak global growth and a surge in production will see inventory levels surge and prices correct.

Noting that commodity prices are (1) volatile, and (2) haven’t really been moving in concert with either the broader global economic expansion, nor the bull-market in equity and property, the questions aren’t easy to answer.

Demand  support is certainly there. As I outlined last week, global industrial production has risen sharply. In China we are seeing a rebound and in some of the more advanced industrial economies we are talking about the strongest expansion in 14 years (ex the post GFC spike). It makes sense to me that commodity prices, especially those of base metals, would spike.  The global economy is young and the rebound is driven, in part, by strong rates of construction growth and manufacturing. These are commodity intensive industries.

Similarly, inventory data suggests that there isn’t much to the view that a supply glut is either already in existence or will emerge. Data from the London Metals Exchange shows inventory levels for many of the base metals are at low levels. So, for instance, aluminium stockpiles are their lowest in a year. Zinc and lead are the lowest in about four years, while for copper this is more like a seven-year low.   

The Australian Bureau of Resource and Energy Economics complements that data, showing that for the most part global inventory levels for those metals are quite tight, with only a few weeks supply here or there (see Table 1). In some cases stocks have declined, in others they’ve increased. Either way, we are not talking inventory levels that are at extreme positions. This is the reason why weekly or even daily reports on inventory changes contribute to price swings. The market is only ever a few weeks away from a supply crunch!

As a final point, the production side looks non-threatening, although growth rates are forecast to be above consumption rates. Similarly, forecasts of consumption invariably point to growth rates falling against those achieved last year. Having said that, as these forecasts are underpinned by the assumption of a sluggish global recovery, the reality is there is ongoing scope for these to continue to surprise on the upside. This is a well-established pattern, and indeed global steel consumption numbers are continually revised up as the industrial production cycle proves to be stronger-than-expected, and China evades once again, its long-expected hard landing.  Overall, the sign posts all point to a sustained rally in base metals from this point. There is certainly more reason to expect this than a correction.

As to how broad-based this rally could end up being? Well, the same fundamental forces are at play across the commodity spectrum. Industrial demand is a positive across the board. Yet supply and inventories factors differ considerably. For bulk commodities, iron ore and coking coal, the outlook couldn’t be more stark. Demand from China remains very strong for both, yet the supply response, especially for coking coal as depressed prices to a six year low.  Ongoing consolidation is expected, with Bloomberg reporting many North American coking coal operators are unprofitable at current prices. So the long-term prospects are for prices to rise, yet this could play out over some years. Certainly this is the expectation of analysts at Moody’s.

For iron ore, short-term dynamics suggest a rebound from current five -ears lows. Reported inventory levels for steel mills are at two-year lows and restocking is widely expected to occur throughout the second half of 2014. Offsetting some of these dynamics, reports from Chinese ports are that imported stocks are at record highs.

Gold and crude are tougher calls. Both are politically sensitive and have been subject to jawboning by central banks or other authorities – e.g. the G7 on oil.  Central bank demand for physical gold remains strong – the swing factor being investor demand. Coming into a Fed tightening, it is unlikely that we will see any sustained gold rally for some time.  On the flipside, real demand from consumers and central banks will act as a support. So with that in mind, it’s likely that gold will continue to trade around the $US1200-1300 mark.

For crude, the situation is even more nuanced. Crude has been range trading since 2011 and I see little that would change that. Demand is strong, sure, supplies are tight and stocks are little changed. That’s the reality. Sentiment remains fairly lacklustre however, on the mistaken view that there is some world glut of energy. That isn’t what the data shows though. According to BP, world crude consumption rose by 1.6% last year, and production by only 0.6%, despite a 13.5% surge in US crude production. Mistake or not, that’s where sentiment lays however – the Peak Oil thesis was just as incorrect, yet it was the primary factor driving an oil price spike –it was speculatively driven. That’s the nature of markets though, subject to huge swings of the pendulum.