Natixis Commodity Markets' Third Quarter Metals Review

Base Metals:
Is The Bad News Behind Us Yet?
Gold Set To Underperform In 2011

       When we released our previous quarterly report, two key concerns were dominating the base metals market; the escalating sovereign debt crisis in Europe and uncertainty regarding the impact of the measures by Chinese authorities to curb excessive credit creation, which put substantial downward pressure on base metal prices during the second quarter. However, much of the bad news seems now to have been priced into the market, with prices trending higher in July from the depressed levels of early June. We retain our positive stance towards prospects for the base metals sector.

       Western markets continue to recover from a low base. The recovery in demand in western economies has to be viewed in the context of the exceptionally weak post Lehman environment, but nevertheless a sharper than expected rebound has been experienced in many countries. This reflects three main factors - fiscal and monetary stimuli, strong growth in developing countries and increased capital spending in mature economies by a strengthening corporate sector, which has in turn encouraged restocking. The first of these factors will progressively diminish as the second half of the year unfolds. Even without fiscal stimuli, an ultra-low interest rate environment should help to sustain the recovery in the United States.
       In 2009, the only developing country that mattered was China. In 2010, the developing country growth story has broadened to the other BRICs and countries such as Indonesia and Turkey.
       The global automobile sector illustrates this situation very clearly. Despite lackluster growth in developed countries once scrappage schemes had been terminated, global car production rose to new historic highs thanks to the exceptionally rapid growth in demand from consumers in developing countries. China is not the only expanding market. Russian, Indian and Indonesian sales in June were up 47%, 22%, and 78% respectively, year-on-year.

       China experiences a temporary demand slowdown...The desire of the Chinese government to rein in some of the excesses of its recent incredible growth seems to be taking effect. Industrial production and fixed asset investment have both slowed in recent months. Specifically for the base metals, destocking (the reverse of the situation in the West) has led to slower growth in demand, certainly when compared to the period of rapid restocking during the first half of 2009.

       ...even as production soars. Chinese production of non-ferrous metals and steel registered sharp gains during the first half of 2010. Gains were generally over 20%, with the increase for aluminum closer to 50% despite repeated efforts by the central government to curb output. The authorities are now embarking on a more assertive set of policies that are intended to promote overall energy efficiency by curbing this energy-intensive sector, with particular focus on smaller, older, inefficient and polluting producers, as well as deterring production of energy-intensive basic industrial goods destined for immediate re-export.

       Limited increases to Western supply. The supply position outside China is more straightforward. At one extreme we have primary aluminum, with the market having to absorb significant capacity increases from the Middle East, India and Iceland, while at the other extreme we have the structural tightness that is emerging in the copper and tin markets. There are nevertheless other supply issues which could support the market - political and economic risk (notably in the African Copperbelt) and environmental risk (such as La Oroya, and a myriad of operations in China) and strike risk along the lines of the extended dispute at Vale's nickel operations in Canada.

       Aluminum: Our supply-demand analysis sees the market surplus declining this year before drifting towards broad balance in 2011. Given that these projections are well below consensus, we take a positive view on prices despite the remaining potential for over-supply. Long term financing deals, which could remain a feature of the market in the current low interest rate environment, mean that 70-80% of metal at exchange warehouses remains unavailable for immediate delivery. IAI and LME stocks are slowly starting to trend lower, suggesting that the global supply/demand imbalance is becoming less extreme. We forecast prices to average $2,148/tonne this year followed by $2,400/tonne in 2011.

       Copper: We expect refined production to increase by 4.4% year-on-year, to exceed demand by 150,000 tonnes, which would see the surplus being just one fifth of last year's figure. In 2011, we anticipate that consumption will finally "catch up" with supply, culminating in the first annual deficit since 2007 of around 65,000 tonnes.
        The gradual improvement of the copper market is driven primarily by the tightness at the concentrate stage. Natixis Commodity Markets expects more price substantial gains to be achieved later in the year as the picture for 2011 becomes clearer, which should boost the annual average to $7,230/tonne, followed by $8,300/tonne in 2011.

       Lead: Importantly for the lead market, the inventory accumulation in this cycle remains relatively small, with LME and Chinese stocks representing less than three weeks of consumption, which is amongst the lowest of the base metals. Our analysis still points to a small surplus of just under 100,000 tonnes, but we would envisage a return to deficit of around 100,000 tonnes in 2011. In terms of prices, this scenario should support a second half average of $2,050/tonne, which in turn implies an average for this year of $2,041/tonne. A return to deficit in 2011 should allow average prices to reach $2,250/tonne.

       Nickel: In terms of price projections, we have scaled back our forecasts following the correction from the early second quarter high of over $27,500/tonne. However, we remain fairly optimistic in that further downside potential is limited as the ongoing market deficit progressively erodes stocks. We project an average annual price of $20,994/tonne in 2010. We forecast another deficit in 2011. However, the potential for higher Chinese nickel pig iron production may cap the average price next year at $23,000/tonne.

       Tin: The speed and extent of the supply side recovery has been restricted by the ongoing problems faced by Indonesian smelters, which look set to continue. When combined with a continued demand side recovery, we expect the tin market to record a 4,000 tonne deficit over 2010 that should support an average price of $18,250/tonne. If supply growth remains limited next year, the deficit should widen to around 11,000 tonnes, helping to push average prices to $19,750/tonne.

       Zinc: The increase in output in both China and Europe means that the surplus this year should be around 300,000 tonnes in 2010. Given solid Chinese demand growth, and with prices close to production costs, downside potential is limited. We forecast a full year average of $2,114/tonne.
       We forecast the market to move to a 109,000 tonne deficit in 2011 thanks to the eventual recovery of the construction sector in developed economies, after three years of extreme contraction. In addition, we expect global zinc production growth to slow to 3.5%, in part affected by the closure of the huge Brunswick mine, which will restrict concentrate availability over the second half of 2011, and which should allow an average price of $2,500/tonne.

Gold Set To Underperform In 2011

       There has been sufficient political, financial and economic uncertainty to support gold's safe haven status and it has outperformed the rest of the sector, which has a more industrial bias, over the last few years. This was particularly the case for platinum and palladium.
       However, Natixis Commodity Markets expects a mirror image of this in 2011 as some of the arguments for holding gold become less relevant. For the PGMs, the auto sector, particularly in the developing economies, should support some modest gains in average annual prices for platinum and palladium.
       Having rallied strongly to a fresh all-time record of $1,265 in late June, the gold market has since experienced a setback, slipping below the $1,200 mark in July to a low of $1,157. We believe there is the potential for further weakness. With the increase in supply and suppression of fabrication demand at current high prices, this requires a constant stream of investment inflows to balance the market.
       Critically, we feel that the arguments supporting investment are steadily being eroded. The sovereign debt problem is slowly becoming less of an issue, or is already priced into the market, and as such the need to hold gold as an alternative safe haven asset is being progressively reduced. Another bearish factor is producer de-hedging, which having averaged around 350 tonnes a year for the period 2006-09 is set to fall to trivial levels due to the much reduced scale of the outstanding hedge book.
       In 2009, mined output rose by an estimated 6.5%, and we would expect this to rise further in 2010 and beyond. In combination with potential net selling from investors, higher mined output will lower the equilibrium price at which jewellery demand can balance the gold market.
       We forecast a slide in prices in the third quarter, perhaps accelerating in the fourth quarter, with the market at some point this year approaching the $1,050/oz mark to give an annual average of $1,125/oz. With gold's negative fundamentals being deep-seated, further weakness in 2011 could take the average price down as far as $950.
       Given our negative outlook for gold prices we anticipate silver prices following in tandem, with the third quarter generating an average of around $17.75 per oz, after which losses could accelerate to give a fourth quarter average price of around $16 (and an annual average price $17.30 per oz). A more bullish base metals market in 2011 is expected to give some support to industrial silver demand, justifying an average price only a little lower at $15.50 per oz, avoiding the more overt weakness likely in gold prices. As a result, the gold:silver ratio should narrow considerably to an annual average just over 61, taking it closer to its longer term average in the high fifties.
       We expect global automobile production to maintain its recent strong growth driven by the emerging markets, despite the end of the scrappage schemes in a number of the mature regions. With automobile growth being dominated by petrol-driven cars, and palladium continuing to make in-roads into the diesel sector, we continue to favour palladium over platinum from a demand perspective.
       The supply side, especially in South Africa, should offer some support with the potential for electricity supply bottlenecks, labour disputes and safety issues all to impact negatively upon the supply of platinum in particular. We therefore project a rising trend in both pgms' prices over the rest of this year.
       Overall, we expect platinum prices to average $1,600/oz for 2010 as a whole, with the average palladium price at $465/oz. Next year, ongoing increases take our forecast for platinum to an average of $1,700/oz and palladium to $510/oz.
       Editor's Note: Natixis Commodity Markets Third Quarter Metals Review - Base Metals Outlook is published by Natixis Commodity Markets Limited, Cannon Bridge House, 25 Dowgate Hill, London EC4R 2YA, United Kingdom.
       Natixis Commodity Markets Limited, a trading company, provides on and off-exchange products and services. It also offers brokerage and clearing facilities; and arbitrage and physical, and stock and warrant financing and averaging services. www.natixis.com