Base Metals Break Out… But Is It All Just Dollar Weakness?
Base metals started 2017 on strong note, only to fade just as quickly from late February to early June. However, since then they have rallied and the Bloomberg Commodities Base Metals sub-index is now up 12.8 percent year-to-date – to its highest level in over two years.
The best performing base metals this year have been copper and aluminium, both up over 15 percent year-to-date, with zinc also up 12 percent. Nickel and tin have lagged, up 3 percent and down 3 percent respectively.
This recent strength has caught many market participants by surprise which, in itself, has been a contributor because several funds have had to cover short positions established at what they believed were the top end of price ranges. The key question for investors now is whether this rally marks the start of a prolonged rally or if it is largely a technical move driven by quantitative funds which will reverse as soon as the momentum stalls.
What is certainly clear is that a major factor has been the turnaround in the U.S. dollar which has been weakening since the end of 2016. The failure of U.S. President Donald Trump to drive through any meaningful legislation to support his reforms has led to a waning of post-election optimism in the United States and, at the same time, a revival in European and Asian growth – all factors which have put pressure on the U.S. currency. This has helped push up commodity prices in general, given that costs in local currencies increase and many quantitative funds trade the correlation between the two.
However, with the U.S. dollar trading near the lows of the range in which it has been since early 2015, there is a risk of a reversal in the next month or so which could put pressure on metal prices in the short term.
Do Fundamentals Play A Part?
While the U.S. dollar move has contributed, it is also true that fundamentals for many metals have improved in recent months. The main driver is demand or at least expectation of demand from China, and that has risen markedly. In April-June 2017 concerns grew that the fiscal stimulus in China was ending and demand for metals would fall as the residential housing market weakened, in turn undermining appliance sales. However, while physical metal demand was weaker in that quarter, it appears to have been largely due to some destocking by fabricators and end users.
As Chinese government spending on infrastructure has continued to be strong, confidence and orders have returned in the ongoing quarter.
Physical indicators in China support the improvement in sentiment.
- Premia for delivery of copper cathodes in China has risen from a low of $45 per tonne at the end of March to $70 per tonne currently.
- Steel and iron ore prices have recovered, with rebar prices at their highest level since early 2013.
- Steel production is currently growing by close to 5 percent year-on-year, and the output of air conditioners grew 16 percent year-on-year in June.
- Chinese infrastructure spending continues to be robust with a number of large projects just starting construction after being approved and financed last year.
- Excavator sales have grown 110 percent year to date underlining the rebound in activity, emphasising that it is not just a technical bounce.
At the same time, news on supply has generally been negative. Following the strike at Escondida in Chile, the world’s largest copper mine, in the first quarter of 2017, copper mine disruptions have continued to occur - Freeport’s Grasberg mine in Indonesia is still underperforming even after the ban on concentrate exports was lifted temporarily.
Looking at aluminium, the plan of the Chinese government to cut and even close environmentally poor smelters and refineries continues to make headlines.
Inspectors are touring the country identifying plants that lack permits or those that are failing environmental standards. Following the announcement of the plan to shut in capacity in the winter months, there has been speculation since January on how much production would actually be affected, not least as many companies have plans to replace old polluting capacity with newer, cleaner and more efficient plants in the west of the country.
However, as winter approaches and the prospect of more closures gets closer with the Chinese government sticking to its intentions, aluminium prices have risen.
While some argue that this will incentivise more production, it appears that in the longer-term, new capacity will be harder to permit and bring on, reducing the surplus over time as mills focus on profit margins rather than just volume.
Turning to zinc, Glencore’s decision to cut production a little under two years ago has succeeded in lowering inventories and tightening the global market. Of course, as prices rise, speculation increases about the reversal of this decision, which would return around 400,000 tonnes of production to the market. So far, Glencore has made it clear it will only do so when prices can support such a move. With its balance sheet now strengthened and profitability restored, the company is under less pressure to resume full production until it is confident that such a move will not damage prices.
Finally, in nickel, the recent news that First Quantum is putting its Ravensthorpe plant on care and maintenance, removing 35,000 tonnes per year of production (1.5 percent of global supply), has led to a recovery in nickel prices in recent days. However, with Indonesia resuming exports of nickel ores and the Philippines stepping back from a widespread ban on mining, supply remains robust.
Can The Rally Sustain? Do Equity Valuations Reflect These Moves?
While technical factors were very prominent in the recent break upwards in base metals prices, we believe fundamentals are underpinning these moves in most cases. Of course, a major disruption from geopolitical factors, such as a strike by North Korea, continues to overshadow markets. In the absence of any such move, the macro-economic backdrop looks supportive over the rest of 2017 and into 2018.
As a result, the new ranges being established for many base metals could be sustained and in some cases, we may see prices push higher.
We would focus on aluminium in particular if the Chinese government implements capacity closures fully, and zinc if the deficit persists. For copper and nickel, we would need to see further disruptions or closures respectively to get more confidence in further prices rises from here.
If we are correct, and base metals have established new ranges, then equity valuations do not yet reflect these latest moves as the market remains sceptical.
With balance sheets much stronger than they were two years ago and positive cash flow generation now being reported by most mining companies, after dramatic cost cutting and reduction in capital spending, these higher prices are likely to lead to further cash returns to shareholders.
As some companies move to net-cash positions over the coming months, their ability to withstand shocks to the global economy is also strengthened and volatility should reduce. We continue to see good upside to valuations in our equity models and believe the attraction of owning mining companies is increasing as cash returns improve and confidence in their sustainability gradually grows.
George Cheveley is Portfolio Manager - Natural Resources Team, at Investec Asset Management.
The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.