Tarnished - Part One

This last of three issues covering my thoughts about 2015 will focus on base metals and a couple of bulk materials with some guesses on major markets. The editorial was a long one and has been split into two parts of which this is the first. As you already know the news from this corner of the commodity universe has not been good.

The results of the ECB meeting and Greek election were as expected, only more so.

Credit where it’s due; Mario Draghi did a masterful job of playing both the traders and the Germans. He had to make a major concession to Germany and other northern central banks to close the deal. That concession will weaken the impact of the QE program but let’s not quibble during Mario’s victory lap.

The ECB is starting a €60 billion per month QE program (€50 billion new money and €10 billion in an existing program). The program is slated to run until September 2016 and the ECB left the door open to extending it. The date is not random choice. It brings the total potential buying to over €1 trillion. The ECB needed to announce a program at least that large to convince traders it was serious.

One drawback of the program is the lack of risk sharing. Central banks within the EU will buy their own country’s bonds in proportion to their size within the ECB’s capital pool. The Germans and other northern Europeans won’t be buying debt from the southern or peripheral countries. That weakens the program but Germany would not go along with any form of risk sharing and would have never agreed to a 1€ trillion price tag otherwise.

Even with all the “leaks” Draghi still managed to present surprises and deliver the weakening in the Euro he hoped for. The QE announcement caused the Euro to drop 4% in two days. The Greek situation means continued uncertainty but I think we may have just seen the bottom on the Euro now that all the “bad stuff” is out there.

There have been some better than expected economic readings out of Europe lately. That has been tempered by the ongoing Greek tragicomedy. Currently, there is optimism that a debt deal will be struck which is generating risk on buying in NY and selling in the gold market. A deal would be a good thing but I don’t think we are out of the woods yet. Germany and France insist Greece has to stick to the austerity program. Reduction or removal of that program was THE election plank for the Greek government. I don’t see how that government retains power or credibility unless it dismantles some of the austerity measures. Either the EU is willing to compromise or this drama will have more acts before it’s done. If a solution is found however I think the Euro starts moving higher.

The lower chart above shows the gold price and with the gold/USD correlation below it. The correlation has weakened quite a bit and the one shown is a moving average. Using single data points the correlation has gone negative in recent sessions. Unfortunately it picked poor times to do it. The gold price was trounced when the US released a very strong payroll report. Nonetheless, the USD has been trading sideways lately as the Euro bottomed and traders get concerned the strong greenback will be a negative for the US economy. If that trend continues we may see some support for gold and other commodity prices if the Euro does strengthen.

The deflationary trend continues to strengthen everywhere and more and more central banks cut rates. Inflation rates are still dropping in all major economies. The pullback in most commodities is but one aspect of this larger trend.

Dollar strength takes some of the blame for all this, but not all. Commodities have individual supply/demand backdrops. In the end, the supply balance for each metal will be the main determinant of price in the coming years. I don’t want to weigh you down with too much detail but I will give a quick overview of a few metal markets we have the most interest in and where I think prices will go.

Copper traded much as I expected through 2014. A surplus was expected for this year and I thought the copper price would, and should, reflect that. I assumed there would be a drop in price in the 10%+ range last year. That is pretty much what happened. Then the wheels came off in January.

The chart below shows how wild the ride was. At the time I suspected the 20% drop in two days was driven by hedge funds or China based traders who had used copper as collateral on loans. Large changes in Shanghai copper inventories through 2014 seemed strange. Some of that may have been traders using copper as loan collateral much as other traders had done with iron ore.

In recent days it’s become clear my suspicions were correct. The mid-January drop was a bear raid by China based funds. That news calmed the market a bit and put in a bottom for now. Whether that lasts will depend on how large this year’s supply surplus is.

Note that Shanghai is, by far, the fastest growing metal trading market. It’s taking an ever larger market share from the London Metal Exchange. The day is coming where you’ll routinely check prices in Shanghai rather than London so China based funds cannot be ignored.

A year or so ago, the copper sector expected a surplus of as much as a million tonnes in 2015, followed by (probably) renewed supply deficits from mid-2016 on as mines depleted. Recent comments by some of the world’s biggest producers (BHP, Freeport, Codelco) indicate most of that surplus is not going to arrive. All three have cut back planned mine site expansions and development level copper projects are scarce.

China is, of course, the dominant user. Slowing growth there is a good reason to be cautious about base metals. Not too cautious though. China is still expected to grow at 6-7%. Real estate construction has slowed but there has been talk about accelerating infrastructure spending. We should still see demand growth from China.

While the recent price drop is concerning it could pave the way for a stronger rebound later. It may be enough to curtail marginal projects and has already halted several mine expansions. Nowhere is the phrase about bear markets giving birth to bull markets truer than in metals and commodities.

Big copper producers are talking their book when they claim there will be no surplus this year. I don’t expect traders to take that at face values unless they see the combined London and Shanghai copper inventories falling back later this year. They haven’t climbed much and are still relatively low compared to the past three years but after the recent scare bulls will be hesitant.

Assuming the US posts good growth, the EU a bit better and China continues accelerated infrastructure investment I think Copper should be stable this year.

One possible positive wild card is the rapid buildup of deflationary forces in China. With consumer inflation and producer input prices collapsing China now has high real interest rates. Beijing has room to cut rates quite a bit. I think they are hesitating because they fear reflating China’s property and mal-investment bubble. Understandable, but pressure to cut rates will increase and if Beijing succumbs that will be taken as a positive for copper other base metals.

If inventories fall do later this year the price should work its way closer to $3/lb by year end. I don’t think copper will get a three handle this year unless there is clear evidence of renewed growth outside the US, particularly in China.

Always the bridesmaid, never the bride. That seems to be zinc’s lot. 2014 was another year with little price movement but most commodities did worse. Zinc was one of the best performers and I think this will get repeated in 2015.

I’ve said before that zinc’s year is coming, I just wasn’t sure which year. Warehouse inventories climbed as high as 1.25 million tonnes between 2009 and 2012 but have been declining since at a rate of 2-300,000 tonnes per year. We’re not down to the levels that would trigger a real price move yet.

Current warehouse inventories are a bit under 650,000 tonnes. To see a real price move I think we need to get under 400,000 tonnes or preferably 300,000. That won’t happen this year but we will continue moving in the right direction. Production growth of 3+% per year in the next 2-3 years will be less than demand growth which is estimated at 4%+.

There are only small new operations planned during this period and the world’s third largest zinc mine, Century in Australia, should be depleted in Q3 of this year.

Galvanized steel is the largest end use and most of that us consumed by the auto industry. Worldwide car sales have hit records in the past two years and another is expected this year. We can thank zero interest rates and loose credit checks for that. The loose credit part will probably come back to bite us at some point but for now it’s all good.

Continued inventory drawdown will support the zinc price this year. It should get back above the $1.00/lb. level and could see $1.10 later in the year. Once Century goes off line the decline in warehouse inventories should accelerate as long as car sales stay up. 2016 may finally be the year when zinc stops being the bridesmaid. Once it really starts to move prices above $1.50/lb. could come quickly. It has that sort of market. I’m looking hard at a few zinc explorers and will probably add one or two in coming months.

Nickel traders got pretty excited last January when the Indonesian government banned the export of unprocessed nickel concentrate. It made similar moves with copper though some of the large copper producers have been given timing extensions for getting smelters built. Indonesia wants more of the value adding activity to stay in-country particularly smelting.

There aren’t enough smelters in country for either the nickel or copper sectors. New ones are being permitted but it will take time to get them built. Indonesia does not have a great power grid and smelters are voracious power consumers. I don’t know how that will be resolved.

You can see from the chart above that nickel had a good run after the announcement tough the gains petered out fairly quickly. Like Indonesia, the Philippines has large reserves of lateritic and saprolitic nickel that can be simply upgraded to a low quality direct shipping product that Chinese smelters will buy.

A number of small Philippine operations stepped up production and helped fill the supply gap. After an initial 50% price run nickel prices softened though the remainder of the year.

Significantly perhaps, nickel has not seen declines in LME warehouse inventories. They aren’t huge but have been building steadily for a couple of years. That was one reason I was a skeptic about nickel prices staying high. Most analysts expect another good year for nickel. I think we may see a gain if growth doesn’t slow too much but I’m not sold on it being a moon shot. If LME inventories actually top out I would start looking a lot harder at nickel deals. I didn’t see many that looked good a year ago.

It may happen though I’ll be a lot more comfortable seeing inventory levels I can check dropping. I find it hard to be as bullish as many others at this point.

I do keep an eye out for new nickel plays however. Even at $6-7/lb a high grade nickel find can have impressive value per tonne. There are few good ones so a new high grade find will always get attention. Indonesia’s new Prime Minister does not sound mining friendly to me so I don’t see export restrictions getting softened. That should support a $7-8 price for nickel this year.

This early year overview will conclude with “Tarnished – Part II” that will discuss bulk minerals, oil (again) and major equity indices.

Join me at our annual Toronto Subscriber Investment Summit on February 28, 2015. For more details or to register for this limited seating event, go to: www.subscribersummit.com or watch the video now.

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