LONDON, July 21 -- Banks stand to make attractive profits financing and tying up zinc stocks, leaving prices for the London Metal Exchange's worst performer this year with limited downside.

Zinc has fallen 29 percent this year under pressure from swollen stocks, doubts over demand prospects and a growing supply surplus. But since mid June, it has risen 5.5 percent, beating copper, aluminium and nickel.

While the Chinese have bought LME zinc on the cheap, the metal has also been supported by the artificial market tightness created by bank financing deals.

"The near-term outlook on (zinc) prices is generally sober until the first or second quarter of 2011. However, we do not see a price collapse," said CPM Group commodity analyst Douglas Horn.

He said prices were near the cost of production, Chinese output was set to dip near term while banks will be able to buy nearby zinc and sell it forward at a profit for some time to come.

"Zinc financing deals are garnering more interest now because market watchers are seeing demand volumes ease but premiums are rising. It is likely that deals are being rolled over from last year."

Premiums, the amount paid over the LME cash price to cover the cost of shipping and delivering metal, for Rotterdam zinc are currently at around $123 a tonne versus $90 in early January.

U.S. premiums have risen some 50 percent since end-May even though demand is ebbing while LME stocks are near their highest in five years, with more than half of the 616,000 tonnes located in New Orleans, where zinc demand is minimal.

The situation is alarming consumers, who fear finance deals in zinc might become more widespread.

"Material for prompt delivery is short so consumers have to set priority to secure supply. What's been happening in aluminium could start happening in zinc. One reason for these transactions is the interest rate, which is too low," a metal trader based in Europe said.

CRUCIAL

Low interest rates are crucial for financing deals, given banks need to lend the money to buy nearby metal, sell it forward at a higher price and strike a cheap warehouse deal to store the material in the interim.

Rates have been extremely low since the financial crisis of late 2008, while lacklustre demand and increased supplies have resulted in a widening spread or 'contango' between nearby and forward prices of many metals.

The combination has made financing deals, most notably in aluminium, very profitable. What worries consumers about zinc is that its price structure is starting to mimic aluminium - the contango has been widening for most of this year given the growing oversupply.

At present the spread between cash zinc and zinc for delivery in 15 months is about $93 with a roughly 5 percent rate of return, compared with $50 at the start of February with a 2.4 percent rate of return.

Moreover, the market conditions that make deals profitable look set to remain in place for some time to come. Rates are expected to stay low for an extended period while demand growth prospects are dim given the global recovery is slowing.

"There's nothing foreseeable to stop these deals. They're a nice sort of technique designed by financial engineers to form another source of demand," said Credit Agricole analyst Robin Bhar. "If there's as much zinc as is reported you could in theory have a physically backed ETF."

ETFs, or exchange traded funds, that back their shares with a physical commodity, are said to be the ultimate financing deal because, if successful, they indefinitely extend the tying up of commodities for non-consumption purposes.

However, they are not expected to be launched in zinc any time soon.

It remains difficult to even estimate what percentage of LME zinc stock has been tied up in financing deals, although it is generally agreed that the figure is far less than the estimated 70 percent tied up in aluminium.

In other words if conditions remain as they are or improve, a lot more metal could be tied up, creating havoc for consumers and tasty profits for banks and producers.

"We probably will see more financing. The whole over-supply becomes self reinforcing. Deals hold prices up, producers produce more and more gets tied up in financing. It's supportive of prices for the time being."