Natixis Metals Review 2014, H1

London, 31 March 2014

Better late than never: 2013 was another difficult year for commodities, with total return indices trading in a narrow range to end the year down between 1.2% (S&P-GSCI) and 9.5% DJ-UBS. While DJ-UBS industrial metals lost around 13.6%, DJ-UBS precious metals suffered more substantial losses, with a negative return of almost 31%. In contrast, G3 equity markets rallied strongly, with the S&P500 up 30% and Japan’s Nikkei gaining by more than 50%. Investors might reasonably ask themselves whether commodities will ever begin to share in the global economic recovery: Natixis Metals Review.

For us, industrial commodities are naturally a late-cycle asset. During the early stages of an economic recovery, while equity markets are rallying in the anticipation of future growth in profitability, industrial commodities are typically held back by an outstanding overhang of accumulated inventories and spare capacity. Even as prices begin to rise, total returns are negatively impacted by steep contangos (given the implicit costs of storage for surplus output and therefore negative rolls for investors).

As the economic cycle matures, excess capacity eventually turns to scarcity, and physical stockpiles are gradually eroded. Spot prices outperform as markets move into backwardation, boosting roll returns for investors. At the same time, the rise in commodity prices represents an intrinsic part of the rise in inflation that eventually prompts central banks to tighten monetary conditions, something which is anticipated by an accompanying fall in fixed income and equity markets.

Where are we in this simplified cycle? After the extreme weakness in G3 economies in the wake of the financial crisis, a substantial surplus of both inventories and spare capacity has been generated in many commodities by the combination of weak global growth versus on-going expansion in new capacity. Even as the US economy has begun to improve, weakness in Europe and in many developing countries has helped to sustain this excess capacity.

Among the base metals, some are already making the transition from surplus to deficit, with zinc and lead top of this list. Aluminium and nickel, two metals that have suffered from substantial excess supply in recent years, face the prospect of a potential shift from surplus to deficit if Indonesia persists with its current ban on exports of unprocessed raw materials. Copper, in contrast, is swimming against this tide, with a solid increase in new mine supply being delivered between 2013-15, taking the market from deficit to surplus.

For gold and silver, the optimal point in the economic cycle is even later. These precious metals offer a safe-haven store of value in times of impending crisis, when central banks (in particular the Fed) are attempting to stimulate economic activity in the face of imminent recession by cutting interest rates and weakening their currencies. As such, they have a tendency to outperform at the very end (or arguably right at the beginning) of the economic cycle. In this respect, gold and silver’s near-term peak is most likely behind us now, as the US economy improves and the Fed begins to withdraw excess liquidity on the path towards (eventually) raising interest rates.

For gold and silver, a period of consolidation is likely, during which costs of production are likely to become a more important determinant of prices than the strength of demand. As these rising costs of production catch up with the (falling) price of gold and silver, so prices will form a base and eventually begin moving higher once more.

Platinum and palladium lie somewhere between industrial and precious metals. Like gold and silver, both have benefited from investor demand, which could at some point reverse into a new source of net supply. Like base metals, both are looking forward to a period of stronger growth in demand in the years ahead.

Aluminium

After years of chronic surplus, the global aluminium industry is going through a period of substantial change. In Russia and the west, producers continue to curtail unprofitable smelting capacity. In China, the growing influence of the price mechanism is likely to limit overcapacity in the aluminium industry. In Indonesia, the ban on exports of bauxite will deprive Chinese alumina producers of their main source of raw material. These three factors are expected to result in a further slowdown in global output growth. With demand for aluminium remaining strong, this is expected to push the market into a deficit for the first time since 2006, which should help to support a steady improvement in aluminium prices over the coming years.

In our central scenario, an improvement in the LME aluminium price is expected to be a relatively slow process at first. Adjustments will come, initially, in terms of a gradual decline in physical premiums and a move from contangoContango - 
A condition in which distant delivery prices for futures exceed spot prices, often due to the costs of storing and insuring the underlying commodity. The opposite of backwardation.  towards a flatter forward price curve. Only once it becomes clear that the market has moved into a substantial deficit will prices be able to move materially higher, given that there may be as much as 9 million tonnes of aluminium currently held in global stockpiles. We are therefore forecasting average LME aluminium prices of $1,880/tonne in 2014, rising to an average of $2,075/tonne in 2015.

Copper

Over the course of Q4 last year and much of Q1 this year, spot copper prices were supported by perceived physical scarcity. Over the remainder of 2014 and into 2015, the market’s perception is likely to shift emphatically towards surplus. Thanks to higher TC/RCs, fewer smelter outages and greater availability of scrap, the supply of refined copper is expected to increase more rapidly than mine output this year. As the market moves to price in the new copper surplus, the forward curve is expected to push into a sufficient contango to support the financing trades which will absorb this excess metal. Under such circumstances, spot prices are likely to remain under pressure.

By 2015, the copper market is likely to be faced by a new dilemma. In the near term, supply is likely to expand more rapidly than demand, but at the same time the market will need to face up to the prospect of a potential supply shortfall (or at the very least significantly higher costs of production) in Chile over the coming 5-10 years.

Against this backdrop, we would expect spot copper prices to remain under pressure for much of the 2014-15 period, with the forward curve progressively steepening. Our expectations for a gradually strengthening US dollar are also negative for copper prices. We forecast average copper prices in 2014 of $6,750/tonne, to be followed by $6,350/tonne in 2015.

Lead

Lead prices experienced a period of extremely low volatility in 2013, spending much of the time between $2,000 and $2,200/tonne between Q2 and Q4. For us, this belies a number of substantial structural changes that are taking place in the lead and lead-acid battery industries around the world. As a result, there is scope for greater price volatility over the coming two years, with prices expected to increase as the global lead market moves further into deficit.

In our central scenario, we expect that the growing deficit in the lead market will result in a gradual increase in prices. As lead stocks decline, so the forward curve should drift from contango towards backwardation, with spot prices outperforming. For 2014, we envisage an average lead price of $2,250/tonne, followed by an increase in 2015 to an average price of $2,450/tonne.

Nickel

The decision by Indonesian authorities, on 12 January, to ban exports of low-grade ore came as a major shock to the nickel market. Since then, as the market has digested the full implications of this move, nickel prices have rallied sharply, increasing to a high of over $16,000/tonne in March. Substantial risks remain, both on the upside and downside, as a market that is still struggling with a substantial surplus in 2014 faces up to the prospect of a potential deficit in 2015.

In the near-term, alongside the depletion of China’s accumulated stockpiles, nickel pig iron (NPI) prices will be pushed higher by the growing scarcity (and higher prices) of nickel ore. Over time, Chinese stainless steel producers will substitute increasingly expensive NPI with cheaper imports of ferro-nickel and potentially also refined nickel as the market continues to tighten. In our central scenario, we forecast average nickel prices of $16,000/tonne in 2014, rising to $17,500/tonne in 2015. Around these average prices, however, there is expected to be substantial volatility, given the sharply differing fundamentals in 2014 (surplus) versus 2015 (deficit), and the prospect that Indonesia may at any point over the forecast horizon rescind its current ban on exports of unprocessed raw materials.

Zinc

Zinc entered 2014 with some of the best fundamentals among the base metals. Exchange stockpiles declined by 380,000 tonnes last year, reflecting both an improvement in demand for zinc as well as constrained supply. International miners are struggling to raise zinc output against a backdrop of investment cutbacks and zinc mine closures. Accumulated stocks of zinc ore are likely to have diminished over the course of 2013, restricting smelters’ flexibility to raise refined zinc output. If demand for zinc continues to grow at its recent robust pace, the market should tighten further over the course of 2014-15.

Our forecasts for demand and supply anticipate that the global zinc market will move into a steadily widening deficit, which will generate real concerns about physical scarcity of metal over the course of 2014-15. This view is reinforced by the sharp drop in reported zinc inventories in 2013 as well as the rise in physical premiums for delivery of zinc and a switch in the LME zinc forward curve from contango to backwardation late last year. All of these indicators clearly point towards higher zinc prices. In our central scenario, we expect zinc prices to average $2,185/tonne in 2014, rising to $2,450/tonne in 2015 as the market progressively acts to ration near-term demand for the metal, as well as incentivising mining companies to increase investment in new mines over the coming years.

Gold

In 2013, the average price of gold dropped by 15.5% yoy to $1,400/oz, ending a ten-year bull run. Four major developments drove the price of gold lower. First was the announcement by the Cypriot central bank that it intended to sell its gold holdings, prompting concern that other peripheral European countries could follow suit. The second important event took place in June when the Fed announced that it would seek to start tapering its monthly bond purchases. Third, strong ETP outflows reduced demand for gold, after higher bond yields increased the opportunity cost of holding gold. Fourth, central bank demand fell to its slowest since the financial crisis. All of these elements contributed to lower gold prices.

In 2014, we believe that economic improvement in the US along with a slow-down in central bank and western investment demand will help drive the average price of gold to lower levels than in 2013. Gold prices may receive some support from Asian physical demand, but ultimately we would expect the rising cash costs of production to provide a floor under which gold prices will stop falling. Our base case forecast for gold prices envisages an average price of $1,240/oz for the current year and $1,250/oz for 2015.

Silver

Although industrial demand for silver is expected to increase alongside a growing global economy, the price elasticity of this source of demand is low, hence it would be unlikely to be able to offset any substantial decline in investment demand. Since the beginning of the financial crisis, investment demand has grown to 25% of total demand for silver. Were this to fall back to historical levels of 8% it would leave a major gap that industrial demand is unlikely to be able to fill.

With our negative outlook on gold (rising US yields, appreciating USD, return to global growth), and additional downside risks attaching to silver prices, our forecasts envisage an average silver price of $18.6/oz in 2014 and $15/oz in 2015.

PGMs

Over the past two years, PGM prices - especially platinum – have been driven primarily by events on the supply side. Rising costs of production in South Africa (strikes, higher wages, higher electricity prices, lower ore grades) have put mining companies under increasing pressure, although this has been alleviated somewhat by the depreciation in the rand.

On the demand side, consumption of platinum has been depressed in recent years by the weakness of the predominantly diesel-powered European automobile market as well as technological advances which have reduced the amount of platinum used in autocatalysts.

Within South Africa, a new round of strikes in the platinum industry were initiated early in January. We do not believe that these strikes will have a material impact on platinum prices, since most producers had increased their platinum ore reserves in recent months and should therefore be able to sustain refined metal output at a level sufficient to meet demand. Furthermore, the weakening of the South African rand will offset the effects of any increase in wages upon the dollar price of metal. That said, we believe that the most important factor behind higher platinum prices this year could be a pick-up in European automobile demand. As such, our base case scenario for platinum envisages an average price of $1,490/oz for 2014, followed by $1,650/oz for 2015.

Palladium prices have remained closely correlated with platinum prices over the past year, with the 3-month rolling correlation currently at +0.8. Nevertheless, their fundamentals differ quite significantly. On the supply side, Russia is the world’s largest producer of palladium, followed by South Africa, implying that palladium is not affected as much as platinum by South African strike action, but could be significantly more affected by any post-Ukraine sanctions. In recent years, official Russian stockpiles have offered an additional source of potential supply. While rumours have regularly suggested that this stock of palladium may be close to depletion, there have been few signs that stockpiles have been exhausted. Restricted availability of this source of palladium would, nevertheless, represent one of the more logical anti-western sanctions that Russia could implement in retaliation for any economic sanctions imposed upon Russia in the wake of their annexation of Crimea. On the demand side, palladium is less affected by European automobile demand because it is used more intensively in the autocatalysts of gasoline-powered engines which are more prevalent in the US and developing countries.   Our view is that average palladium prices will rise to $755/oz in 2014 and $770/oz in 2015 on the back of higher automobile sales in developing countries and the increasing use of palladium as a substitute for platinum.

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