2016 Preview Part III; Metals
From the January 31, 2016 HRA Journal: Issue 245-246
This is the third of three parts of the 2016 preview that appeared in HRA Journal Issue 245-246. This part deals with the outlook for various metals. The assumptions about what the economy will do (see Part I) underlie the discussions on metals though each has unique supply/demand issues. In most cases the supply demand balance looked better than expected though, obviously, market sentiment will drive markets short term. Volatility will be high.
Gold: It’s Different This time. (no, seriously)
I know, I know. I can’t believe I wrote that either. The most dangerous phrase in finance and for good reason. The backdrop for the gold market and the market internals themselves really are quite different this time however.
I’ve seen plenty of comparisons to 2008 recently. There is concern that we’ll see a sell off like we did then if markets in NY really drop. That’s certainly what happened to gold equities in 2008. When margin calls hit everything got sold. Importantly however, it’s not really what happened to gold itself.
The two charts above show gold prices leading up to and through the 2008-2009 bear market and a chart of similar duration ending now. Before looking at them in any detail a fairly obvious fact jumps out at you, namely that the top chart is depicting a bull market while the lower chart is clearly a bear. At the most basic level the backdrop and backstory of the gold market is very different from the time leading up to the Great Recession.
The red vertical bars on the two graphs denote the bull market highs for the SPX (assuming, as I do, that we won’t see a new one for a while) while the shaded box in the top chart is the “crash phase” of the 2008-2009 bear market.
As you can see, overall gold performed quite well through the last bear market. It wasn’t straight up by any means. There was heavy selling “post-Lehman” when the real panic set in and traders were throwing everything overboard. Importantly however, gold didn’t follow equities all the way down in late 2008, early 2009. Gold was spared the final December to March down leg. Gold bottomed four months in advance of the SPX. By the time New York hit its 2009 low gold had already moved up over 30% from its earlier bottom and 20% from the levels it traded at when the real bear market kicked in.
Gold miner stocks didn’t fare as well, at least in terms of their overall drop. Charts for the gold miners ETF for similar periods are shown below. Significantly however gold miners also bottomed four months in advance of the SPX and had taken back all of their post Lehman losses by the time New York bottomed. Keep in mind that all of this happened before QE started. Those gains came later.
Like the gold chart, the current version of the GDX chart is just plain ugly. The relatively flat performance through the past six months is the first show of stability since 2014 but it’s at rock bottom levels. Gold and gold miners have a lot to prove at this point.
Chartists and technical analysts continue to insist gold needs one more price breakdown to complete its bear market. Notwithstanding recent market gyrations most are still calling for a low in the $900-950 range to “complete” the pattern.
They could be right but I’m not a technical analyst so I don’t consider “the chart says so” to be a real reason. We have to view gold in context. We may get a repeat of 2008 but I will be surprised if it happens.
As the charts for both gold and the GDX make clear the current situation is diametrically opposed to the 2006-2009 market backdrop. Gold and gold stocks were a “baby with the bathwater” situation in 2008. Markets were falling apart and margin calls were flying. As a widely owned sector (then) gold miners were popular sells when margins had to be covered.
This time around the sector is despised and most institutions are out. There will be some selling if we get a crash but nothing like 2008. Funds have to own the stuff to be able to sell it and, right now, most just don’t.
The top chart on this page shows gold ETF holdings through the past year. The pattern is the same here. There has been a bit of renewed buying since the start of the year but it’s coming off a very low base. Fickle ETF speculators are not my favorite gold holders. That said, it’s a vehicle that allows a lot of gold to be taken out of play fast if prices start running.
Gold gets traded/priced as a currency and a way to avoid systemic risk. I’ve laid out the reasons I think the USD could weaken earlier in this issue. That is one potential mover for gold. The other is gold’s status as a vote of non-confidence in the financial system.
It’s no coincidence the most recent small spike in the gold price took place while the US Fed was disappointing the market. When traders start thinking the financial system is messed up an asset with no counterparty risk like gold sounds good. Periods of lower risk tolerance favor gold. As the VIX chart above shows traders are still not that worried. That will change if markets continue to decline.
If the US market evolves into an “official” bear market as I expect increased buying of gold and gold miners and perhaps other miners as well. Even though the sector has been “cheap” that is not enticement enough when there is easy money to be made on the big board. As traders there accept that the overvaluation issue is real and companies get into trouble as easy debt financings dry up traders will be looking for things that really are cheap and oversold already. Gold miners certainly fit that bill. We don’t need a mass exodus from Wall St. Even a tiny fraction of the money crossing the tape in NY could have a huge impact. The same is true for bullion. The Fed’s wilting credibility could be gold’s gain.
Copper is by far the most important and closely watched base metal. It’s widely considered a meaningful barometer of the world’s economic health even though its track record in this regard seems far from stellar.
The current state of the copper market is a perfect example of the contradictions inherent in the metals market. I'm sure you’re all too familiar with the cooper chart on this page. It’s ugly. I started out 2015 mildly bearish on copper, expecting a drop in price of 10% or so.
Turns out I wasn’t nearly bearish enough. Copper has now dropped to around $2 a pound and has been flat lining near that level since the start of 2016.
Traders remain very bearish on copper though as the year progressed the market internals for the red metal (other than price) actually started to improve.
If you only watch daily copper prices you might be surprised by the lower chart on this page which displays LME warehouse stocks for copper. Copper at LME warehouses has declined about 120,000 tonnes since mid-year. The level hasn’t declined for the past few weeks which may add to trader’s nervousness even though the absolute level well into the lower portion of the five year range.
If you’re surprised by the LME chart you’ll be even more surprised by the chart at the top of the next page that shows monthly imports of wrought and unwrought (concentrate) copper to China. China imported 530,000 tonnes of copper in all forms in December. That is the second highest monthly import level, ever.
Granted, that total came after some weak months early in 2015 but the trend in imports has been strongly positive since August. I noted a while back that there are rumors Chinese hedge funds are using copper shorts as a proxy for shorting the stock market which authorities wouldn't allow. Maybe, but importing copper so you can short it seems like a stretch and the hedge fund universe is quite prone to urban legends. I have trouble taking that story seriously.
A more reasonable, if not really more bullish, explanation would be industrial end users stockpiling to take advantage of low prices. This would imply copper piling up somewhere that still needs to be consumed. On the bright side it also means end users (if not hedge fund traders) are not expecting prices to fall much more.
So what gives? There seem to be a couple of reasons for copper’s continued weakness. One is that there is new supply coming on stream this year and next from some large new mining operations. That is a reason to be cautious though it’s not an immediate problem. It’s really confirmation bias for those already bearish.
As I have noted many times over the years the forward supply numbers for most metals are almost always too bullish. That seems to be truer for copper than most. Industry groups that draw up supply projections assume few if any start-up problems, smooth passage through financing windows and perfect operational and metallurgical performance against plan.
Anyone who has spent more than a week working at a mine knows that level of assurance is laughable. The bigger the mine the more likely there are teething pains, that it’s late on the construction schedule and that the mill has to be tweaked, sometimes for months. And smooth financing? I’m sure I don’t have to point out how absurd that assumption is in this market.
You can be pretty sure that actual production growth from new mines will be lower than the expected 5-6% into 2017. At current prices there is no incentive to grow production. Anything in the development pipeline that isn’t lowest quintile cash cost, already financed or owned by an extremely obstinate miner isn’t getting built.
While there is more supply coming we’ve also seen accelerating cuts in existing supply. Granted, most of this has come from mines that are small and marginal but it still adds up to several hundred thousand tonnes. China’s copper industry is talking about cutting refined supply by 250,000 tonnes next year.
Most copper mines have low enough cost structures that not that much production (25% perhaps) us underwater on a cash basis. On an all in basis it’s a different story and it’s no secret several miners are in real trouble. The scrap value of a mining operation is low especially at the bottom of the cycle. I doubt we see many bondholders force closures unless it’s to demand money losing operations in multi mine companies get cut.
Even with the slowdown in China it doesn’t appear there was much surplus production in 2015. Assuming a normal amount of production bottlenecks and supply cuts there should not be a large one this year either. So why the ugly chart?
Part of the drop is traders pricing in a steeper drop in Chinese growth. I expect slowing but perhaps not as much as the market. A second larger issue for traders is the assumption the $US will strengthen considerably this year. You know where I stand on that issue. A rollover in the USD is the best shot all commodities have for short term relief.
That’s the good news though a weaker dollar would accompany a weaker US economy which could provide another excuse to sell. On balance I think there are enough positives in the outlook that by the end of 2016 we see higher copper prices –perhaps $2.20-2.40/lb and potentially more but there is a probability of a bit more pain before we see the gain.
Zinc: Glory Delayed
Zinc was the metal I was most positive on heading into 2015. Things went well for about four months then went very, very wrong. As you can see from the top chart on the right zinc not only joined other base metals in falling prince but actually had a chart as bad as or worse than several of them.
So what went wrong? Not nearly as much as the price chart would lead you to believe. Zinc is an interesting test case because the way its traded tells you a lot about market sentiment towards commodities in general and metals in particular.
Zinc’s supply/demand metrics are markedly different from several other metals but its chart looks much the same. That tells us that sentiment is driving a lot of the trading in the space. That’s not surprising given the bearish extremes seen across the commodity sector.
Understand, I’m not saying issues of oversupply in some commodities and weakened demand in most others doesn’t exist. I’m saying that in some cases traders are ignoring potential upside because they are too busy selling or shorting everything in sight. Even if a particular metal has a more positive supply/demand outlook it will still face an uphill battle until sentiment starts to turn.
Like most metals zinc saw a reduction in demand in 2015 and it centered on China. The largest use for zinc by far is in steel galvanizing and most of that has construction as an end user, accounting for about 55% of demand. The automotive sector comes next with about 25% of overall demand.
The cut backs in both construction in China and in the steel sector worldwide are hurting there. Zinc demand is expected to be up marginally for 2015 when all the numbers are in and perhaps 1-2% in 2016. The slightly stronger number in 2016 does assume some increase in construction activity in China. It’s too early to say how much of that there will be. Beijing prefers to stimulate other sectors and there is inventory to work through in real estate but we’re likely to see more interest rate cuts so that may improve the animal spirits of developers.
Consensus estimates are for another strong year for auto sales. I don’t completely buy in on that. I think the huge sales in the US in 2015 brought some demand forward and my view is that we don’t see much increase, if any in auto sales this year.
The two charts on this page from CRU and Macquarie give two views on why the zinc price should improve in 2016, at least from its current depressed levels.
The top chart shows a five year history of average spot treatment charges per tonne levied by zinc smelters. Smelters want to be running at or near capacity due to high fixed costs. When concentrate supplies are tight they offer lower TCs in order to entice sellers and keep the smelter running near capacity. Treatment charges are there for a good indication of how tight the market is. As you can see from the chart TCs dropped from near $200/t to $140/t last year, most of that drop coming near year end. Smelters are clearly starting to worry about the market tightening up which is a positive sign for the miners.
The lower chart shows announced supply cuts for this year, broken down by region. Note that these are cuts in supply due to low prices, not exhaustion of ore bodies. Several groups announced cuts in the second half of 2015, notably Glencore which said it is cutting production by 500,000 tonnes and Nystar which plans 400,000 tonnes of curtailments, sales or closures. Some of those sales may go to parties that keep operating mines so the actual reduction may be less.
In addition to those cuts we have the exhaustion of the Century mine in Australia and Lisheen in Ireland, both of them coming off stream about now. These two closures remove about 600,000 tonnes from the market.
Collectively, these cuts should lead to supply deficits of 4-500,000 tonnes in 2016 and 2017 with no relief in sight. Worldwide zinc inventories are still high, especially after someone (probably Glencore) dumped 500,000 tonnes into the warehouses last August but the sort of drawdown I envisage should be enough to move the needle even assuming weak demand growth. Current prices are making life hard for a number of small producers so additional cuts are certainly possible.
With the expected draw down this year we should see prices move back to the $1/lb range. If it looks like 2017 will be a decent year for the world economy a similar percentage move to $1.30-1.40 next year is quite possible which may actually generate some excitement.
Nickel: Too Much Soft
Not that long ago, nickel was considered by many to be the surest bet in the metals space. When Indonesia changed its laws and required nickel mined in country be smelted there before it could be exported most expected a large run in price. I wasn’t among the believers which is why I have been essentially bearish on nickel for years. I’m not seeing evidence yet that causes me to change my view much.
The nickel exports Indonesia is controlling are oxidized nickel bearing laterites. Most of these are mined by small low tech operations which do minimal upgrading before shipping the material to China. These soft rock miners are the swing producers of the nickel sector. Chinese mills have perfected methods of producing relatively low grade pig nickel iron that is used in turn for feedstock in stainless steel plants. Stainless steel accounts for almost all nickel usage.
I didn’t jump on the bandwagon then because I had experience, not altogether happy, as an investor in a company mining the same material in the Philippines. I assumed this region would be able to take up most of the slack when Indonesia banned concentrate exports. That view turned out to be true. It’s commonly believed that Philippine exports will trail off before Indonesian smelters start to operate in a couple of years. That’s possible though oxide nickel is fairly widespread and not well documented so I won’t be surprised if it turns out analysts are too optimistic again.
I used one year charts to be consistent in presentation with other metals. A longer term view of the warehouse stocks in particular would make the bearish case more plainly. With the exception of the dip in the second half of 2015, now largely reversed, LME nickel inventories have been climbing relentlessly since early 2012.
There was a large drop in Chinese demand in late 2015. This is related to a falloff in construction. It’s too early to say how long this lasts but no one expects a quick return to higher growth rates. One bright note in the current low price environment is that is encouraging a switch to higher grade stainless steel that uses three or four times as much nickel. This should help generate some increased nickel use even if the total stainless steel production doesn’t increase.
Like several other metals it’s going to take supply cutbacks to balance the market. In nickel’s case those should definitely be coming.
The graph below shows the C1 cash cost curve for global nickel production. At current nickel prices of just under $4/lb most nickel production loses money on a cash cost basis. This situation cannot be sustained for long.
Large low grade operations in Australia are in real trouble. Some of these newer operations have very high capex and debt loads. The only area that may see incremental production is Indonesia if sufficient smelter capacity gets built in country. Any smelter that isn’t currently under construction won’t be financed at these prices.
The lower chart on this page is Macquarie’s estimates for the supply demand balance going forward. They estimate five years of supply deficits. They are assuming lighter production from the Philippines than I would but at current prices even those low tech operations must be struggling so they could be right.
One assumption most agree on is that we’ll see at least a couple of shutdowns. Virtually none of the nickel projects in the development pipeline will be advancing. Most need nickel prices of two or three times the current level to be incentivized and financed.
It’s widely assumed that a lot of nickel that was fabricated during the Chinse pig nickel boom is still in unregistered warehouses. Periodic dumps of material into LME warehouses bears this assumption out. That’s why most analysts assume inventories will stay high by historic standards for years to come.
All this adds up to a market that could allow for a bounce off multi-year lows but not a very strong one. The price won’t be strong enough to make much of anything look economic. It’s tough to generate excitement for nickel discoveries against that backdrop. It would take a pretty amazing discovery to get me interested.
Uranium: Waiting For Godot
I talked about uranium briefly in a recent extended review. Not much has changed but I’ll lay out the case for a potential price move a little more fully. I stress again that I don’t classify this price move as something immanent. I think the move may start this year but this is really more of a 1-3 year call.
As longer term subscribers know HRA exited the uranium space except for a single deal (Hathor) that was taken over by RTZ shortly after. I have had a couple of short term exploration trades since then but only added a longer term story recently.
HRA dropped everything but Hathor the night of the Fukushima nuclear accident. We feared politics would turn against uranium and there was a small oversupply building in any case.
Japan closed its entire nuclear power fleet and Germany largely followed suit. The decision was safety related in the case of Japan and most reactors are expected to be back on line within 2-3 years. That will take care of some of the current above ground oversupply. Germany’s decision was more political/philosophical and I don’t see that one being reversed. The current low oil and natural gas prices will make that decision easier to stick with.
The closures exacerbated the small market oversupply and the result can be seen on the chart on this page. Prices dropped rapidly, getting as low as $28/lb on the spot market before levelling off. Things have stabilized in the mid-$30s but there have been no real price gains yet.
Most uranium is sold through long term contracts and this is where the potential for a larger price move could develop. Long term prices held up slightly better than spot prices and currently sit at $44/lb against a spot price of $35/lb.
With the uranium price flat lining utilities have felt less pressure to lock in long term prices. Marginal demand could be filled in the spot market. That is (slowly I admit) setting up a market that could allow for a steep increase in prices later.
While Fukushima hurt the political case for nuclear power it’s by no means dead. Unsurprisingly, the areas with the most growth potential are China and India. Both are large scale energy importers and both use coal fired electrical plants as their main source of base load power. While renewable power sources are increasingly used in both countries they are not reliable enough yet for base load. Current multi year lows for oil and coal may reduce the immediacy of the problem but the pollution they cause doesn't. Beijing has had almost daily smog alerts this year and that is sure to keep the pressure on politicians to continue adding to the nuclear fleet.
China should be building 4-5 new reactors per year and there are rumors that the next five year economic plan for the country will increase even that impressive pace. India indicates it will also accelerate its nuclear power plant construction schedule. While I think India is serious getting anything through its infamous bureaucracy and approval process is a struggle. I’m more skeptical we’ll see an accelerated program in India but a measured one should still be enough to positively impact demand.
On the supply side uranium has to overcome the combination of increased production started up in the wake of the last price spike and inventory from shut reactors and weapon decommissioning. The weapon recycling is winding down and new production additions are stalling. Aboveground inventories need to be worked through but that seems inevitable since mine production is again below demand.
While there are some in-situ leach operations in the design stage and/or permitting pipeline there is little incentive to build them at current uranium prices. Even these relatively low capex operations would be breakeven exercises at current long term contact prices. The large high grade discoveries in the Athabasca basin look impressive but involve long permitting and construction timelines and 10 figure capital costs. These are not going to alleviate a potential supply shortfall any time soon.
The charts below show the pounds currently contracted going forward and future uranium requirements that are not yet contracted. As you can see, the contracted fall off rapidly this year and next.
The lower chart indicates uncontracted requirements were low for the past couple of years, easily covered by spot purchases without worry that those purchases would move the price up. That soon changes though. It will be hard for utilities to source enough uranium in the spot market going forward. The situation is not immediately critical but at some point utilities will have to suck it up and raise their offers. Paying $10 or $20 or $30 more per pound has little impact on the utility’s cost base. They won’t pay it if they don’t have to though. As the U market continues to tighten this year and next those utilities will be forced to move prices up and, once started, the move could extend and be large. That’s the opportunity.
Iron Ore, Coal, Potash: Moar Stoopid
The multi-year iron ore chart on this page shows how ugly the market for this basic material is. I haven’t included charts for coal or potash but they wouldn’t look much different. I don’t intend to focus on any of these commodities in the near future so I won’t spend much time on them.
All of these bulk minerals share a couple of attributes. One is that the market size grew very rapidly from 2000 to 2012 and all of that increased demand came from emerging markets. In all cases production in emerging markets is a small fraction of overall demand. That means these materials generated some of the highest offshore percentage demand increases in the sector.
Double digit (in most cases) annual demand increases generated big percentage price gains and lots of excitement—for a while. When the tide turned it turned harder for these markets than for base or precious metals.
One amazing aspect to the saga is that, in the case of iron ore and potash at least, the markets were essentially oligopolies. In the case of both of these commodities three or four companies controlled over half the supply.
Unfortunately, management of these companies apparently skipped the oligopoly lectures in Econ 101. Oligopolies only “work” if all the major supply side actors keep a close eye on each other and factor their competitor’s plans when estimating future supply. This means the big suppliers have to cooperate (or conspire, if you’re going to be picky).
That’s exactly what didn’t happen in the potash and iron ore markets. The main suppliers ramped up production simultaneously in order to minimize costs and drive out smaller competitors (they’re still ramping up in iron ore). This has generated oversupply that will take years to work off.
There have been demand side issues too but these bulk materials sectors have been the worst when it comes to supply management. Things look a bit better for potash though it has the problem that its biggest end use markets have the most depreciated EM currencies so getting $USD prices anything like those in the recent past seems unlikely. In iron ore its “devil take the hindmost”. Most small producers will go under which is what the big three want. They can’t even manage an oligopoly properly, us it any wonder it’s tough for miners to source capital?
Coal is a broader market with many participants but here too the oversupply is extreme. There are a number of large coal producers that won’t be around at year end. We’ve seen this movie before in the coal business.
Coal may start to turn as producers go bankrupt but it has and existential issue too. No one really wants to burn the stuff. It’s needed for power generation but something that will get phased out as soon as it’s practical. All of these sectors will be slow to come back and have fewer producers when they do. Best avoided for the foreseeable future.
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