Bipolar Base Metals

From the HRA Journal: Issue 301

Wall St continues to bask in the love of the FOMC, with lots of soothing comments to warm the cockles of trader's hearts and bring on the bids.

I've still got some real concerns about the US economy as the year wears on, but maybe all this stock market joy turns things around. Some rapidly deteriorating economic readings will need continued attention though.

While the US-China trade dispute isn't settled, the two sides are talking and it sounds like the next round of tariffs will be delayed, perhaps indefinitely. That, plus signs of bottoming in the Chinese economy has brightened the mood for base metals.

This issue's editorial is mainly about base metals markets. I give my view on copper, zinc, lead, nickel, uranium as well as more general comments on "minor metals". Most of them should have decent years, notwithstanding my concerns about the US which is not, after all, the main user,

Gold moved to $1350 and is consolidating now. It's still trading well against currencies and I still think its got a good shot at a breakout. We're only days away from the next MIF in Toronto, followed by the PDAC. We should know soon enough if we're due for yet another year of "PDAC curse" for the juniors of if we dodge that particular bullet this year.

Eric Coffin
February 27, 2019


Bipolar Base Metals

There seem to suddenly be a lot of base metal bulls suddenly. It's not chart based, at least for most base metals. Prices look better than they did a couple of months ago. I wouldn't call most base metals charts bullish just yet, though I'd say copper is the exception.

Some of this is fundamentals, for sure. There are good reasons to believe the "main" base metal-copper-should have some good years ahead of it. But there are still potential stumbling blocks in the short term.

The US-China trade war is the headline issue, but China's economy itself, and slowdowns elsewhere, are the most important ones. Longer term, things look good for several metals. But you should be prepared for some short-term price swings is you're buying now.

Economic readings were quite weak from China heading into the start of 2019. Q1 numbers are always tricky because of the huge impact Lunar New Year holidays have on the entire economy, but things seem to be stabilizing again. There has been a notable turn around in both new lending and capital investment, both key readings for China.

A turnaround is also reflected in China's stock market. The Shanghai index was among the worst performing Global indexes through 2018, dropping 30%. Things have turned around dramatically since the start of this year, with the CSE Composite Index entering a bull market again when the tariff increase was postponed. You can see both the credit growth and CSI index charts below. Credit conditions started improving in Q4, which should bode well for an uptick in China's GDP growth. It's certainly needed, as that measure is still at a multi year low.

Going forward, we'll be watching for signs of agreement in the US China trade dispute, and China's manufacturing sector. The US just put off implementation of higher and broader tariffs as the two sides are still meeting. The recent jump in both copper and the Shanghai index are directly related to optimism that there will be a trade deal.

The jump in credit growth implies we'll see increased construction activity in China, a major consumer of all base metals. Things still look shaky in the manufacturing sector though. Purchasing Managers Indexes have been diving for the past few months, right along with exports to the US. For all of Beijing's attempts at bravado, China really needs that trade deal.

The chart below shows the longer-term relationship between copper prices and China manufacturing indexes. They are far from perfectly correlated but the relationship is clear. Note that the NBS Index, which covers larger companies had a slight bounce in January, which the Caixin index, which includes more smaller companies, dove even harder.

Seeing gains in both these indexes in the next couple of months would go a long way to confirming the demand side of the recent copper price move. That said, metal prices have moved ahead of China manufacturing indexes during other large moves, like 2016.

Things look considerably brighter on the supply side for copper. Whatever the short-term outcome of the trade war, the supply/demand balance for copper is getting increasingly bullish. While we need to be wary of sudden negative turns in the economy and political landscape, the doesn't seem to be any way to avoid increasing copper supply deficits going forward.

The chart above shows a widening supply deficit for copper out to 2022. While there are a couple of new large producers, notably Cobre Panama, several other major developments have been pushed back. Development of underground block cave operations at the giant Grasberg, Chuquicamata and Oyu Tolgoi are all moving slower than expected. Production guidance for Grasberg and Chuqi have both been severely reduced for the next 2-3 years. That alone takes a few hundred thousand tonnes out of supply and more than offsets new Cobre Panama production.

Tier 1 copper producers seem to be increasingly focused on block cave mining. If things go perfectly, block cave mining costs can rival open pit costs, in theory anyway. The bigger issue for large miners is permitting. They are only interested in very large throughput operations and are worried giant open pits will become harder and harder to permit.

An increased move towards bulk underground mining could exacerbate the supply issue. Large miners must expect block caves will have a shorter permitting period that will make up for the longer development time lines. Block caves need careful planning, most underground workings need to be excavated before production starts and it takes years to ramp up to full production. If block cave truly is the wave of the future, we're in for a long supply deficit for copper.

Shorter term, copper is in the midst of a short squeeze. Colling of China-US tensions is part of this, but warehouse inventories may be a bigger factor. Worldwide copper inventories have been dropping for months, and LME copper stocks hit historic lows last week. That freaked out traders that were short, prompting the covering rally.

Part of the "bipolarity" in base metals is reflected in the copper market. Chinese manufacturing looks weak, but copper imports are exceptionally strong lately. Refined copper and copper concentrate imports to China in January were 14% and 17% higher MoM and historically high.

Maybe the copper is being stockpiled rather than used. At the end of the day, it won't matter if these import levels continue. It still takes available supply out of the market and keeps upward pressure on prices.

I still want to see that China-US trade deal, and I'm still concerned about deceleration in the US. A real slowdown in the US would put downward pressure on copper prices in the near term but won't impact the long-term view very much. Copper looks destined to head back to its all-time highs, eventually. That should give us some comfort to ride out shorter term volatility, if that even arrives.

Other base metals have had similar price recoveries in the past two months, though their markets are all a bit different.

Zinc has moved back above $1.20 and it's warehouse inventory levels are even more historically low than copper. While that is bullish are first glance, the reasons behind it are different.

There is still a serious bottleneck in at the smelter level for zinc. This was created due to environmental shutdowns of several Chinese smelters. I don't know how many of those are permanent, but they are having an impact on smelter charges.

There are annual meetings of the International Zinc Study Group, an industry association, going on now. Deals made at this meeting often define the smelter TC/RC charges for the balance of the year.

TC/RC charges dropped from $172/t in 2017 to $147 in 2018, on average. No one expects a repeat of that. Recent quotes have been as high as $250/t. That's very high by historic standards. It should bring some Chinese smelters back on line, assuming they get environmental clearance.

In short, there isn't a shortage of zinc production right now, there's a shortage of zinc metal production. There have been some new start ups, and higher prices have brought on more production in China. But that concentrate has to be turned into metal before its usable.

Ignoring the smelter situation, zinc should be in surplus this year. That only puts downside pressure on the market if it's smelted in to metal though. LME zinc inventories are currently less than one day of demand, which is critically low.

I expect will see smelters increase their capacity as the year wears on. I've always thought China was serious about tougher environmental laws. I still do. But if supply of zinc metal gets critical within China itself, I think Beijing will give some of the cleanest smelters a pass, at least for a while.

The biggest potential positives for the zinc market would be a marked increase in China infrastructure spending. We might get that if Beijing doesn't think the current stimulus is doing enough. Infrastructure spending is one of Beijing's most popular fallbacks when its trying to goose the economy. The other positive could be the high TC/RC charges I expect. Smelters demanding $250/t to handle concentrates could be enough to take the most marginal producers off line. It would have the greatest impact on small Chinese producers we don't have much info on, but it's no secret they are inefficient and high cost.

Overall, there should be enough new metal to cap zinc prices near the current $1.25/lb level. If the smelter situation gets solved, I would expect prices to pull back towards the $1.00 range. How far they pull back will depend on whether China ups its infrastructure spending or things really slow in the US/Europe. At this point. I think assuming 10% downside in zinc prices, but hoping for a pleasant surprise, is the wisest course.

The story is similar for lead and nickel, though nickel clearly has the best demand growth prospects. Lead tends to trade along with zinc but with lower volatility. The two metals get thought of together but there are few areas where they can be substituted, and even less where they would be due to lead's toxicity.

The main thing lead has going for it is that it will be a long time before the world fully moves away from lead-acid batteries, which are the main end use now. Since lead is viewed as "yesterday's metal" few, if any, miners actually go looking for it.

Almost all lead produced these days is by-product production from polymetallic vein or VMS mines. As such, its supply has more to do with silver than lead prices. Lead mine production has been declining overall for years. Most lead demand is satisfied by recycling which accounts for about two thirds of the market.

Overall, the lead market is expected to have about 200k tonnes of supply shortfall over the next two years. Warehouse stocks have declined steadily but there is still plenty around to cover that deficit. With little new mine supply, lead has the potential to trade slightly higher this year as LME stocks continue to decline. No fireworks, but a price in the $1.10-$1.20 range is possible by year end if the world economy doesn't slow too much.

Nickel has been "next years metal" for several years now. Demand growth is expected to be strong, between stainless steel demand, the largest end use, and increasing demand by battery manufacturers.

Despite all that promise, nickel prices haven't done much since a price surge topped out in early 2016. In 2018, the price again ended the year lower than it started it.

I think it will be nickel's year at some point, perhaps two or three years out. Nickel inventories at the LME have been declining for three years and are down to about 200k tonnes. That isn't low enough to trigger any supply worries as its still above the longer-term average at about 6 weeks of consumption.

The nickel market should be in deficit for the next couple of years. Industry sources estimate a drawdown of about 150k tonnes in 2019 and 2020. It 's worth noting that the 2018 deficit came in much higher than expected; 185k tonnes rather than the 15k estimated.

I've been a skeptic about nickel. I agree that it should see higher demand based on battery market growth, though its going to take several years of double-digit growth before battery demand is a meaningful size in relation to stainless steel which dominates the nickel market now.

I was concerned about high inventories, but those concerns are lessening as official levels decline. I still wonder how much "off book" inventory there is, especially on the pig-nickel side. A lot of production came out of the Philippines and Indonesia that was process into pig-nickel in China when demand was weak.

I'm neutral to mildly positive on nickel now. I think we could see another 10-20% tacked on the price this year, as long as growth in China stabilizes. At some point, I expect a larger move but the market will need to convince me that this is the year. I'm on the lookout for a good nickel exploration story. There have been a couple of good Australian listed ones in the past few years but not much on this side of the Pacific.

I've looked at all the arguments on both sides. while I think there is some merit to the bullish argument, I'm still not sold on a large near term price move in uranium.

I agree that the equilibrium price for uranium should be higher than the current price, though I'm not convinced it should be a lot higher. At least not in the near term. There still doesn't seem to be a shortage of above ground inventory and reactor approvals, as always, are moving slower than planned. And then, there's the Kazaks.

Kazakhstan is the swing producer. It has massive low grade resources and the seeming ability to expand production at will, without worrying too much about pesky things like environmental approvals. Their cash cost is low. I think they can make a lot of money at $28/lb uranium prices.

Until there is some clarity on the intent of the Kazaks, I'll remain very cautious on the uranium sector. They could add 10+ million pounds to annual production fairly easily. I think most uranium analysts underestimate the scale potential of ISR in Kazakhstan.

We could see uranium move a bit higher this year. If we did see a real bullish surge in U prices, I'd look for a good trading opportunity, but it would only be a trade. I'm skeptical uranium can hold prices much higher than the $30-35/lb range for very long.

There a a few "minor" metals I keep half an eye on that I won't bother going through here. Haven't had long and direct experience with tungsten (my late father was a senior exec at the -then- premier tungsten producer for many years) I know how fast they can move. Both ways.

It's the "both" part that is the problem for me as supply has a way of appearing when the price spikes. The problem with most of these metals is that the market doesn't care until the price spikes, then it cares too much. Because they tend to have small markets, the arrival of a new supply source or inventory some market player sat on can make the price crash hard.

And also because of the small market, there tend to be one or two winners when a specialty metal gets repriced, and a long list of losers. When they are hot, traders tend to vastly overestimate market growth, and vastly underestimate available new production at higher prices. Lithium, Rare Earths, Graphite and even Vanadium are not really that "rare". There is plenty of all of them around in the Earth's crust.

What ARE rare is deposits that have the combination of high grades, logistics, metallurgy and longevity to make them one of the "first past the post" mines. Those are the only ones that actually get bought out and/or go into production in these small metal markets.

The preceding is a long-winded explanation of why I don't spend much time looking at or covering the "metal du jour" whatever it might be. In my former life I have some experience with industrial and specialty minerals. I know how tough that business actually is. I also know that just the right operation can be valuable. I am looking at a few things but I'm not interested in jumping on specialty metal momo plays. If that happens, it will only be in the Alert with the foreknowledge that I'll be looking for the exit the whole time.

Let's close this long editorial out by moving back to gold and equities. The first chart below shows the current gold chart. Gold made a nice move back to $1350 before giving up some of its gains. That wasn't unexpected, short term, as gold had gotten extremely overbought.

The move has befuddled a lot of traders, since it hasn't been happening for the "right" reasons. That is to say, it hasn't really be trading against the $US.

I think the middle chart below may explain it the best. Real (inflation adjusted) yields have been falling again as you can see on the chart of the yield for the 5 year inflation protected treasury note. As I've stated many times in the past, real yields are something any gold or metals trader needs to pay attention to. Some of gold's best markets come during times of falling real yields.

The third chart above, courtesy of Martin Murenbeed, is also pretty interesting. It shows that central banks bought more gold in 2018 than in any year since the US killed the gold standard over 40 years ago. I don't think that buying caused the price to move directly, but it's certainly stiffened the backbones of some weak longs.

Gold prices, and equities, are all about the Fed. Again. Numerous speeches by various FOMC members have done little to convince traders the Fed is about to turn hawkish again. Wall St is loving that message. Loving it enough to ignore some more recent economic readings that I suspect the FOMC was somewhat aware of early. They certainly help to explain the FOMC's sudden caution.

Exhibit A is US retail sales, which appears in the bottom chart. That chart shows monthly changes in the "Control Group" retail sales figure, the one that goes into the official GDP calculation. The January reading was pretty awful, the worst in 15 years in fact. Bad enough to make many assume it was a fluke.

I wondered myself but some more recent data has me thinking that drop was no fluke. Still, "temporary" issues like the shut down in Washington and the December dive on Wall St no doubt affected things. We still need to see if there is a trend forming.

One such piece of recent data is same-store credit card sales. The US is the land of milk and honey, and credit cards. They make up a large percentage of retail sales. Year over year growth in credit card purchases fell from 6% in October to 0.89% in early February. These figures are not inflation adjusted. So, in real terms, sales fell.

Like some other recent data I've pointed to, this isn't a four-alarm fire, but there's definitely smoke. It looks like Q1 growth in the US will fall fairly hard, perhaps back below 2%. Regional Fed indices, which ARE leading indicators, are telling the same story. The Fed's caution may not be all about sucking up to Wall St after all.

I'm on record saying we may see a US recession start this year. I'll be happy to be wrong on that. Even so, I think the Fed will stay dovish. And that's bullish for metals, especially precious metals. Maybe this will be one of those rare years with no "PDAC Curse". We're due for some luck in our sector. Fingers crossed!

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