Base metals: This time, it's different

Strong emerging markets demand will likely continue to offset weakness in the US so the main concern is not if metals will rally, but when

By JAMES GUTMAN

(LONDON) Over the past 50 years a slowdown in the US economy has almost always meant sharply lower prices. This time, however, is likely to be different.

Strong emerging markets demand will likely continue to offset weakness in the US, supply disruptions will likely persist, and cost pressures will likely to continue to support long-dated prices.

As a result we see a high potential for a renewed bout of upward pressure on prices. Copper, for example, is our favourite metal, and is likely to reach fresh highs in 2008, ending next year at a record US$10,000 per tonne.

In our view, the main concern is not if the metals will rally, but when. The implosion of the US housing market and the resulting credit crunch is shaking global markets, and this may postpone the next rally for a number of months.

However, there is no sign of a slowdown in key emerging markets like China and India. This is critical, because it is these emerging markets that are driving demand growth in metals.

Ten years ago, the developed economies (mainly the US, Europe and Japan) accounted for more than 85 per cent of the demand for most base metals; today, that ratio is closer to 60 per cent. The long-term trend towards industrialisation and urbanisation in the emerging markets remains intact, and the near-term cyclical strength in these economies persists as well.

Metals demand tends to fall at the outset of a downturn, so much of the pain may have already been felt. US home building, for example, turned more than a year and a half ago and is now down by a third from its peak; unless home building in the US is going to come to a complete standstill, it is unlikely that we will see a further acceleration in year-on-year declines.

If this proves correct, and if the US avoids a full-blown recession, then the drag from the US on stronger global metals demand is likely to moderate over 2008.

Long-dated futures remain firm, as this is needed to motivate investment in the high cost projects that will balance demand in the future. As emerging markets demand has accelerated, so too has the need for new metals and mining projects.

Unfortunately, this also means that costs have exploded as mining companies compete for the same labour and equipment and as they turn to lower grade or more remote ore bodies, all while paying more for environmental remediation and taxes.

We believe that this cost pressure, which has caused long-dated prices for copper to triple over the past five years, is unlikely to reverse for the foreseeable future.

Finally, as mining companies work existing facilities harder, disappointments in output become more frequent.

Equipment breaks down, ore grades disappoint, unions go on strike, and so forth.

In addition, many of the recent increases in production that have been in response to high prices are unrepeatable - an idled aluminium smelter in Germany or an idled zinc mine in the US can only be restarted once. Going forward, new supply will have to come from new facilities.

While demand is likely to remain strong and supply is likely to struggle, we face 2008 with inventories still at relatively low levels for most of the complex. Copper exchange inventories, for example, are still close to the 2005 lows.

The main risks to our view are on the demand side. If the US slides into a steep recession, or China has a policy-induced hard landing - neither of which is expected - then metals demand could fall by enough to allow inventories to meaningfully build, thus allowing prices to fall.

Even so, this would likely only delay the next rally by another year or two. -- Reuters