China: post-holiday put or call?

China: post-holiday put or call?

 Base metals prices have rallied strongly since the start of this year with gains ranging from
11% in the case of aluminium to 20% in the case of tin (basis cash settlement prices) (Fig.1) .
This advance has reversed much of the drop in prices that had been seen since mid-September.
However, whether this marks a firm break from the down trend that had been seen in most markets
since mid-April of last year is now a matter of much debate, with views varying among different
market participants and across the different metals markets.

Base metals price indices

 In our opinion this rally is not fundamentally warranted in the case of aluminium, zinc or lead and
although more constructive cases can be advanced for copper and tin we think that even for these
metals it has run too far, too fast, from a fundamental perspective. Only in the case of nickel are
we more comfortable on a fundamental view and only then on a seasonal short-term outlook.

 Many consumers are reported to have been “bamboozled” by the rally and have not been buying.
At the same time there are increasing reports of producers selling outright, notably in zinc, as well
as buying put options at what are considered to be good levels, notably in copper and aluminium.
Taking these reports together then suggests that this rally owes much, if not most, of its progress
to fund flows. Indeed, we think it has been, in part at least, a positioning rally that began with
short covering in a number of markets, although lately it would appear that some new longs have
also been coming into some markets including, perhaps significantly, sovereign funds.

 Whether this rally can be sustained we think will depend, in part at least, on investors’ perceptions
of the appetite for metal in the world’s most important market – China. As such, we shall be watching
closely activity following the return from the new year holidays next week and physical premiums
may be a useful barometer for this.

 The premium for base metals is the amount a buyer is prepared to pay above the exchange price
for physical possession of a particular parcel of metal in a named location. In principle the premium
is to cover the cost of providing the metal in that location and will be a function, inter alia, of brand,
distance, parcel size, payment terms and timing. In practice premiums can diverge from this cost
depending on the balance between physical supply of metal available to buy and demand in the
market. When market balances become tighter premiums tend to rise and vice versa, with the
result that premiums can provide a useful guide to physical market conditions.

 Copper premiums have been mixed in recent months, reflecting the relative strengths and
weaknesses of different regional markets (Fig.2 overleaf). In China, copper premiums have
actually dipped since early December, reflecting the fact that some buyers have been retreating
from the market in response to the rally in exchange prices. This is fully in keeping with the
pattern we have seen in the market over the last two years and, in our view, reflects the fact that
although copper stocks are thought to have been run down to low levels, especially among
consumers, buying can still be deferred if exchange prices are seen to be too high. Whether the
Chinese return and buy into this rally or refrain will have a potentially decisive impact on its duration.

 There are some fundamental reasons to think that higher copper prices should be supported.
Much has been made of the strong rise in imports into China in the last three months of 2011
and, more recently, the rising cancellation of copper stocks from LME warehouses in the USA.
It is also likely, in our view, that the copper market will continue to run a deficit this year.

 However, we think the positive case has recently become exaggerated. Some of the imports into
China are thought to have gone into stocks, not end consumption, including for gray market financing.
Regarding LME stock cancellations, some of this is thought to be related to repositioning of
inventory and not all due to higher end market demand. We are reminded of this time last year
when financial markets were reported buying into the perception of tighter copper balance, based on
Chinese demand growth and driving the price through $10,000/t to its all time record highs in
February 2011, while the physical market was actually weak, especially in China where premiums
were falling to very low levels (Fig.3). Financial markets were finally forced to recognise this
reality and the exchange price capitulated in short order at the end of that month.

 In contrast, the rally in nickel prices, while out of step with the consensus for a market expected to
move into surplus over the course of this year, is fundamentally reasonable in our view. In China,
nickel pig iron production had fallen sharply late last year in response to the drop in prices,
stainless steel production (the principal driver of demand) is typically seasonally strongest in the
first half of the year and ferrochrome prices are also now rising. Nickel and ferrochrome share a
common customer in stainless steelmaking and prices tend to trade together (Fig.4).

 The rise in tin prices also appears fundamentally reasonable although the swiftness of the latest
move probably owes much to financial market positioning. The market continues to run a deficit
on our estimates. LME stocks continue to fall and at around three-year lows. Mine supply from
Indonesia, the world’s second largest producer and the key swing supplier to the market can be
vulnerable to monsoon rains at this time of year. At the time semi-conductor shipments, a good
proxy for tin demand in its main market of solder making, tend to rise from the fourth quarter to
first quarter of the calendar year, with obvious positive implications for tin demand.

 In the case of aluminium, zinc and lead, however, we see no fundamental reason for the recent
rally and feel that prices are rising on air. Aluminium and zinc markets remain very well supplied.
Recent production reports have been strong, especially for zinc and lead mine output in China,
while demand-related data releases have been disappointing, notably for zinc in galvanised steel
production.