What Are Metal Prices Telling Us?

Includes: DBB, GLD, JJC
by: David Coffin

China in particular and developing countries in general are the focus for growth generation. That was always the case as far as we were concerned. China fell out of favour among the Wall St cognoscente who did not understand the difference between a stock market and a country, but the basis of the secular bull in metals never changed for us.

Note that we are not saying the bad stuff has gone away. Far from it. There is much to do and trillions to spend to bury the toxic debt and plenty can still go wrong. In addition, the real economy stats in the developed world need to show improvement - especially employment - before we have something truly sustainable. Enjoy the run but keep a wary eye on earnings reports and jobless claims. Unless those too start to stabilize and show real (not doctored) improvement the odds of another dip in the markets are good.

Gearing for the next stretch of economic road is hard to predict. We have moved past frozen panic, but icy patches of doubtful loans remain hidden behind overturned automobile companies. Until we get some more sun on the debt issues it is tough to gauge if the indicators that show decelerating losses, if not bottoming, over the past few weeks actually are market waypoints. However, there is also a significant shift away from an assumption that the resource sector is a dead issue until the financials sector recovers.

Leading this shift is a move towards copper. This has been due partly to the improved psychology, but it can also be tied to several other points. One is, with credit conditions improving, the resale of finished copper to make cash has slowed. Red metal stocks available through the LME have pulled back 10% from peak levels, but remain at a large 500,000 tonnes (500 Kt).

China’s copper imports for the first two months of 2009 were up 20% from the same period last year, at 562 Kt. Most of this gain came in February after this year of the Ox had been ushered in. Shanghai pricing has a significant premium to LME spot, pushed by industrial users. China’s government has been adding to its stockpiles, to replace stocks sold down during 2006 peak pricing. Market socialism can apparently be profitable.

Reports from China indicate the government has contracted about 300 Kt that will mostly be delivered in the first half of the year. We don’t know how much copper China will stockpile, but at US $4000/t ($1.80/ pound), 300,000 t represents 0.06% of China’s foreign reserve, and around 0.16% of its US$ holdings. Is copper at four year lows a poorer store of wealth than low-yield US T-bills?

There have been similar gains for zinc’s price from its recent bottoms, accompanied by a 5% drop in LME stockpiles to 350 Kt. There is some enthusiasm for next year’s zinc pricing based on supply going off line, and there is little question zinc is trading too cheaply for producer comfort. Whereas copper is a major import into China (from mine supply), zinc is a Chinese export for which the government doesn’t have strategic concerns to spur stockpiling. For the moment zinc’s gains should be viewed as an add-on to those for copper.

The news around bulk minerals pricing is one of stand-off. Chinese steel mills are looking for 2007 pricing of iron ore, and in response the major exporters are refusing to sign year long price agreements typical of the sector. There is also less news on coal contracts than we had expected by this point. This is simply more evidence that Asia is setting resource prices, which is the main underlying reason that support has come back to the sector. That and continued expectation of the US$ weakening.

The measured creation of a convertible Yuan that will allow its appreciation, the move we had expected to auger a resumption of the secular commodities bull, is underway. The shift towards spending of domestic savings is also picking up steam in China, which is prompting a Yuan pricing of many commodities above global levels. Copper has now gained 40% since mid-February, and though we expect some price consolidation at some point we do not expect a strong down draft for the red metal. Copper has entered a period of support based on what can be called a China centered “copper-is-money... syndrome. Since copper stocks are measured in days of demand, further gains for the red metal are entirely possible.

The gold note in Gordon Brown’s post G-20 summation, that the IMF would sell the yellow metal to fund poor country programs, may be viewed as a final test of the yellow metal’s market. This actually reiterates plans in the works to sell some of the 13 million oz of off-balance sheet gold in the IMF holdings. The market is right to view this as a significant amount since it would be as much as 11% of the annual demand. It is not however large in the scale of central bank transactions.

The other drag on gold has been selling of “scrap” by Indian’s taking advantage of record Rupee based prices. The Indian market represents as much as 25% of total gold sales, so this mood shift should be taken seriously. Scrap in this case mostly means old chains and the like to avoid duties on raw gold.

Selling of family heirlooms after strong price gains has always been a feature of the precious metals markets. We are actually pleased with the resilience that gold has shown against it. While we do feel it is important to balance holdings with copper equities, we also think resumed gold gains are still just a matter of a wait for US$ weakness to set in. China beginning to set up for a weaker greenback offers the best reason we can think of to expect it to happen.

Disclosure: No positions.