Is the base-metals rebound on solid ground?

Unreported inventories are a hidden risk.

Andrew Hepburn 23 March, 2018 | 5:00PM
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Attendance in early March at the annual Prospectors and Developers Association of Canada convention in Toronto, which bills itself as the "world's premier mining and exploration" event, was the highest since 2013. The 25,606 attendees are a sign, PDAC organizers say, "that the mineral exploration and mining industry has regained its swagger and is building momentum."

For investors in base-metals mining stocks, the question of whether the industry is back in a durable bull market is of the utmost importance. Prices for key metals such as copper, nickel and zinc all plummeted from 2014 to 2016, wreaking havoc on stock prices. Copper, for its part, had sat comfortably over US$3 per pound in August 2014, yet by January 2016 it touched the US$2 mark amid a strong U.S. dollar and fears over Chinese demand.

The rebound in prices since the bottom has been dramatic. Copper is back over US$3, zinc has more than doubled off its lows and nickel is up over 50%. Base-metals stocks have been stellar outperformers:  Vale SA (VALE), which produces iron ore in addition to other base metals, fetched US$2.45 per American Depositary Receipt (ADR) just over two years ago, and was trading this week at US$12.83.

Analysts are generally bullish, though not exuberant, on the industrial-metals complex. "The global industrial outlook is robust, which continues to support the demand side for base metals," says Colin Hamilton, managing director, commodities research at BMO Capital Markets in London, England. "Add to that the fact supply is lagging, and it remains a supportive fundamental environment."

Hamilton does see gains starting to moderate, however. "I'd say we are passing through the peak growth rate in terms of industrial output, and we can already see the PMIs (purchasing-manager indexes) starting to drop a little (but still expansionary)", he says. "The supply story is one which has more legs. Companies just aren't willing to spend capital expenditures yet despite strong free cash flow, and the restrictions on Chinese supply can have a big market impact." All told, BMO Capital Markets sees 2018 as a year of price consolidation for the base-metals markets.

Oliver Nugent, a commodities strategist at ING in Amsterdam, expects base-metal prices to be generally flat for 2018. That said, he points out that given how much prices rose last year, this is actually a bullish stance. He believes the turning point supporting the belief that higher prices are sustainable is the theme of global synchronized growth. "We don't see any crashes and burns because of this underlying economic strength," he says, although between metals the outlook isn't uniform. On a two-year horizon, Nugent favours copper, while he currently sees nickel as having run ahead of itself due to speculation.

Robert Cohen, a portfolio manager with 1832 Asset Management LP in Toronto who co-manages Dynamic Strategic Resource Class and DMP Resource Class mutual funds, takes a barbell approach to base-metals equities, looking to the "big, liquid companies of the world" and the what he calls rising stars. "I like some of the big diversifieds," he says, such as Glencore PLC (GLNCY) and  Rio Tinto PLC (RIO), given their product mix.

At the other end of the spectrum, Cohen owns Vancouver-based Ero Copper Corp. (ERO), which has operations in Brazil and a market capitalization of roughly $700 million. As to the metals themselves, he says he's positive on the outlook for copper, citing the weakening of the U.S. dollar and the fact that global demand is tied to population growth.

Regarding nickel, Cohen says that electric vehicles "are not necessarily a mover and shaker" for the market "but they certainly help underpin things." As a significant component of the batteries, the commodity is seen by many as a beneficiary of the boom in electric cars.

China: The obvious risk

As always, the Chinese economy is a large potential risk to industrial metals. At the moment, though, analysts do not seem overly concerned. "Everyone is expecting a slowdown this year," ING's Nugent says, but adds that growth is still expected to be fairly stable and the notion of a hard landing has "gone out of people's minds." He concedes that measures such as credit tightening and a clampdown on the housing market are potential downside threats to the Chinese economy (and by extension, metals demand).

From a contrarian point of view, the lack of real worry about China's economy by commodity analysts could be taken as a sign of complacency. Moreover, it's notable when contrasted with the warnings coming from both the International Monetary Fund and Bank for International Settlements in recent months. The IMF and BIS have separately warned that the country's sharply rising debt levels risk a financial crisis. This would be very bearish for base-metals prices, given that China consumes a large amount of the global production of these resources.

Inventories: The unseen risk

As with all commodities, inventories are crucial when it comes to analyzing the base metals. Rising inventories imply a market in surplus, while falling inventories suggest a deficit, necessitating a draw on available material. The problem with base metals for years has been that a significant quantity of material appears to be held outside of publicly reported storage systems, such as that of the benchmark London Metal Exchange. Historically, traders looked to movements in LME stock levels to get a sense of the tightness of metal markets. But increasingly, large stores of material have not been "visible" to the market.

Indeed, back in late 2013, the Wall Street Journal wrote about networks of so-called shadow warehouses around the world in which banks, hedge funds and other traders stored millions of tonnes of zinc, copper and aluminum. In China, which most commentators say has seen a voracious appetite for metals, there are also lingering questions about unreported inventories. In the middle of last year, for example, National Australia Bank noted that some estimates pegged the total amount of copper in Chinese bonded warehouses at up to 10% of global copper demand. Consensus figures, while much lower, still see more of the metal off-market in China than in LME warehouses.

Investors need to be aware of this apparent overhang of metal for two reasons. For one thing, it strongly suggests that base-metal inventory accumulation, rather than true underlying consumption, has played a formative role in metals pricing in recent years. Second, any large unreported inventories pose meaningful downside risks to prices should they ever be dumped on the market.

None of this precludes the sector from continuing its rally in the short term. But the bottom line for investors is that while the good times may not end yet, they're unlikely to go on for years to come.

The swagger that returned to PDAC? It may just have been visiting.

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About Author

Andrew Hepburn

Andrew Hepburn  Andrew Hepburn is a freelance financial writer based in Toronto. He writes about investments, market trends and personal finance. He has written for Maclean's, the Globe and Mail, RateHub.ca and Canadian MoneySaver.

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