Base Metal Commentary

In the first half of the year, base metal price direction was largely dictated by supply fears, driven by the Russian invasion into Ukraine, set against a backdrop of low stocks and an already tight market, with copper, nickel, tin and aluminium posting their highest levels on record by early March. However, what a difference a quarter makes, with the base metal suite by end Q2 having recorded its worst quarterly performance since the Global Financial Crisis, as supply fears eased and gave way to demand concerns, on extended COVID-19 lockdowns in China, faster than anticipated tightening of monetary policy in the west (on record inflation), heightened uncertainty over the Russia/Ukraine war and the implications for the energy market leading to a downgraded outlook for global growth. As we enter the second half of the year, while price direction for the base metals is still being driven by leading macro developments (including the direction of the U.S. dollar), it appears as though underlying fundamentals are starting to gain in importance, and in our view, will be critical to the year-end divide in performance of the suite. 

LME 3M BASE METAL PRICE PERFORMANCE (W/W CHANGE)

Source: Bloomberg

Are We Starting to See an Uptick in China’s Physical Demand Profile?

Last week marked the first time the base metals suite recorded a weekly gain in eight weeks, breaking the dramatic downturn in prices, which resulted in the index dropping to its lowest level since February 2021. However, as it stands, while the increase was largely driven on the back of a weakening in the U.S. dollar, close attention is being paid towards any improvements in physical demand in China, alongside supportive policy action being taken towards the ailing property sector (which makes up ~20% of GDP).  

Signs of Physical Demand

Even though June’s trade figures for China displayed a weak overall level of domestic demand, with commodity imports lifting by 1% Y/Y (below market expectations and May’s reading of 4.1%), improved industrial production figures (which quickened at their fastest pace since March) and supportive PMI readings for June, alongside a drop in base metals SHFE stocks, could be the first signs we are at a turning point. Indeed, if we look to SHFE on-warrant stock levels over the month of June, each metal of the suite (bar tin) recorded a drawdown, while inventory levels for steel rebar fell to their lowest level February 2022. Turning to copper, premiums into China have spiked of late, with the Yangshan premium currently hovering around its highest level since December 2021, and if we combine this with the fact that imports of unwrought copper into China also rose on a M/M basis in June (marking the second monthly rise since March 2022), it is suggestive that domestic demand may be lifting. In the case of copper, we are optimistic that the plentiful infrastructure stimulus being injected into the economy will support copper’s key area of growth, which comes from its use in the green transition, which is line with China’s move to incorporate stimulus for ‘new’ infrastructure (such as EV charging stations, data centres and 5G networks). However, having said this, we remain cautious that the unpredictability of COVID-19 spreads, weakness in the property sector, not to mention our expectation of lowering external demand (upon reduced global growth), will remain key headwinds to any recovery. The next release of trade data for China will come out on 8th August, and will be informative to our forward-looking view, meanwhile market expectations are set towards a stabilisation in PMI activity in July (with manufacturing set to benefit from reduced lockdowns and falling factory-gate prices, while the service sector will lag). Please note, both state produced and Caixin PMI readings will be released from 31st July.   

SHFE ON-WARRANT STOCKS

Source: Bloomberg

YANGSHAN COPPER PREMIUM 

Source: Bloomberg

CHINESE STEEL REBAR INVENTORIES 

TSource: Bloomberg

Meanwhile, turning to the property sector, which remains a key headwind for Chinese growth (and physical demand with construction consumption taking up 9% and 32% of copper and aluminium demand respectively), further supportive action from the Government of late (which arguably is the largest step taken to far), is helping to alleviate the bearish outlook. Indeed, over the last week, China’s State Council approved a plan to set up a real estate fund to help 12 developers and some distressed firms. It is reported that the fund has secured 50Bn yuan ($7.4Bn) from China Construction Bank and 30 Bn yuan ($4.4Bn) (re-lending facility from PBoC), and if this starts to work, then other banks could follow suit with a target up to 200-300Bn yuan. The fund is set to facilitate the purchase of unfinished home projects, allowing construction to be completed with the purpose of then renting the homes to individuals as part of the Government’s drive to boost rental housing. However, despite this move (in addition to the temporary pause in mortgage payments – to avoid further boycotting), concerns over weak confidence in the real estate sector remains a key issue, especially if these concerns spread past the property and into the wider financial system. 

CHINA BBG PROPERTY INDEX, CSI 300 REAL ESTATE INDEX & HANG SENG MAINLAND PROPERTIES INDEX 

Source: Bloomberg

Natural Gas Flows Via the Nord Stream Pipeline 1 Pipeline Fall to 20%

The Nord Stream 1 pipeline (which is the largest pipeline providing natural gas from Russia to Europe) resumed operation at 40% capacity on 21st July (after coming off a routine eleven-day maintenance period); returning to levels recorded prior to being offline. However, output was reduced to 20% by 27th July with Russia blaming a faulty turbine. As it stands, fears are heightened that flows could be further restricted or cut this year, which would leave current storage tanks below the 80% EU target in November (tanks are ~65% full as of July). As a result, on 26th July, the EU agreed on an amended proposal to reduce gas usage ahead of winter, with an agreement to reduce consumption (voluntarily unless an emergency is called) by 15% from August-March (based on 2016-2021 levels). Please note, there are exemptions to this agreement, with countries that have exceeded the EU target for storage by August, countries that have no direct natural gas links and countries that have a limited ability to export gas to other EU countries excluded, while those sectors that have a high natural gas dependency (such as chemical or steel) will also face exemptions.  

How Will This Impact Our Metals?

It is likely to be a tale of two halves, with first the demand profile for the base metals set to face further downgrades if natural gas supplies are not elevated from current levels. Indeed, based on research from the EC, as much as 0.6-1% of GDP could be knocked off the bloc’s growth this year (in a scenario where supply is cut off completely). Meanwhile, on the other hand, restricted flows of natural gas will lead to higher energy prices (particularly in the winter months), which in turn provides supply fears for metals such as zinc and aluminium, which have already seen smelter margins and revenues reduced this year, resulting in significant disruption, with up to 70,000t of zinc output having been lost in Q1, while 700-800,000t of aluminium capacity was impacted since Q4 2021. To make matters worse, while in Q1 metal prices hit record high levels, we are now in a period of lower prices, with elevated premia on track to decline (as demand dwindles), further pressurising operating margins. Despite having previously seen Governments step in to help create subsides for some of these smelters, it is unclear what steps will be offered next, particularly as while subsides help to cover margin losses, they can’t prevent companies being forced to reduce consumption of electricity (if/when cuts go into action). On this note, it remains unclear from the recent EU announcement whether exemptions will extend to the aluminium and zinc industries. Based on CRU data, while no more closures of smelters are set to occur this year, disruptions (from smelters having to operate under peak electricity periods) are set to rise, especially over the Q4 2022 and Q1 2023 periods (although at a lower overall level than was recorded over Q1. 

ALUMINIUM PRODUCTION IN EUROPE

Source: CRU

 

LME Spot Tightness Arises as Stocks Levels Remain Drawn Down

LME ON-WARRANT STOCKS LEVELS (YTD CHANGE)

Source: Bloomberg

LME CASH-3M SPREADS (Copper, lead, zinc, tin and aluminium face backwardations)

Source: Bloomberg

 

The Dominance of the U.S. Dollar 

Aside from the modest move of base metal prices towards underlying fundamentals in recent weeks, there is no denying the current ruling dynamic in the market from the negative correlation between the U.S. dollar and the base metal suite, which has returned in force since May (after being largely absent over Mar-April period). The U.S. dollar has benefited over much of this year from the robust recovery within the United States, while tightening monetary policy in the face of record inflation saw it hit it highest level since 2002 by mid-July. Meanwhile, given the outcome of July’s FOMC meeting (held 26-27th July), in which the Federal Reserve lifted interest rates by 75 basis points (which was widely anticipated); in our view, this opens the door for the market to focus on the fundamentals (or at least temporarily). Looking ahead, based on Federal Reserve Chairman Jerome Powell’s comments following the meeting, in which he indicated that a slower path of rate rises could ensue, the U.S. stock market rallied and has largely shrugged off the technical recession outcome upon the release of Q2 GDP falling by 0.9% (from 1.6% in Q1) on 28th July. To read in further detail about the FOMC July meeting, please see the report from our Head of Market Intelligence, Rhona O`Connell here. 

U.S. DOLLAR VERSUS BASE METAL 3M INDEX (CORRELATION)

Source: Bloomberg