While precious metal markets watch anxiously for signs of when the world’s major central banks might begin to normalise monetary conditions, prices of industrial metals are currently being determined by fundamentals of supply and demand that are, in many cases, specific to each metal. From a macroeconomic perspective, are any economies strong enough for their central bank to raise interest rates unilaterally? Does it make sense to do so while central bank balance sheets remain bloated from QE? What will happen to exchange rates, asset prices, as well as other countries’ economies, when US interest rates finally begin to rise? These questions may soon need to be answered as the US labour market begins to tighten and the Fed begins to contemplate a renormalisation of monetary conditions. The outcome will have a potentially profound effect upon metal markets, in particular those precious metals held by investors as a safe-haven store of value.

Industrial metals have managed to remain somewhat detached from generic economic conditions, with the fundamentals of supply and demand being the dominant driving force in determining trends in prices for each individual metal. A wide range of factors have been causing these divergent fundamentals. Among them, Natixis “would consider the following to be some of the most important drivers of potential surpluses and deficits.” All the following is taken from Natixis Metals Review 2014H2.

With only minor concessions to Indonesia’s two main copper producers, the country’s ban on exports of unprocessed raw materials remains firmly in place. So far, the ban has done little to alleviate the surplus that is currently affecting the nickel market, but this situation may change significantly as we head into 2015Q1. It is similarly difficult to gauge when the ban might result in a shortage of bauxite, in particular among China’s alumina refineries.

Structural change in China is having a profound effect upon metal markets.
• Credit conditions have tightened, as authorities seek to encourage lending through official channels in preference to the previously popular shadow-banking conduits. This is affecting availability of financing for metal inventories
• The new imperative to maximise profit, introduced at the third plenum, is fundamentally changing corporate behaviour
• The growing importance of addressing poor air quality, especially in major cities, is affecting the output of many heavy industries
• Recognition that Chinese growth will slow in future implies reduced demand for precautionary stocks.
Combining these factors, Chinese metal producers are being encouraged to reduce excessive inventories of material, whether in the form of ore, concentrates, semi-finished metal or metal products. Some portion of previous years’ consumption may have contributed to inventory accumulation, so it is difficult to gauge exactly how strong underlying Chinese demand really is for some base metals.

Destocking behaviour is clearly evident in a number of the base metal markets, e.g. lead, zinc. In others, destocking has gone hand in hand with external “constraints” that are working in the same direction. This is especially true in the nickel and aluminium markets in the wake of Indonesia’s ban on exports of unprocessed raw materials, making it difficult to tell whether these markets remain in balance, or whether there are imminent dangers of surplus or deficit.

Other government policies around the world are also having a significant effect upon metal markets:
• Chile’s government must reconcile pre-election campaign pledges for higher spending on health and education with Codelco’s need to invest heavily in new underground mines
• Zambia’s government is struggling to administer a “fair” tax on the country’s mining companies
• India’s government is encouraging some domestic industries, such as aluminium, via higher tariffs on exports of raw materials, while deterring others, such as gold, via higher import tariffs
• China’s SRB took advantage of the sharp fall in copper prices to add to strategic reserves this year.  With precious metal prices falling to four-year lows in October, China’s State Administration of Foreign Exchange must decide whether to accumulate additional holdings of gold
• After a lengthy period selling metal held within the state reserve, Russia’s Gokhran intends to commence restocking of palladium in 2015
• What can South Africa’s government do to alleviate the problems faced by the country’s platinum miners? Talks with Russia, the world’s second largest producer, could lead to co-ordinated action to support PGM prices
• Indonesia, Zambia and the DRC are all trying to boost economic development by encouraging mining companies to process ores and concentrates locally.  Other governments could choose to pursue similar policies, especially for those ores which are in scarce supply, e.g. nickel and bauxite.

The return to prominence of fundamentals has reduced the degree of positive correlation between metals, as well as dampening many of the typical correlations that exist between metals and other assets such as the US dollar.  This makes it vitally important to analyse each individual metal on its own merits, drilling down into the details of supply and demand.

Aided by cutbacks in output by western producers as well as Chinese smelters, the aluminium market looks set to experience its first annual deficit for eight years. This has supported an improvement in aluminium prices, although this gain has been split between modestly higher LME prices and a further escalation in aluminium premiums.  In the very near term, there is a risk that higher Chinese output of aluminium, accompanied by higher exports of aluminium products, could lead to near-term weakness in aluminium prices. However, over the period 2015-16 we would expect the shift towards deficit to become more firmly entrenched within the aluminium market, supported by robust demand growth and constrained supply, as Indonesia’s ban on exports of unprocessed raw materials and China’s efforts to curtail overcapacity are both expected to exert a growing influence over the coming two years. As a result, aluminium prices are expected to push higher over our forecast horizon.

The bullish Natixis view on LME aluminium prices is tempered somewhat by the likelihood that premiums will stay higher for longer. After averaging something in the region of $1,860/t in 2014, it expects LME aluminium prices to rise to an average of $2,070/t in 2015 and subsequently $2,240/t in 2016.

Since 2010, the mining industry has struggled to satisfy global demand for copper. In 2014 Natixis finally expected to see a surplus, only for China’s SRB to take advantage of the sharp fall in copper prices during March to add to its strategic reserves, leaving the market once again facing a deficit. This does not change the underlying fundamentals of the market, viz that copper is currently moving from deficit to surplus, but it has left the market with a dwindling supply of available copper stocks, keeping the forward price curve in backwardation for the time being. With rising mine output and elevated TC/RCs, Natixis is increasingly optimistic that a copper surplus will soon become visible. This is expected to lead to further weakness in copper prices over the period 2015-16.

Natixis is therefore projecting a decline in copper prices to somewhere around $6,335/t in 2015. This would be followed by a gradual recovery in copper prices during 2016, averaging $6,500/t, as market expectations focus increasingly upon prospective deficits in the period out to 2020 rather than the surplus in the market during 2015-16.
Lead
Global demand for lead has remained weak in 2014 due to a second consecutive annual decline in Chinese apparent demand. While other base metal markets with stronger fundamental have seen prices push higher, lead prices have instead remained trapped in a narrow range.  In our central scenario, the lead market is expected to remain in broad balance, helping to keep prices within this tight range. There are, however, significant uncertainties surrounding the Natixis outlook for both supply and demand, which could result in unexpected price volatility in the years ahead.

Analysis of supply and demand suggests that the lead market will run a cumulative deficit of perhaps 20,000 t over the period 2014-16. With this in mind, Natixis forecasts a very modest increase in lead prices over the period 2015-16. After an average of around $2,120/t in 2014, it forecasts lead prices averaging $2,145/t in 2015 and $2,195/t in 2016.

Nickel
Of all the base metals, there is perhaps the greatest potential uncertainty surrounding the outlook for nickel.  Uncertainty surrounds;
• the strength of Chinese demand for nickel
• the size of unreported nickel (and stainless steel) inventories held in China
• the likely volume of NPI produced in 2015H1 as a ban on exports of Indonesian ore combines with seasonal weakness in Philippine supplies
• the pace at which Indonesian nickel ore is likely to return to the global market in the form of 4% NPI.

The Natixis central forecast anticipates a period of deficit during 2015H1, resulting in an average LME nickel price of around $19,000/t over 2015 as a whole, although there is scope for substantial variation around this mean. By 2016, it expects the market to have settled more closely upon its longer-term equilibrium, hence a forecast for an average price of $17,375/t for that year.

Zinc
As the zinc market has progressively tightened over the past year, so zinc prices have rallied from less than $1,900/t throughout much of 2013 to around $2,300/t in September this year. Despite forecasts for modest demand growth over the coming two years, the global zinc market is expected to tighten further as supply becomes increasingly constrained, and new mines are not expected to arrive until existing inventories are dangerously close to depletion.  Against such a backdrop, Natixis would expect to see substantial upward momentum in zinc prices over the period 2015-16. In its central scenario, after averaging around $2,200/t n 2014, it expects zinc prices to push up to an average of $2,520/t in 2015 before $2,725/t in 2016.

Gold
Since June, the price of gold has been steadily declining and in September prices breached the $1,200/oz mark.  Behind this drop has been a strengthening dollar throughout Q3, supported by higher yields as the US bond market gradually priced in imminent rate hikes. Throughout this period, gold consumption in both China and India has been weak, while investment and central bank demand has remained limited.

Events in the US are expected to exert the biggest impact on gold prices. As the US economy improves, so investors’ need for a safe haven dissipates. With this economic improvement comes a strengthening dollar as the US bond market pushes yields higher in anticipation of interest rate hikes. These factors are expected to have a mildly negative effect upon gold prices over the forecast horizon, given the substantial rally in the dollar and rise in US yields that has already taken place so far this year.
On the producers’ side, there is a risk that miners may return to hedging future output if gold prices threaten to fall below cash costs of production. Due to aggressive cost cutting by gold producers, all-in sustaining costs of production have fallen to somewhere around $960/oz. That said, there are still many mines operating at higher costs that could potentially need hedging. This represents a potential source of supply in the market, which could help to accelerate any decline in prices. The Natixis base forecast is that gold prices will average $1,170/oz in 2015 and $1,180/oz in 2016.

So far this year silver prices have fallen by 10%. The strong correlation with gold meant that the price of silver dropped as a result of a stronger dollar and US economy. Although silver mine supply is increasing, the drop in silver prices has led to a contraction in supply of silver scrap. As for demand, the main concern remains the ever increasing amount of silver being held in physically-backed ETPs. Based on a positive outlook for the US economy (modestly rising US yields, appreciating USD), and additional downside risks attaching to silver prices (low cash cost of production, potential for sales from ETPs), Natixis forecasts envisage an average silver price of $15.8/oz in 2015 and $16.1/oz in 2016.

Both the platinum and palladium markets were affected this year by the prolonged strikes in South Africa, which curtailed mine output. In addition to this factor, the palladium market was impacted by the turmoil in Ukraine which drove palladium prices to their highest level since 2001. Fundamental demand for both metals has been noticeably weak this year, especially for platinum.

Over the last two years, supply-side issues have been the main drivers behind the price of platinum. Along with frequent strikes in South Africa, which have caused supply cuts, falling prices have forced producers to cut back output at their higher-cost operations. Natixis estimates that the cash cost of production for a large number of producers is in the region of ZAR15,000/oz. Since the end of the strikes in July, the price of platinum has collapsed, not because of an increase in supply, but because of extreme weakness in demand.

At the current low prices, we could see an increase in Chinese platinum jewellery demand once again, especially if the platinum/gold price ratio continues to fall. While Natixis does not expect a strong increase in European automobile demand, replacement of Europe’s ageing car fleet should be enough to support moderate growth in demand for autocatalysts over the coming two years. In its base case scenario it sees platinum prices rising to $1,450/oz in 2015 and $1,550/oz in 2016.

Natixis expects that automobile demand from North American and developing countries should help lift demand for palladium, but at a slower pace than previous years given expectations of moderate growth in developing countries. The majority of cars that are sold in these countries run on gasoline; catalysts of such cars require a higher palladium content. Natixis expects that demand for palladium from Russia’s state reserve will materialise next year which should also help sustain palladium prices. The outlook for the global economy and that of developing countries is more positive for 2016, which leads Natixis to believe that there might be good support for palladium prices that year. In its base case scenario it sees palladium prices rising to $770/oz in 2015 and $740/oz in 2016.