Most of the base metals have fallen significantly in the past two months

It's A Zero Sum Game

Most of the base metals have fallen significantly in the past two months, with prices coming close to their marginal cost of production. There is only limited downside from here onwards

DEVANGI JOSH I & SANTAN U M I SH R A ET I NTELLIGENCE GROU P

BASE METALS as a whole have witnessed significant declines amid rising concerns over possibilities of a global recession. Plunging stock markets across the world and deepening global credit crunch continue to weigh on the outlook of base metals in general. Chinese demand — a factor that largely contributed to the bull run in the past five years — has also started showing signs of a slowdown. As most of these metals have a direct correlation with the overall economic growth, weakness in the world economy has pulled down their prices.
    Another indicator of demand slowdown is the rising level of inventory at the London Metal Exchange (LME). The inventory level for zinc and aluminium has increased by more than 30% in the past six months, whereas copper inventory rose by 90% during the same period. Hence, it's not surprising that copper prices have fallen the most (almost by 40%) during the same period.
    However, the recent plunge in commodity prices has pushed most metals close to their average marginal cost of production and hence, most market participants expect prices to have a limited downside from here. This does not necessarily mean that base metals are expected to regain their winning streak, considering sluggish demand against the backdrop of slowing economies across the world.
COPPER: Prices have taken a beating in the past few weeks. They are off by more than 40% from their July highs of near $8,645 per tonne and are currently trading just above $4,700. Recent problems in the financial markets and subsequent fears of a global slowdown or possible global recession are expected to cap prices.
    However, the $4,200-4,500 range is seen as a strong downside support that coincides with lows reached in late '05. While China, the biggest consumer of the metal, is not expected to escape the tremors of the slowdown in world's major economies, the production cycle of the past four years indicates a decline in output for the next 3-4 months.
    Most domestic non-ferrous metal producers get their revenues from the treatment and refining charges (TC/RC margins), which are a function of the availability of copper concentrate and prices of final copper metal. But the TC/RC margins have been under pressure for quite some time.
    If there is any cut in the production of mined copper and a consequent fall in supply, the TC/RC margins will come under further pressure. But if there is no closure of mines, the supply of mined copper may be in surplus, improving TC/RC margins.
    Among the two big players in India, Sterlite Industries gets 50% of its revenue from the copper business, while Hindalco gets 63% (on a standalone basis) from this segment. Sterlite's margin is also slightly better than that of Hindalco because the former sources some of its concentrate from captive sources.
    Sterlite is also developing its copper mines in Africa, which will further increase the availability of mined copper. We believe that Sterlite is better positioned to tackle the current volatility in copper prices.
ALUMINIUM: Prices have started moving downwards since July '08 and the market is expected to remain oversupplied this year. In the first eight months of '08, China produced 8.9 million tonnes (mt) of metal and is on track to produce more than 13 mt in the whole of '08 — twice the output seen in '04.
    This is at a time when the LME inventory is at a much higher level compared to '04. This may result in prices further coming under pressure, unless smelters announce significant production cuts.
    Currently, aluminium is trading near $2,200 per tonne — well below the global marginal cost of production near $2,500. The decline is expected to find a strong support near March '05 lows closer to $2,000. On the other hand, the medium-term upside is expected to be capped by the $2,500-2,700 range.
    Most domestic aluminium producers are integrated and even at the current price level, there is still some room to generate profits. If the current trend continues, the operating margins for most players will almost get halved. Hindalco enjoys higher operating margin among the three big players.
    But Novelis, the company it acquired last year, has still not turned around and the current credit market crisis may force it to go slow on expansion plans. In this space, Nalco is relatively better placed with huge cash reserves and zero debt. This will help it to implement new projects and expand volumes.
ZINC: Prices have seen the sharpest decline from their peaks in late '06. Prices have been in a downtrend for nearly 18 months and are down nearly 65% from their May '07 highs of around $4,120 per tonne. Among base metals, zinc has continued to move downwards for quite some time now and is currently trading well below its estimated cost of production of $1,600 per tonne. At this price level, 10% of the world's zinc production may be forced out of production. But looking at the weak economic scenario, this may not put much upward pressure on prices. A further downside is expected till its strong support at $1,100 level.
    Hindustan Zinc, the subsidiary of Sterlite Industries, is the largest integrated player in this segment. And if the current price level is sustained, more than 70% of its operating profit will be wiped out, compared to its peak level in FY07. We advise investors to avoid exposure to this stock.
    devangi.joshi@timesgroup.com