It’s been an exhilarating yet nerve-racking climb back from the dark pit of plunging demand. In the past year, metal companies were one of the worst hit by the global recession, as demand – and prices – nose-dived from the US to China. Expectedly, the sharp fall in metal prices led to a bludgeoning of metal stocks.

Take copper for instance. The price of the metal, whose demand is widely seen as a lead indicator of economic activity, plummeted by 57 per cent in 2008, but Sterlite, a major copper producer, lost 76 per cent on its stock price.

Going in the opposite direction, it’s been the same story. Since the start of this year, copper has appreciated 118 per cent and Sterlite has zoomed up by 229 per cent

In 2010, economic growth in the US could be about 3 per cent and may halve to 1.5 per cent in 2011, which will impact demand for metals

. Even strugglers like Hindalco seem to have recovered their verve and now rank among the outperformers in the market.

Metals, incidentally, bottomed out much ahead of stocks. For example, copper has not looked back from its December lows, while aluminium, one of the last metals to revive, hit a low in February this year. Most metals have gained between 30 and 120 per cent since the start of this year. In contrast, equities didn’t hit bottom until the first week of March. Despite operating conditions for companies being nowhere near the peaks and realisations having fallen sharply since January 2008, most stocks have climbed 150-300 per cent in the past year.

Yes, metals have been flying high for quite some time now. It’s time for a reality check on terra firma: will the giddying run continue or will prices take a breather?

Thank the dollar

First, let’s explain what caused the breathtaking surge in metal prices since the start of this year

Copper is likely to stabilise above $6,000 a tonne and any dip below this is a good buying opportunity

. Part of the sparkling returns can be attributed to the weakness in the dollar, the currency in which metals are globally traded. In the past 12 months, the greenback has weakened from 1.25 against the euro to nearly 1.50 per euro, a fall of nearly 20 per cent, primarily as risk appetite has returned with a bang among global investors. Experts say that those happy days for metals may not go on for too long. “The weakness in the dollar is only a reversion from the excess risk-averseness seen last year,” says David Keeble, executive director, global head of interest rates strategy, Calyon, in London. “From here on, the dollar’s movements may be relatively subdued.”

That’s a view supported by other international economists. “Three key factors have been weighing on the US currency – increased appetite for risk, concerns about the inflationary implications of credit easing, and China’s reservations about the dollar’s dominance as a reserve asset,” said Kevin Grice, senior international economist, Capital Economics, an economics research outfit in the UK, in an interview to Outlook Profit recently

The World Steel Association has revised the forecast for steel demand this year from a de-growth of 14-15 per cent to about 9 per cent

. “However, all three of these factors may soon go into reverse.”

For now, the gains from a declining dollar seem to be coming to an end.

Infrastructure boost

But dollar gains are not the entire metals story. A significant part of the demand has come through the fiscal stimulus packages designed to kickstart economies into growth around the world. In the past year, there have been intensive efforts from governments to boost spending in their respective economies. China was the first, announcing a $585 billion stimulus package, most of it aimed at infrastructure development. This was followed by a $787 billion economic rescue package in the US. Both packages, in particular the Chinese one, have helped metal companies climb back from the abyss.

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Different strokes

Financing deals have propped up inventory levels artificially, which is evident in the case of aluminium and zinc where prices and inventories have moved in tandem

Source: Bloomberg

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So far, so good. But what happens when some of the very generous quantitative easing measures are withdrawn some time next year? Will metal companies be able to galvanise themselves into action over recovering economies, or will there be a lull for the stocks and investors?

It all depends on how strong and sustainable any recovery is, in particular in the US and Europe. Most economists believe that, in the US, a double-dip recovery is on the way. “I think a V-shaped recovery is highly unlikely given the economic and financial problems that still confront the American consumer and banking system,” says Scott Anderson, vice-president and senior economist, Wells Fargo Securities, in the US. Like many others, he believes that a W (a double dip — a brief spurt in growth followed by another decline in economic activity) is the most likely possibility. Capital Economics’ Grice believes that after a sharp jump in US economic output in 2010, growth will halve to 1.5 per cent in 2011. He also thinks that the initial recoveries in the UK and the eurozone are likely to be less than impressive, although the rebound in the less heavily indebted European nations might ultimately prove to be more sustainable.

But not everyone thinks that way. JP Morgan is betting that the US economy could grow more than 3 per cent in 2010 (with no falling back to earlier bleak levels) with the bulk of the growth coming in the first six months of the year.

What does all this mean for metal demand and prices? Well, given that the US, China and Europe account for up to 60 per cent of total demand for industrial metals such as copper and aluminium, it suggests a revival of demand, until mid-2010 at least. While prices may not have much room to climb further, they may not fall much lower from current levels because of improved demand, experts point out. (See table, Big three)

Back home, the Indian government has also implemented a multi-billion-dollar fiscal stimulus package to lift spending in the economy, which has also improved the fortunes of Indian metal manufacturers, especially the steel producers.

Another development is the much-talked about push on low-cost housing, which again could benefit steel producers immensely. Demand from China and a weak rupee, until recently, also gave some cushion against a hard landing for these companies. While the currency movements have been a cause for concern, most analysts are confident about demand from China.

Pulling the demand string

So what does all this add up to for demand-supply for metals going ahead? We’ve taken the four metals that boast the most listed stocks globally — copper, aluminium, zinc and steel — as the best indicators of mining activity and prices. While copper, aluminium and zinc witness regular trading and their London Metals Exchange prices are viewed as global benchmarks, steel is more infrequently traded and has several benchmark price indicators. For investors, it’s important to understand what’s happening globally because they play the driving role in determining local metal prices.

Aluminium

Aluminium has been the prime beneficiary of the cash-for-clunkers scheme which was introduced in the US and some countries in Europe and of a demand jump from China, which has slashed taxes on new cars by half. Both measures have resulted in a sharp demand for the industrial metal. But there’s a curious trend visible here: while there has been an uptick in prices, there has also been an increase in inventories on the London Metals Exchange (LME). While the spot price of aluminium rose from $1,250 per tonne to $2,040 per tonne between February and August this year, inventories rose from 3.1 million tonnes to 4.56 million tonnes during the same period (by September, they were around 4.59 million tonnes. See chart: Different strokes). “Around 75 per cent of the aluminium held at LME warehouses is locked into long-term financing deals, and people bought into the spread in order to exploit the contango,” explains Reena Walia, commodities analyst with Angel Broking. (Contango refers to a situation in which futures trade at a premium to the spot price, encouraging people to make a spot purchase, enter into a cheap warehousing deal, sell the futures and release the metal at the end of the settlement period, thereby capturing the premium). However, David Thurtell, director and metals strategist at Citigroup Global Markets, in London, has a more conservative view of the role of these financing deals, placing them in the 50-60 per cent bracket. He says the high inventories visible on the LME are therefore a distortion, as they are not physically available until either the position is unwound or the contract expires. Sumeet Singhania, assistant vice-president at Antique Stock Broking, seconds that opinion and estimates that the financing deals might end by mid-2010, leading to an unwinding of these positions, and possibly lower prices.

In fact, things don’t look that hot for aluminium in the medium term. The National Australia Bank (NAB) recently estimated that cheaper production (energy) costs could result in a supply overhang despite major producers like US and China curtailing output. According to Citi estimates, global aluminium supply, at 39.4 million tonnes, shrunk by 11 per cent in 2009 from the previous year’s levels but it still leaves a supply overhang of close to 1.6 million tonnes. In 2010, that supply glut could reduce to 0.6-1 million tonnes on the back of a 16 per cent jump in demand from China, the world’s biggest consumer of the metal, but the glut will keep prices subdued.

NAB also anticipates the demand for efficient cars will result in inventory draw-downs to more normal levels over the medium term. Other experts agree. According to Citi’s Thurtell, until now, it appears that re-stocking by industrial consumers had been a dominant factor in the improvement of demand for aluminium, given that auto makers had under-hedged and held low inventory. He expects prices to remain under pressure in the short term, unless further production re-starts are put on hold. He is somewhat optimistic on the longer-term prospects for aluminium, expecting prices to rise although profit gains for producers will be capped as energy prices also climb.

Copper

Copper probably gets the strongest vote of confidence from analysts, given the stronger fundamentals compared with other metals.

Most experts believe that a supply shortage could happen pretty soon, which sets the red metal’s pricing dynamics apart from other industrial metals that are mostly facing surplus supplies. The deficit for copper is expected to continue for a while, rising from a marginal figure in 2009 to almost a quarter of a million tonnes next year. “Copper faces a situation where there may be smelting capacity available, but not enough mining to back that capacity. Hence the tightness in supply is likely to persist,” says Antique’s Singhania.

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Big three

More than half of the demand for metals originates from China, Europe and the US, which are likely to see stable demand growth

Source: Brokerage reports

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Citi’s Thurtell agrees that mining output has not recovered despite surging profitability due to various factors. Chile, one of the biggest suppliers of copper, for instance, faces labour unrest as wage agreements come up for renewals with mining companies. With higher product prices and an improved outlook for the mining sector, the chances of mine workers holding out for a better deal are high. This could further affect supply, and give prices another adrenaline dose. For instance, the ongoing strike at the Spence mine in Chile and the operational problems at Australian mining giant BHP Billiton’s Olympic Dam operation in south Australia could remove 60,000-80,000 tonnes from the market, which is a significant chunk of global stocks.

Also, unlike the case of other metals, there isn’t a lot of capacity that can be re-started, because a very small portion was shut down in the first place during the downturn.

On the demand side, China is one of the biggest consumers, with demand rising strongly even without strategic reserve purchases, on the back of infrastructure spending and other schemes, says Citi’s Thurtell.

He also believes that prices are likely to stabilise above the $6,000 a tonne mark and any dip below that represents a good buying opportunity. He predicts prices will rise to $6,600 a tonne in 2010, assuming a synchronised global economic recovery takes place. Walia of Angel Broking is even more bullish and pencils in a short-term price target of $5,700-$6,500 a tonne, but cautions that Chinese imports could slow down in the last quarter of this year. In the long term, prices could rise to $7,500 a tonne, she adds.

Steel

Steel producers were probably the worst hit during the global downturn. Now, there’s good news in the revised forecast by the World Steel Association, which says the de-growth in world demand for steel this year will be much lower (about 9 per cent) than earlier estimated (14-15 per cent). China, especially, is predicted to become hungry for more steel, which is also reflected in the sharp uptick in prices of nickel, one of the alloys required to make stainless steel.

Experts believe next year will turn out much better for steel. Morgan Stanley predicts that global steel (crude) demand may witness a 12 per cent spike in 2010 and then stabilise at around 6 per cent over the next five years. Capacity utilisation will also rise to 77 per cent in 2010. This year, capacity utilisation has been estimated at 71 per cent, sharply down from the 80-90 per cent in the previous two years.

Next year, China is expected to up output by about 4 per cent, while that figure will be about 18 per cent for the rest of the world. Overall, that translates into an increase in global output by 11 per cent, a tad lower than demand, according to Morgan Stanley.

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Cash returns

Most cash-rich metal companies have done better than their leveraged peers

Source: Bloomberg

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Cash returns

Earnings multiples may decline for most metal companies in 2011

Returns (%)	1-month	3-month	6-month	YTD	1-year	PE-2010	PE-2011
Tata Steel	1.7	19.7	102.8	143.9	154.6	20.2	8.1
JSW Steel	3	34.9	149.9	271.9	272	13.3	8.7
SAIL	3.5	6.1	58	135.1	118.2	12.6	11.5
Sterlite	7.9	26.7	108.1	218.7	236.3	19.3	12.4
Hindalco	5.2	50.8	147.1	175.2	169.7	19.6	14.1
Hindustan Zinc	13.9	35.5	87.4	176.1	254.4	11.6	10.3
Sesa Goa	17.2	38.6	160.4	277.2	321.1	14.2	11.4
Gujarat NRE Coke	7.2	24.9	153.5	159.3	122.7	12.3	6.7

Source: Bloomberg; Data as of Oct 23, 2009

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The long-term estimate for the price of steel is at $550 a tonne. Currently, hot rolled coil — the most basic steel output — sells at a little below those levels at around $530 a tonne. And it could stay that way for a while. Antique’s Singhania believes that steel prices could be range-bound in the light of idle capacity in Japan and Europe. Some experts such as commodity guru Jim Rogers believe that the more interesting plays in steel could be among iron ore and coking coal companies, given the short supply evident in these market segments, rather than the simple steel producers.

Back in India, the government’s thrust on infrastructure and low-cost housing will keep steel mills buzzing with activity. In fact, even as the economy has been gingerly getting back on its feet, local steel producers have been able to push through small price hikes to their advantage.

Zinc

The International Lead and Zinc Supply group (ILZSG) predicts that global demand for zinc will shrink by about 6 per cent in 2009, despite a higher demand from China and India. Making matters worse, the world body predicts that there will be an output surplus of 2.27 lakh tonnes, in addition to the 3.8 lakh tonnes surplus in 2009.

Despite this, Angel’s Walia believes that zinc has benefited somewhat from smelter shutdowns. For instance, pollution concerns have led China to clamp down on lead production, which in turn has led to some zinc smelters shutting down. (Lead is a by-product of zinc.) Walia expects zinc to trade between $1,800 and $2,100 a tonne in the near term.

Meanwhile, Citi’s Thurtell is betting on a global recovery to take prices to beyond $2,000 a tonne. Singhania of Antique points out that while zinc may be in oversupply, factors such as the shrinking supply from mines and that a lot of mining is concentrated in Chile and Peru (troubled by labour unrest) could keep interest in the metal high for some time.

End game: Playing the stocks

In India, the bulk of metal stocks are in the ferrous segment, with Tata Steel, SAIL and JSW Steel in the top spots. The prices of all these stocks have surged (See chart: Cash returns). Tata Steel has jumped 266 per cent from a low of Rs 149 in December to Rs 530. Most analysts continue to give the stock a thumbs-up.

Antique’s Singhania believes that the re-structuring of Corus gives Tata Steel shares an edge over rivals. Morgan Stanley feels that along with Tata Steel, smaller companies like JSW Steel will also benefit. JSW’s capacity addition will provide the driver for earnings growth, aided by higher realisations, says the foreign brokerage.

In the non-ferrous arena, Sterlite seems an obvious pick with its operations in aluminium, zinc and copper. The only hitch is its proposed diversification into power, which dilutes its attraction as a pure metals play. Hindalco is also expected to benefit from a turnaround in Canadian subsidiary Novelis in FY11, as cost savings kick in and the overhang of contracts that capped prices fades, according to Antique. Even cash flows are expected to get better as demand picks up and the scope for potential mark-to-market improves.

For most commodities, output and prices are forecast to stay stable until the middle of 2010. After that, some global headwinds could develop as a possible decline in economic activity exerts pressure on prices.

Until then, stable metal prices will allow manufacturers to breathe a sigh of relief as they don’t have to worry about volatile raw material costs; instead, they can concentrate on manufacturing strengths and efficiencies. Given this picture, the best bets seem to be Tata Steel and Sterlite.

The prospects for copper also appear much brighter in the near term and that optimism is already reflected in the metals markets.