Categories:
Base Metals
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General Market Commentary
Topics:
General Base Metals
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General Market Commentary
The Base Metal Breakout - Industrial Commodities Threaten Their Decade-Long Downtrend
Summary:
* Base metals are showing signs of real strength, with prices across the complex breaking out, or threatening to do so.
* Copper and zinc have looked the strongest of the bunch and both have recently broke out of multi-month consolidation patterns.
* The moves we are seeing have the hallmarks of a supply (destruction) driven rally, which tend to be sharp and ferocious in nature.
* An industry-wide decline in reserve quantity (depletion) and quality (grade), accompanied with a complete lack of new discoveries means we believe we're likely to see an increase in M&A as prices begin to rise, which is why we're interested in quality exploration and development stage plays.
Every now and then you get a feeling that the market is sending a message. Last week was one of those weeks as we witnessed a whole host of commodities either breaking out of multi-month consolidation patterns, or seriously threatening to do so.
The topside moves were generally spread across the commodity complex, but by far the most significant moves were seen in the base metals where we witnessed breakouts across the board, some in rather spectacular fashion.
From a higher level, this is best shown in a chart of the Bloomberg Industrial Metal Index, which has now broken out above a down trend that has been in place since the index peaked way back in 2007, over a decade ago.
Figure 1: Monthly candlestick chart of the Bloomberg Industrial Metals Index as of Friday, 18th of August, 2017.Source: Investing.com
When we dive into the individual metals, the recent top performers have undeniably been zinc (+ lead) and copper, both breaking out of multi-month consolidation patterns over the last few weeks to new multi-year highs.
This is not surprising to us given the strong fundamental drivers we see impacting the industry (largely supply side) and the moves we are seeing have all the hallmarks of one of Rick Rule's favorite sayings playing out in reality - "Bear markets are always the authors of bull markets".
That is because we are finally seeing signs of real supply destruction as a result of the brutal five to ten year bear market we've experienced in the commodity complex. Crucially for investors, it appears as though this is also starting to have an impact on commodity prices.
So, let's take a closer look at two of the more dramatic movers - zinc and copper.
Zinc:
Zinc in particular has looked extremely strong and you can clearly see the week's breakout on the chart below. The metal most commonly used as a galvanizing agent now appears to have successfully consolidated its 2016 run, which saw it claim the status of the best performing metal last year (with the exception of iron ore).
As of its close on Friday, the zinc price is up 115% from its January 2016 low of $1,440/t.
Figure 2: Weekly zinc price candlestick chart, as of Friday, 18th of August, 2017. Source: Thomson Eikon
Zinc's run has all the hallmarks of a supply (or lack thereof) driven move, which tend to be swift and devoid of major pullbacks or periods of choppiness.
This is supported by the hard data, which shows that since 2012, we've seen over 1 million tonnes (Mt) of shuttered production in a 13Mt market*1. Glencore alone (the world's largest zinc producer) cut its zinc production by 24% in 2016, a year which also saw the closing of two of the world’s major zinc mines in Century (Australia) and Lisheen (Ireland).
We have been hearing of potential tightness in the zinc market for a while now, only to see "hidden" supply (likely of Chinese origin) dumped on the market whenever prices rallied.
However, this dynamic seems to have completely changed and Chinese figures now show the country is dealing with a significant mined deficit caused by declining production from the countries domestic mines.
Last week’s news that the Chinese government ordered a shutdown of all the lead and zinc mines in the Hunan province's Huayuan county (a major zinc producing region) suggests that the countries zinc deficit is only likely to grow in the near to mid-term, further adding to the already strong tailwinds currently affecting the zinc price.
Copper:
Whilst not quite as spectacular as zinc, copper has shown signs of a real resurgence in 2017. The move started late in 2016 after the copper price ground out a text book basing pattern throughout the first three quarters of the year before breaking out proper in November.
2017 saw those gains consolidated as price traded in a sideways range before leading the base metals complex in breaking out topside a few weeks ago back in late July. Price is currently testing the key $3/lb level, as shown in the chart below.
Figure 3: Weekly copper price candlestick chart, as of Friday, 18th of August, 2017. Source: Thomson Eikon
As with most commodities we follow, we believe the most reliable drivers of the copper price into the foreseeable future are going to come primarily from the supply side of the equation. This is because we know that the industry is mining well above its reserve grade, meaning that over time the industry average mined grade is almost certain to decline.
Lower mined grades mean miners will have to increase the volume of ore they process every year, just to "tread water". It also means we're likely to see a climbing industry wide average cost of production (less copper produced per ton of ore mined/processed), increasingly rendering mines at the higher end of the cost curve uneconomic unless the copper price rises enough to compensate for the declining grades.
A text book example of this phenomenon can be seen at the Escondida mine in Chile, currently the largest copper mine in the world, producing over 5% of global annual supply.
The Escondida mine is currently mining ore that grades around 1% Cu, which is 1.4 x the life-of-mine reserve grade of its sulfide ore body, which currently sits just under 0.6% Cu. In other words, the mine is being "high graded", meaning simple mathematics dictates that mine grades are set to steadily decline into the future.
This phenomenon is clearly visible in BHP's (57.5% owner) 2016 operational update which highlighted a huge 28% year-on-year decline in mined grade during the year. Whilst part of the decline was due to grade variability within the ore body, it highlights a trend of a declining grade profile that's only going to worsen over time.
Figure 4: Excerpt from BHP's June 2016 year end operational review. Source: BHP's June 2016 news release, page 6.
This problem is by no means limited to Escondida, but rather is pervasive across the entire copper sector. With the world’s copper mines not only rapidly depleting in absolute terms (depletion), but also falling in quality by way of grade decline (result of high grading), we believe we're likely to see significant downward pressure on the amount of the copper the industry is able to produce.
Completely ignoring the demand side of the equation (which is harder to quantify, but we are generally bullish on - think the increasing push towards electrification), an industry wide flat to declining production profile is usually a key ingredient in the recipe for higher prices.
To compound matters, low copper prices have all but killed the copper exploration sector, both at a brown fields (near existing mines) and green fields (new discoveries) level. The result, with a couple of notable exceptions, is that there is almost nothing in the way of new world-class copper projects ready to replace depletion from existing stock of copper mines.
This is why we are paying particular attention to exciting exploration projects, new copper discoveries and the few existing high-quality development plays which we believe are becoming increasingly attractive acquisition targets as the copper market turns and producer are forced to look at options to replace their rapidly depleting reserves.
Elsewhere in the base metals complex - nickel and cobalt look interesting
I wanted the focus of this article to be on zinc and copper, however it's important to note there have been equally as important moves elsewhere in the sector, particularly in the metals that are leveraged to the rapidly growing lithium ion (Li-ion) battery sector like nickel and cobalt.