Sunday, October 23, 2011

Base metals and the business cycle

There has been a significant decline in prices which may lead to an eventual increase in demand but it can more immediately change the buffer stock and will lead to an inventory decline. With falling price, the desire to hold inventories relative to financing costs decline, so inventories will be reduced first. The decline in inventory in warehouses will then ultimately lead to demand for metal from miners. This is a consistent and usual inventory cycle story associated with most business cycles. Base metals have become more like equities in the current cycle. 

Market power can come from buyers or sellers. In this case, China demand represents the entire deficit in copper relative to production. Nickels is more sensitive to EU and US slowdown given its higher usage at about 1/3 of global demand. Most metals like aluminum copper and zinc are 25%.

Correlation with equities have moved higher from about .3 to .5. Sensitivity to a one percent decline in equities is .8 for nickel and .45 for Aluminum.Speculative copper has fallen off a cliff and has moved from net long to net short.

Base metals are affected by marginal cost curves which makes for uncorrelated markets given the cost curves are different. If prices move above marginal costs based on overly positive expectations, there will have to be a decline when price expectations are revised down. That will occur when global growth is expected to slow. 

Copper may be the most sensitive to a slowdown based on the current difference between price and marginal cost of miners. Aluminum which is affected by smelting costs will not have the same price sensitivity. The marginal cost curve is steeper even with the sizable over capacity in smelting. The will be a point where marginal costs will match existing prices at which there will be a change in speculative flows. 

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