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MERRILL LYNCH & CO.
North Tower, 21st Floor, New York, New York
(November 13, 1997) METALS: PRECIOUS METALS–Gold fixed at a fresh 12¼-year low of $308.15 an ounce on Wednesday the 12th of November as the market continued to move nervously lower. Shortcovering rallies up to the $314-$315 area basis spot bring out fresh selling interest. We continue to look for prices to trend sideways to lower for a very long time to come until we have closed down at least 300 to 400 tonnes a year of annual production capacity. At current prices a lot of mines are feeling varying degrees of pain. But the pain has been insufficiently intense or prolonged enough to even begin closing down big chunks of capacity. Only tiny operations have closed so far.
This is not surprising given that Gold Fields Minerals Services Gold 1997 Update estimates that average western world cash costs in the second quarter of this year totalled only $267 an ounce. On a total costs basis the picture is a bit grimmer because only around 40 pc of the world's mines cover all their costs at prices below $300. Total costs include royalties, taxes, debt service , capital expenditure, and depreciation.
However, miners are both a tough and optimistic breed and will not close down a mine until they truly believe there is no hope of the gold price rising again and thus justifying their decision to carry on operating at a loss for a prolonged period of time. This is why we feel very strongly that gold prices will continue to trend sideways to lower for many years to come until we have finally seen the closure of at least 300 to 400 tonnes of capacity.
Theoretically the high cost South African mines should be the first to go. South African production has already fallen considerably over the last few years and is now running at around 475 tonnes a year. Some analysts are predicting a 10 to 15 pc loss of production next year from shaft closures. But others are pinning their hopes on rationalization and cost cutting measures and a depreciation of the rand next year as saving the day. Only time will tell which school of thought will be proved right.
In the meantime good rallies will be jumped on by the producers as fresh forward selling opportunities. As one producer put it to us the other day, “We are in a survival mode! We intend to hedge sell forward whenever we get a chance.”
Meanwhile physical demand in Asia remains very poor after the sharp currency depreciations of recent weeks. At least the heavy disinvestment selling seems to be over. At one point the selling was so heavy that gold fell in Singapore to a one dollar an ounce discount to London. Now the discount has disappeared and we are looking at a small premium of 20 to 40 cents an ounce over London. This is up 10 cents an ounce from last week. The normal premium is $1.50 an ounce. We would expect to see demand pick up a bit more in Asia as time goes on. But we seriously doubt if next year it will be anything like as strong as it was this year or last.
It certainly remains difficult to be bullish about the gold price. Supplies are rising from increasing supplies from more producer hedge selling over and above normal mine output. You also have some central bank sales, disinvestment sales from many Asian countries, and some new by-product and primary product mine production. Physical demand in Asia, India, and the Middle East next year, in our opinion, is unlikely to be anything like as good as it has been this year. This is why we are very comfortable with our gold price forecast of $310 an ounce average for 1998. We were going for $320. But we have revised it downwards in view of the poor demand outlook. The gold price has averaged around $338 an ounce so far this year. Last year it averaged $387.73 an ounce.
The Bundesbank said on 11/12/97 via a German newspaper report that it is lending gold to the bullion market and has been for some years but it has no plans to sell gold before the European Central Bank is formed on January 1, 1999. No one that we know expected the Germans to sell before that date anyway so that news is neutral for the gold market. But the confirmation that the Bundesbank is lending gold to the market highlights just how involved in, and knowledgeable of, the gold market the bank is.
We expect the Germans to revalue their reserves (now valued at $93 an ounce) in the next few years and release value from their 3,701 tonnes of gold reserves. They will do, in our opinion, more or less what the Swiss are proposing to do. It seems the news story was sparked off by some journalist noting that a high Bundesbank official had been in London recently. (Perhaps discussing the liquidity of the market as a prelude to lending more gold or perhaps the discussions were the preliminary ones that need to be held before actual sales are done? Who knows? Is there smoke without fire?)
Finally on the subject of the European central bank (ECB) itself, it is interesting to note that the rumor mill has started on whether or not the ECB will have gold in its reserves and if so how much. A Dutch central bank spokesman said on 11/12/97 that no decision has been taken on the amount of gold to be held in the ECB. “The final decision will come after the executive board of the ECB is established and that is probably in the beginning of next year,” the spokesman said. A spokesman for the Portuguese central bank said that Portugal wants gold to form part of the reserves of a future ECB. Our own view on the ECB's gold reserves is based on discussions with a number of central bankers and treasury officials in Europe. We repeat again the comments we made in the October Monthly Base and Precious Metals Report: “...we understand, that there is likely to be a very low threshold imposed by the ECB for gold sales by member states. This is because the ECB will almost certainly wish to avoid having great rows with member states about gold sales when its creditability will be at stake in trying to manage the Euro in general. Assuming that the gold contribution to ECB's 50 bill ECU capitalization is 20 pc that would imply a contribution of around 1100 to 1200 tonnes of gold. As one Swiss banker put it to us “Hardly a vote of confidence in gold's reserve role in to the next millennium!” Dutch reserves are currently around 1200 tonnes of gold.”
“So if the ECB ends up with 20 pc gold backing, there will still be some 12,000 tonnes plus left in national vaults. And that gold, we continue to maintain, will be increasingly mobilized. More and more of it will be lent to the market (increasing the market's liquidity); much more will be actively managed by writing options against the holdings and the central banks will not mind being called away. So the bottom line, in our view, continues to be to sell forward into any good rally one sees. The bear market has only just started.”
Silver is looking very frisky these days with the bulls building up their strength again for a fresh attempt at breaking through the $5.00 basis spot barrier and marching on to the $5.10-$5.20 level basis spot. Syndicate and other silver longs are obviously hoping that the constructive chart patterns of $5.00 plus silver will bring in a fresh wave of fund buying. If the fund buying is strong enough, then the syndicate and other silver longs will be able to get out of at least some of their longs at a nice profit. If the rally to $5.20 or better never materializes, then we are going to see more and more stale bull selling develop in silver over coming week. The silver market in London remains very tight and lease rates remain very high. The one-year lease rate is around 3.5 pc. Such high lease rates tend to discourage short sellers unless they are very determined and feel the downside is quite large.
We were speaking with a precious metals consultant friend on 11/12/97 and learned from him that Indian silver imports in the first nine months of this year have hit a record of 2,859 tonnes. But the imports are now tailing off after a very strong first half. The September imports were around 125 tonnes. So on that basis we should end the year with total imports of around 3,000 to 3,300 tonnes. That level of imports, in his considered view, will not continue next year. And it certainly won't continue with prices above $5.00. The higher silver is above $5.00 the less the Indians buy. Demand is very price sensitive. Below $5.00 the Indians almost gobble it up!
PGMs continue to diverge. Platinum is moving sideways to lower on greater availability of South African supplies and slowing Japanese demand while palladium holds steady on the back of consumer and speculative buying interest. The Russians have indicated that they are going to roll over their supply contracts into the first quarter of next year. So the market is generally feeling a bit more comfortable about the Russians meeting their supply commitments. But no one is sanguine. There is still a nagging feeling that the Russians will not be very generous with the level of palladium sales next year. As a result price dips in palladium tend to be very well bought.
BASE METALS–We continue to see copper prices trending sideways to lower for some considerable time to come. We would not be surprised at all to see cash LME prices fall to 80 cents a pound ($1,737 a tonne) by the third quarter of 1998. The impact of the Asian situation on copper demand is still to be seen. But we can already begin to understand how bad it will be when we read that only 15 out of 150 major construction projects in Indonesia will be reactivated after the IMF rescue package or that Malaysian copper product makers of tubes and wires expect to see their business volumes drop 25 to 30 pc next year as a result of the collapse in the construction industry.
All the makings of a long and hard bear market are starting to fall into place for copper. Consumption is going to be falling next year, probably quite sharply, while mine and refined metal supplies will be rising very sharply. Brook Hunt (BH) is forecasting an 8.7 pc increase in total mine production next year to 10.297 million tonnes while refined metal production is expected to rise by 6.4 pc to 11.480 million tonnes. This will lead to a very big supply surplus of at least 500,000 tonnes next year.
As copper prices fall, miners–particularly the newly established low cost ones, will raise production to maximum levels to lower unit costs.
There was a time when many observers, including ourselves, thought the Chinese would act as a buffer stock and buy up sufficient volumes of copper to keep prices in the 95-90 cents a pound region in order to support their own domestic smelter industry. This now seems most unlikely to happen for a number of reasons. But the most telling to us is that the authorities in Beijing are increasingly reluctant to subsidize the smelters or the copper industry generally.
Chinese import and export statistics for the first nine months of 1997 confirm a very subdued buying approach. Chinese third quarter net imports of all forms of copper totaled 212,400 tonnes of copper content. This was a fall of 17 pc year on year and 18.5 pc quarter on quarter. This slowdown was unexpected by most observers, including ourselves, and it adds credence to reports we are increasingly hearing from Japan and Korea that the Chinese economy is actually slowing down. Alternatively it could be destocking has been higher than expected. But the recent cut in interest rates in China would support the first opinion that the economy is actually slowing down. That has to be another bear consideration for copper prices in our view.
So at some point in coming months the psychology of a surplus market will take over and consumers will be increasingly happy to buy on a hand to mouth basis. Scrap sales may dry up for a time when prices fall below 85 cents a pound. But the longer the bear market continues the more likely it is that the western scrap merchants will decide to sell off their stockpiled copper scrap rather than wait for higher prices. Russian merchants certainly won't stop selling their copper scrap to the west. They may stop initially. But we would be surprised if they didn't continue selling in the same volumes as they have been no matter what price was on offer in the west. The important thing to realize is that the Western price is in dollars and, as one Russian merchant put it to us, “it's a living!” As he personally is a dollar millionaire, one would have to remark that it seems to be quite a good living!
Probably by the end of 1998 we will start to see the closure of high cost mines. Some observers would not be surprised to see as much as 500,000 tonnes of annual production capacity close in Spain, Morocco, The Philippines, the States, and Western Canada.
The optimists will hope for better average prices in 1999 on the assumption that economic growth will be in a recovery mode then. Well, it may be. But the recovery is likely to be from a low consumption base and remain that way for some time. Meanwhile the surpluses will keep on building.
Looking into 1998 BH is now forecasting a Western world supply surplus of nearly 500,000 tonnes. “With major expansions in capacity in the pipeline, further surpluses in following years are almost inevitable. Indeed, over the five-year period 1997-2001, we forecast a cumulative surplus in excess of 1.6 million tonnes. Just how far prices will fall as a result is open to question, but it is clear that they will come to be determined more by the costs of production than the activity of the funds and other market players. In current dollars, we forecast a low point of $1,540 a tonne (70 cents a pound) to be reached in 2001.”
All in all, there are far more reasons to be looking to forward sell the rallies or buying puts than there is to be going long copper. We continue to feel that this year's copper average price (106.4 cents a pound) will prove to be the highest we will see for some years to come.
(Reprinted by permission. Copyright © 1997, Merrill Lynch, Pierce, Fenner & Smith Incorporated.)
Ted Arnold
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