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MERRILL LYNCH & CO.
North Tower, 21st Floor, New York, New York
(November 26, 1997) METALS: PRECIOUS METALS–We think the bear market in gold should continue next year. But once prices get down to the $280 to $270 level basis spot we should start to see major mine capacity closures being announced and that could be the trigger for some violent price swings. Those running short positions may want to consider buying calls to protect their profits. But so long as gold continues to trade in and around the $300 level basis spot, the upside risk from a major shortcovering rally looks fairly limited with few dealers expecting to see more than $315-$320 basis spot as an upside target. In our opinion, we really need to see 300 to 400 tonnes of mine capacity close down before we have the makings of a more balanced market and higher average prices. Gold has averaged around $336 an oz so far this year. That is still not low enough to convince enough mine operators to close down.
But at some point in coming months, we should reach a stage when prices have been so low and look likely to stay low that enough mining companies will decide to close down large chunks of their high cost capacity. And when that starts to happen, as we expect it to, the price “fun” should begin in earnest with wild price gyrations likely to be the norm for a time. There could be even more producer buy backs seen in the market. (And we have seen a lot of producer buy backs recently according to some bullion market sources.)
According to Gold Fields Minerals Services Gold 1997 Update the average western world cash costs in the second quarter of this year totaled only $267 an oz. but 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.
Theoretically the high cost South African mines should be the first to go. Their weighted average cash costs in the second quarter of this year were $318 an oz basis spot. 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.
In the meantime good rallies will be jumped on by the producers as fresh forward selling opportunities. Physical demand in Asia remains very poor after the sharp currency depreciations. But at least the heavy disinvestment selling of recent weeks seems to be over and premiums over the London price are slowly recovering in many centers.
One market feature that will grow in importance next year is the European Central Bank and how much gold it will have and what the other central banks will do with their left over gold. At present the argument behind the scenes seems to be for either 10 to 20 pc gold backing to the 50 billion ECU bank. But some European central bankers have actually suggested zero gold holdings. Indeed, the governor of the Bank of England, Eddie George, is on the record as saying to the European parliament's monetary affairs sub-committee on November 24 that he would be surprised if the European central bank held large stocks of gold. Mr. George said that “Whereas gold used to be seen (by central banks as a good asset) it is now seen as the bottom of the pile.”
At a forum held on November 18 at the City of London Central Banking Conference we heard some very interesting comments. But the main conclusion from the forum was simple and straight forward.
The ECB will make its decisions regarding its reserves by mid to late 1998. The betting is on 10 to 20 pc maximum versus an average of around 31 pc now for the present European Union central banks. That implies around 12,000 tonnes of gold on a 20 pc gold backing. This surplus will be increasingly lent to the bullion market or have options written against it. The central banks are not going to dump their gold onto the market but intend to reduce their holdings gradually.
But this should keep gold prices moving in a sideways to lower trend for some time to come because strong rallies would probably trigger off outright sales or swaps (collateralized loans which can end up as sale). Like it or not, the central bank gold is in the market as a new source of very low cost supply.
All in all, 1998 promises to be a very interesting year with lots of events to report and comment upon.
Silver looks to heading for the stratosphere in 1998 with many European dealers looking for $8 to $9 an oz basis spot sometime next year. This bullish view is not based on fundamentals as such but on the growing tightness in the market and the increasing lack of availability of deliverable silver on the London and Swiss markets. COMEX silver stocks are now at 12-year lows and still falling. Lease rates are very high and most dealers are very reluctant to advise any client to sell short. The better the chart picture looks the more likely it is that fund money will pile in on the buy side and thus enable the present large player or syndicate, if you prefer the term, to lighten up on some of the long position that has been accumulated.
But it can not be stressed enough that this is a long-term operation. Many European dealers say that this situation has been building up for the last two to three years. It has cost a fair bit of money to put the operation together. The present players intend to take a good profit out of the market before prices come back again from the massive physical supply response that is to be expected at some point. What price will that be at?
The merchants we speak to in Dubai doubt if much silver will come out of India below a price of $7.00 an oz basis spot in the West. But then it should start to flow. And at $8 or $9 it should flow even more swiftly. However, it is not enough to have the physical silver. It has to be turned into good delivery silver. And this is quite time consuming we understand as there is not a great deal of spare refining capacity about in Europe at present. The bottom line is what ever you do, do not short silver.
PGMs continue to be a steady market with palladium holding very steady on expected supply shortages while platinum continues to move sideways on adequate supplies and unease about Japanese jewelry demand levels next year.
BASE METALS–Hardly a week goes by now without the outlook for base metal consumption in Asia next year worsens further. Two months ago, the view was that only the Asian economies of Indonesia, Thailand, Malaysia and the Philippines were the only ones likely to suffer big drops in metal consumption next year as their financial austerity programs began to hit the construction, infrastructure, and transport sectors of the economy. (These are the sectors that are the big consumers of base metals.)
But then it became clear that Japan's economic recovery had failed and it too was heading towards recession in 1998. Then doubts were increasingly raised about growth prospects for Taiwan and China next year. And now we have Korea, the world's eleventh largest economy in terms of GDP, calling in the IMF. Korea's economy is larger than those of Indonesia, Malaysia and Thailand combined. South Korea has been one of the main power houses of metal consumption over the last decade with consumption of all base metals growing at an average of 10 pc a year.
It is the strong incremental demand growth for base metals that will be lost in the Asian economic slowdown. This loss of demand pressure comes at the same time as supplies of most base metals are rising quite sharply.
This is why we and many other participants in the base metals business expect to see prices for base metals in general moving in a sideways to lower direction over the course of the next 12 months or so. At this point of time, no one can say how bad demand will become in the Asian economies and the rest of the world. That will unfold in coming months. But one can say, we think, with confidence that the risk is now on the downside with all base metal prices. Six to nine months ago the risk was on the upside.
We have discussed this situation at some length with a number of merchant and producer contacts and we list below some of their general opinions and overall conclusions.
1. There will be little or no growth in Asia next year and 1999 is likely to be rather poor as well. U.S. growth will slow next year as will growth in Europe. A 1993-type buying opportunity (when base metal prices were at historic lows in real terms and the U.S. economy was on the verge of recovery) is unlikely to present itself again for probably three years with 2000 or 2001 being seen as the earliest for fundamentals to turn bullish again.
No one can tell at this stage just how poor (or good) consumption growth will prove to be next year. But the general feeling was that it was better to keep one's forecasts low and then, if circumstances justified it, to raise them.
2. The two weakest markets are seen as copper and nickel (“You can forget both of them for the next three years,” was the comment of one merchant) while zinc and aluminum are seen as “promising” in that both those prices will hold up relatively well compared with the other metals.
3. There is considerable unease about growth prospects in China although as of now Beijing's planners seem to be doing what they can to stabilize the situation by cutting interest rates and lifting money supply.
4. There will be some “bare knuckle” competition between the various Asian nations for export market share and competitive devaluations will probably remain a feature of the market for a long time to come. South Korea in particular will compete with the Japanese in the car export market and would-be American and European purchasers could be looking at some “real bargains” next year.
This observation leads on to the more general comment of many economists that the Asian crisis is likely to lead to deflation. The following quotes are from ML's Forecast Addendum of 11th November which is written by Bruce Steinberg, ML's chief economist.
“We expect (U.S.) GDP growth to slow to 2.5 pc in 1998 from an estimated 3.7 pc in 1997. About half a percentage point of that downshift reflects weaker export growth, a quarter of a percentage point reflects less inventory building, the rest, moderation in consumer spending.”
“That said, risks to 1998 growth are on the downside. Consumer spending could slow more than we anticipate. (our emphasis) Though we expect capital spending to remain robust, there is significant downside risk given the uncertain state of the world economy.”
“If the Asian crisis deepens and pulls in Latin America, the U.S. trade balance may deteriorate by more than we currently project for 1998.”
“We believe that deflationary pressures will intensify during 1998 as growth moderates, capacity growth accelerates, and import prices drop. We expect the CPI to rise less than 2 pc during 1998.”
“We expect long bond yields to fall below 6 pc within the next six months, if not sooner. And, as growth moderates and inflation slips further, we believe that the Fed may ease policy in 1998.”
We think Charles Clough, ML's chief investment strategist, summarizes the cause of deflation (and the worry about how prolonged it could be) in the following paragraph which comes from his weekly U.S. Investment Strategy report of 29th October: “The collapse in Asia, which has been building since 1993, reflects an important premise in our global deflation thesis. Overinvestment is the basic engine of deflation and the 1990s saw an explosion in Asian capacity building as high domestic savings rates coincided with strong foreign direct investment to massively inflate Asia's capital stock. Eventually assets in place cannot service the debt taken down to fund them, whether it be Bangkok real estate or Korean steel mills. Capital goods projects are now being delayed or canceled and the natural tendency is to attempt to export one's way out of the deflationary problem. (our emphasis) The U.S. and Europe will import some of this deflation. Similar but more subtle overbuilding of capital stocks may be underway in Europe and North America.”
Copper, in our opinion, is heading into very bearish waters. A few months ago we felt reasonably confident that the Chinese would emerge as good buyers in and around the 93 to 90 cents a pound area basis cash LME ($2,050 to $1,984 a tonne). That view proved to be totally wrong as the Chinese economy slowed and internal copper demand was static (or even fell, according to some outside observers) and copper developed a surplus internally. Shanghai stocks have hovered around the 20,000 tonnes level all year. Indeed, the Chinese are going to be net exporters of cathode this year with China Metals reporting in late November that China will be a net exporter of cathode this year (an estimated 20,000 tonnes) and will probably be a net exporter again next year. Total imports of copper units for the first nine months of 1997 was up 5.9 pc at 770,000 tonnes, according to Brook Hunt.
Secondly, the Chinese authorities such as CNIEC have suggested on more than one occasion to Western metal merchants and journalists that with metal markets now much more balanced than they were in the 1970s and 1980s, China feels it is increasingly dangerous to rely on the spot market for 40 to 50 pc of its import requirements. Beijing is increasingly looking for more long-term supply arrangements directly with producers. To the extent that this policy succeeds over time (and we think it should), it will mean less direct purchases from the LME and probably less volatility on the market as well.
Just how much of a support the lack of scrap sales will prove to be is still to be seen. Theoretically, sales of scrap copper tend to dry up rapidly at prices below 85 cents a pound ($1,874 a tonne cash LME) as the scrap merchants sit on the metal waiting for better prices. As scrap can be up to 33 pc of total copper supply, this can have a stabilizing impact on prices after a few quarters. But the jury is still out on that one, particularly as some commentators make the point that the price to look at is not U.S. Dollars per tonne but the Deutschemark price of copper as that is what the Russians trade in. Many scrap merchants themselves confess that while they will initially hold material back from the market for a time. But eventually, if they become used to sideways to lower prices for a time, they will decide to sell and maintain their previous volumes of scrap sales at lower price levels.
To watch LME stocks rising at this time of year is also a very bearish indicator. Normally stocks rise in the third quarter with the seasonal summer slow down. Stocks normally start to fall in first quarter as the Japanese get ready for their GSP import program (GSP effectively gives the importers a tax break on their copper). We suspect that Japanese imports this year under the GSP system will be sharply down on previous levels. The psychology of surplus begins to take over and dealers think that 80 cents is a very good price if 70 cents is possible!
The copper bulls point to possible El Nino weather effects as being the savior next year. They are hoping for big floods in Chile and Arizona and continuing drought in Papua New Guinea. The drought in Papua New Guinea has certainly had an impact on Ok Tedi copper shipments. This have collapsed to only 86,000 tonnes in the year to date versus 189,000 tonnes for the same period in 1996. But Chile and Arizona remain unchanged by El Nino disaster so far.
However, we wouldn't count on floods saving the day next year. We still look for sideways to lower copper prices next year and we would not be surprised to see prices actually hit 80 cents a pound by the third quarter ($1,763 a tonne). Some other observers would not be surprised to see 75 cents a pound within the next nine months ($1,653 a tonne). We think that may be a bit too bearish. But certainly the trend is sideways to lower for many, many months to come, in our opinion. The International Copper Study Group announced recently that it is currently forecasting a supply surplus of 475,000 tonnes for this year and one million tonnes for next year. We think these numbers too high. But they are in line with the new “surplus” psychology that is gripping the copper market.
Certainly one would expect to see new mined supplies of copper increasing next year and in 1999. The initial reaction of most miners to lower prices is to raise output and to lower mining production costs. This should be particularly pronounced in the newer mines in Chile and elsewhere. By late 1998 we should see a lot of mine closures of the high cost operations in the United States and Canada as well as in Spain, Morocco, and the Philippines. Some consultants would not be surprised to see 500,000 tonnes of capacity closures by the end of 1998.
This should not surprise too many because in 1996 direct cash operating costs for western world copper production was around 59 cents a pound but the 9th decile of producers (the highest cost category and thus the most vulnerable to closure) had cash costs of 86 cents a lb. We have lowered our average price forecast for next year from 90 cents a pound to 85 cents a pound for cash LME copper ($1,874 a tonne). That compares with an average so far this year of around 105.8 cents a pound and 103.9 cents for 1996.
(Reprinted by permission. Coypright © 1997 Merrill Lynch, Pierce, Fenner & Smith Incorporated.)
Ted Arnold
Metals
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