Despite a brief rally early in 2009, the base metals market remains in a “bear grip.” Although the bear is expected to hold on until the middle of the year at least, a modest recovery toward the end of 2009 could herald renewed strength in that sector.

“Base metals as a group rallied in early January,” says Patricia Mohr, vice president of economics and a commodities market specialist withBank of Nova Scotia in Toronto. “But we are still sitting at low levels. I’m not sure we are at the bottom of the market yet. And it’s quite possible we will have additional weakness as 2009 unfolds.”

But given positive indicators, Mohr doesn’t anticipate any further precipitous declines and there may even be renewed strength for some metals.

The steep descent of base metal prices since mid-2008 is unprecedented. Copper, for instance, which traded at more than US$4 a pound in July 2008, hit a low of US$1.26/lb. on Dec. 24, 2008. The decline reflects worsening supply/demand fundamentals as the global economy headed for recession, Mohr says, exacerbated by the forced exit of hedge funds from their positions in the commodities markets, particularly base metals and agricultural products.

Demand for metals began weakening long before prices began to plummet, notes a recent research report issued by London-based Natixis Commodity Markets Ltd. The outlook remains poor, it states, because all the leading purchasing managers’ indices remain weak, “pointing to a sustained period of negative industrial production growth in the mature economies.”

Other indices that reflect demand are also posting 20- to 30-year lows. In December, Japanese shipments of aluminum-rolled products fell by 22% year-over-year, the steepest decline since 1981. In addition, the same-month global production of steel — a good early indicator of turning points for the base metals cycle — was 20% lower than a year earlier.

As well, the strong demand from China and other developing economies that was expected to prop up prices has not materialized. China’s year-over-year industrial production growth was 5.7% in December, compared with rates of 15% earlier in the year. The Natixis report also sees slower growth in India and sharp contractions in South Korea and Taiwan, all significant base metals consumers.

The supply side of the equation is more positive for base metals prices. The sharp decline of prices means high-cost mines have become unprofitable and development projects are being mothballed, keeping inventories lower than in previous periods of poor demand.

“For many of the base metals, we’ve moved down to levels at which the high-cost producers are not covering cash costs,” Mohr says. The copper price, for instance, reached a level this past December that was lower than the average cash cost of production (US$1.45/lb.) of most of the world’s copper mines. The decline triggered mine closures and project delays that took about 600,000 tonnes of copper off the market.

“One positive feature for the base metals sector is that inventories are at minimum levels,” the Natixis report concurs, “which should allow a strong recovery in demand once economic growth is resumed.”

The latest data suggest demand may already be picking up incrementally. “There is some evidence that infrastructure spending in China is starting in earnest,” says Bart Melek, a commodities specialist with Toronto-based BMO Capital Markets Corp. “That’s good for copper and for base metals generally.”

Over the longer term, states a BMO metals and mining research report published in January, stimulus spending, monetary easing and continuing growth in Brazil, Russia, India and China mean the commodities bust should last for a matter of quarters — not years.

“This sell-off is likely to be a cyclical downturn amid a secular uptrend,” the report says. “The combination of very sharp supply-side adjustments owing to extremely tight credit conditions, a low price environment and improvements in demand are all likely to tighten the supply/demand picture, giving a boost to prices.”

But the Natixis report warns that prices may have further to fall before supply cutbacks rebalance the market. In the nickel industry, production cuts are being offset by the commissioning of new capacity and in the aluminum industry, the cuts have come too late, allowing six weeks’ worth of consumption to build up on the London Metal Exchange.

Here’s what to expect over the short to medium term:

@page_break@> Copper is the only potential bright spot in this year’s gloom. “There are expectations,” Mohr says, “that China’s State Reserves Bureau, which builds strategic inventories of commodities, is going to be buying copper to build a stockpile this year. It is probably trying to take advantage of bargain levels for copper.”

That said, copper production has been cut and labour disruptions have taken a lot of supply out of the market. Mohr is calling for copper to average US$1.30/lb in 2009.

The BMO report projects a copper surplus of 411,000 tonnes and lower prices for the metal in 2009, with first-quarter prices potentially dipping below US$1.20/lb. However, it adds, the lower price environment will force additional supply cuts, setting the stage for a modest rally once demand returns.

The Natixis report is also forecasting a decline in supply offset by further weakness in consumption, leading to a global surplus of 250,000 tonnes. It expects spot copper to average US$1.31/lb in 2009.

> Aluminum prices plunged by 51% to US69¢/lb in January from US$1.40/lb in July 2008, as demand continued to weaken and LME inventories soared. Producers have idled more than three million tonnes of capacity in response, but it will take time to whittle down the inventory, even if demand returns.

As a result, the Natixis report suggests, improvement in the aluminum market may take longer than for most of the rest of the base metals. Further, it calls for an average annual price of US70¢/lb this year.

The BMO report is projecting an average price of US79¢/lb, with the latter half of 2009 outperforming the first half because of project spending in the U.S and China and improving economic conditions. Mohr is calling for a US62¢/lb average price.

> Nickel consumption is expected to drop by another 4.6% in 2009, while production is expected to slip by only 2.8%, leaving the global nickel market with a surplus of 20,000 tonnes in 2009, the Natixis report states. Additionally, it expects spot nickel prices to average US$5.40/lb over the year, down 44% from the 2008 average of US$9.57/lb.

Nickel is used mostly in stainless steel and low stainless steel smelting rates globally have been the main catalyst for the precipitous drop in nickel prices from highs recorded in early 2008, the BMO report states. But even though producers are being forced to sell the metal at below cost — creating an unsustainable price environment for the long term — continuing weak demand and high inventories will keep prices low in 2009. BMO is calling for nickel prices to average US$5.75/lb.

Mohr is also bearish on nickel: “Stainless steel is used in a lot of capital projects, and capital spending is going to move down sharply this year and remain at a low ebb. That will take a toll on nickel.” As a result, she is forecasting a nickel price of US$4.20/lb in 2009.

> Zinc. The Natixis report is more positive about zinc’s prospects, calling for an average price of US56¢/lb in 2009. “With buyers having delayed purchases in light of the recent price declines,” it speculates, “the emergence of plentiful supply cuts could see a pick-up in demand in order to replenish stocks.”

Scotiabank’s research note shows that “proactive and very unusual” production cuts by 20 smelters around the world (including a 30% cut at Xstrata PLC’s Kidd Creek smelter in northern Ontario to mid-2009) have prevented the zinc price from collapsing.

As well, China’s State Reserves Bureau is buying zinc from Chinese smelters for its strategic stockpile, stimulating demand. Mohr is forecasting an average price of US50¢/lb for zinc in 2009. IE