HOTTER ON METALS: After challenging year, reasons to cheer

If “challenging” was the word that many metals market participants used to summarise 2016 at the start of LME Week, they might be ending the week on a slightly more optimistic note.

Delegates attending the London Metal Exchange seminar on Monday October 31 had been asked to describe the metals industry in one word at the start of the event, voting through an iPad poll. Other words that were popular included “mixed”, “tough”, and “uncertain”, although the words “promising” and “exciting” also featured fairly heavily.

It would be interesting to run the poll again now, after several days of company meetings during the annual LME Week in London. While few believe the metals world is out of the woods yet, it certainly seems to be in a better state than it was a year ago.

For starters, interest from investors in the commodity markets is showing positive signs of revival. After six or more years of falling out of favour, commodities, including metals, are back en vogue.

Anecdotal evidence suggests that asset allocations are slowly improving, while there are even more commodities-focused funds being set up. Multiple market participants said that meetings held with asset managers suggested a new wave of investment could be just around the corner, and that first-quarter 2017 allocations in particular would potentially help create a very different picture for metals.

The exodus of many banks from commodities over the past few years hit the metals markets hard, but the transfer of their customer business elsewhere has given a lifeline to remaining market participants. The exit from metals of brokerages, merchants or traders due largely to mergers or closures has also allowed nimble players to thrive.

Physical
As yet, the physical market doesn’t seem to be showing dramatic signs of improvement, and it is here that China remains key.

Although market participants are getting used to the normalisation of China’s growth to low single digits after exponential development helped trigger and sustain a commodities bull run, they are still not entirely sure how things will play out.

Fears of a ‘hard-landing’ in China have eased, but the boost from Chinese stimulus is likely to fade, especially given renewed concerns about the country’s reliance on credit-driven growth.

It’s important to remember that next year will be an unusual one for China, in that it marks the highly anticipated 19th National Congress of the Communist Party, to be held in Beijing in the autumn. The twice-a-decade congress – the last was in 2012 – will determine the makeup of the top leadership of the Communist Party, with many top officials expected to retire.

In all likelihood, China’s leaders will be looking to produce a strong set of data and further clean up the nation’s environmental record, much like they did at the 2008 Olympics when polluting operations were shut down ahead of the games. If this is the case, the closure of a variety of metals plants is likely along with the continuation of some measure of stimulus, until the end of the meeting at least.

In the interim, market participants say things are not quite as dire in the physical market as prices suggest.

Competition for business is fierce, with physical merchants and traders scrambling for the same business. This often results in aggressive price undercutting, which is in turn distorting the reality of the underlying market.

In other words, premiums in some areas seem to be weak, but that might in some cases – such as aluminium - be the result of newish entrants boldly attempting to make a name for themselves and causing a bidding war in the process.

Fundamentals
The outlook for prices is also turning more bullish on a fundamental basis.

Nickel and zinc in particular are favourites, while aluminium is seeing increased producer hedging.

Copper has a more mixed outlook, largely due to new supply that is due to hit the market over the next 18-24 months. A pick-up in demand would counteract this supply pretty quickly, however. Similarly, copper’s role as a global economic indicator due to its link to construction and housing means the metal would likely be a top pick for asset managers if and when they return, which would give it a boost regardless.

Miners meanwhile are starting to get back on track, with share prices lifted significantly from year-ago doldrums after a period of tough restructuring. Rumours that firms were on the verge of bankruptcy have been proven false, while corporate mergers and acquisitions have been limited for a variety of reasons, including that many firms were unwilling to budge on target disposal prices.

But miners’ cost cutting programmes, production cuts and closures along with debt restructuring programmes have broadly been working, leaving balance sheets in better positions than they were during the dire days of the second half of 2016.

Mining ceos too have largely survived, although there have been some changes within senior management and market participants predict another shake-up at the top of some firms over the coming months.

LME – fees & regulation
Whether the LME and its parent, Hong Kong Exchanges & Clearing (HKEX), have done enough to reassure members and market users that they are fighting their corner remains to be seen.

Discontent over the high cost of trading has been evident for some time. The exchange cut trading fees in September in response, and is expected to announce a reduction in initial margins for clearing this year; but it has still not been enough to satisfy all quarters of the market.

Lord Michael Farmer, whose 50-year plus career in metals leaves him a highly respected member of the metals community, called on the LME in a speech to the annual dinner this week to further reduce fees. The spontaneous applause that he received spoke volumes.

Lord Farmer also touched on a topic during his speech which is perhaps quietly having the most serious long-term impact on metals market participants – that of regulation.

The hand of the regulator has been creeping ever-tighter around the throats of members and market users, changing not just the nature and avenues of trading but also the cost of trading as capital adequacy requirements rise and costs are pushed through the chain.

According to Lord Farmer, regulation and compliance “can smother free trade and easily extract the oxygen of liquidity from the marketplace”. With MiFID II and Basel III coming, the issue of regulation is set to stay a hot topic through 2017.

It appears the appropriate word to describe feelings on the outlook for the next twelve months at the moment would be “mixed”.

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