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Tuesday, November 20, 2007


Why Zinc has Underperformed This Year

Zinc's Underperformance vs. Other LME Metals

Despite the ongoing commodities bull market, zinc has been clobbered over the past year, with the price dropping nearly 50%. Zinc's underperformance relative to other base metals over the past year is puzzling when one looks at the LME inventories. LME zinc inventories have dropped more percentage-wise than any other LME metal over the past year, yet the price of zinc is down far more than any other LME metal. Here's a summary of each of the other LME metals and their inventories:

o LME lead inventories are actually up on the year, yet the price of lead has doubled this year.

o LME copper inventories are up over the past year, now at nearly double July levels, yet copper is also still up significantly this year.

o LME nickel inventories are about 6 times higher than a year ago, with a significant new source of nickel coming on line recently (pig nickel), yet nickel is still at around the same price as a year ago. LME nickel inventories are actually at the highest level since 2000, yet the price of nickel is up from about $3 to near $14 over the last 5 years.

o LME aluminum inventories are up about 35% over the past year, yet aluminum is only down about 3% in that time.

Despite the weakness over the past year, zinc remains in a longer term bull market. In the past 4-5 years, it has tripled, about the same or more than gold and oil, but it has been a much more volatile path.

Reasons for Zinc's Weakness

There are a number of reasons why the price of zinc has been weak the last year. Here are some of them:

1) Too far, too fast -- From late 2005 to late 2006, the price of zinc tripled. It moved up too far too fast, so it was bound to correct from that parabolic rally. It went from the best performing metal in 2006 to the worst performing one in 2007.

2) A surge in new supply from mine restarts and San Cristobal -- As a result of the huge rally in 2005-2006, a number of old mines that were shut down when zinc prices were much lower because they were uneconomic then have been reopening, as much higher zinc prices made them economically viable again. Another significant new source of zinc is the San Cristobal mine in Bolivia, which just recently started production after many years of development. The market is forward looking, so this surge in new supply has been factored into the price of zinc, even though it hasn't yet resulted in an oversupply situation, at least as measured by LME inventories.

The surge in new supply is only temporary, and doesn't provide the consistent growth in supply needed to meet the growing world zinc demand and offset depleting reserves at existing mines. There are only so many old mines that were uneconomic at lower metal prices and had enough reserves left to be mined economically today. After San Cristobal, the pipeline of sizable zinc projects for the next few years is pretty empty -- Metalline Mining's Sierra Mojada project is probably the only world-class sized zinc project that will be proven feasible in the next year or so. Despite the recent additions to supply, LME inventories indicate that the zinc market is still tighter than other metals, as it had a huge supply deficit to overcome from the last few years -- LME inventories have dropped nearly 90% over the last 3 1/2 years.

We'll soon see if the oversupply situation everybody and their brother have been saying is coming in the zinc market actually materializes, and how long it lasts. Per Scotia Capital's China Commodities Weekly, "China has been sucking up the world’s growing supply of zinc mine output, turning it to refined metals, and then using it for domestic consumption."

3) The perception that China produces more zinc than they can consume -- With the weakness in the zinc price, there has been a plethora of bearish articles on zinc focusing on China increasing their supply of refined zinc without mentioning that they've had to import far more zinc concentrate in order to increase their refined zinc output. China has significantly ramped up their smelting capacity, but their mine supply hasn't been able to keep up -- it's much easier to build a smelter than it is to find and develop a sizable zinc deposit. As a result of the ramped up smelting capacity, China has significantly increased their refined zinc output, but they've had to import a lot more zinc concentrate from foreign mines in order to do so.

The headlines discuss China's increased refined zinc output as if they had a glut of zinc when in actuality their imports of zinc concentrate have increased 178% YOY in the first 9 months this year -- that's an enormous increase in imports, dwarfing any refined zinc exports (China actually became a net refined zinc importer in September despite all these concentrate imports). Once the growth in global zinc mine output slows after the recent supply surge, China may not be able to continue to increase their concentrate imports, and we may have a zinc crisis on our hands rather than the expected zinc glut.

4) Fear of global recession -- With the subprime crisis and weakness in the U.S. housing sector, many fear that the world is headed for recession. Many argue that a U.S. recession means we'll get a global recession, which would mean less demand for base metals. However, even if the U.S. goes into a housing-led recession, that doesn't mean the world will go into a recession, though global growth may slow. Even if China's growth slows dramatically from 10%+ to even 5%, that would still likely mean increased demand for base metals, as the growth in base metals demand has been coming from developing countries, not the U.S. The U.S. doesn't drive the global resource markets any more -- with their huge savings rate and increasing consumption, China is becoming less and less reliant on the U.S. for their own growth. China and other developing countries have a heck of a long way to go to come anywhere near the standard of living of the U.S.

5) Technical shorting of zinc futures -- For most of this year, technical hedge funds have been shorting zinc futures based on a head and shoulders top pattern with a target in the $.90-1.00 area. In the fairly small futures market, these funds dominate, and yesterday's Metals Insider says, "The CTA systematic fund community is running short of this market to over 90% of historic capacity and they are not alone, we suspect." With everybody short zinc, it has been pressured down, but should rebound strongly when the shorts cover. Since zinc hit as low as $1.0185 overnight, it looks like the technical bottom is close.

6) A short-term surge in Chinese zinc exports ahead of an expected tax law change -- The recent uptick in LME zinc inventories may not be an indication of increased supply, but may instead be a reflection of a scramble to beat the impending tax law change in China where refined zinc will no longer receive a 5% export rebate but will instead be assessed a 5% export tax. As Metals Insider explained yesterday, "In China particularly, traders were looking for production and exports to rise ahead of a probable removal of export tax rebates and the possible introduction of new export levies."

Once this short-term surge is over and the tax law change is implemented, look for zinc to rebound, especially with the world's largest producer of zinc likely to export much less refined zinc, if any. Despite the short-term selling it's causing, this tax law change will be bullish for the price of zinc longer term: "The policy will result in a significant drop in China's zinc exports and tight global supply, which will in turn dramatically increase both global zinc prices and zinc concentrate prices. Domestic zinc smelters will have no choice but to accept soaring imported concentrate prices, and will probably be forced to reduce production, Wang explained." (

The Future Looks Bright

We believe zinc is near a bottom and won't go much lower. Mining costs have risen significantly in recent years, especially as measured in U.S. dollars, so fewer mines are economic at lower prices. If zinc prices move even lower, some marginal mines will need to shut down, as they have in the past when prices have dropped. Combine those shutdowns with the approaching shutdowns of mines whose reserves are being depleted, along with the dearth of sizable zinc projects in the pipeline, and the supply picture looks dire even if demand doesn't continue to grow. New, smaller projects or restarts that can only succeed at higher metal prices wouldn't make it at much lower prices. Even if prices rebound strongly, if there are any supply disruptions like there have been with nearly every other metal, the supply increase that everybody has been expecting may not come as planned.

Even most bearish analysts admit that the expected oversupply of zinc won't last very long -- most expect it to only go through 2008, with a deficit returning in 2009 because of the lack of new supply. In our opinion, zinc is pricing in a huge supply glut over the next year, and even if it comes as expected, with the forward-looking market likely realizing that a deficit will be returning soon, longer term the price is more likely to strengthen from here than weaken.

Although shorter term, zinc prices will fluctuate based on such factors as those mentioned above, longer term the prices will be driven by supply and demand. We're confident that growing demand for zinc combined with a dearth of new supply beyond the short term will lead to strong zinc prices for many years.

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