Featured, Research and Interviews

The Case for Base Metals with BMO’s Bart Melek

 

Resource Intelligence spoke with BMO Senior Economist Bart Melek just prior to the 2008 PDAC. We asked him some tough questions then, just as the economy was beginning to show signs of tanking in earnest. Melek made some insightful and erudite observations: He thought copper was going to downtrend and it did; he foresaw credit becoming much tighter with a combination of factors, including the subprime mess, banks hording capital, and the reassessment of mining projects. If Melek was wrong on any point, it was just on the degree of his calculations. It turned out things were much worse than he thought.

Click play to listen to the entire 40 minute intervew with BMO Senior Analyst Bart Melek. Read excerpts from the interview below.

Global Resource Reference: We spoke a year ago about copper and zinc and looking back on our conversation you were very much on the money with pretty much everything you said: You thought copper was going to downtrend and it did; you saw credit becoming much tighter with a combination of factors, including the subprime mess, banks hording capital, and the reassessment of mining projects. If you were wrong on any point, it was just on the degree. Did things get worse than you thought?

Bart Melek: Most certainly worse than I thought, but you know it’s good to know I was right! The big surprise was the events following October, right after Gordon Brown was forced to bail out the British Banking system. We already had a very tight credit situation and a US economy that was slowing demand. Then came October where things went from moderately bad to the sharpest global slowdown in at least sixty years.

GRR: I’ve heard recently that in this type of situation the resource sector is the first one to feel the pain but also among the first to see the recovery.

BM: Yes, I think resources and resource equities will be among the first out. What we have seen in this cycle is the sharpest decline in commodity prices – ever. At least since we have kept records. It was the sharpest and the quickest, not only for commodities but the equity evaluations that followed. And this credit crisis is also precipitating the quickest and fastest adjustment on the supply side. But once that is over and once the credit markets unclog, and fiscal stimulus starts working, we will see a marked improvement in base metal prices.

GRR: So, for 2009, what’s your outlook for copper?

BM: Copper I think is going to be very weak this quarter. We are looking at maybe $1.50/lb average and the risk is to the downside. Copper has actually outperformed the vast majority of other metals. When you compare it to other metals like aluminum where 70% to 90% of producers have costs higher than the current price, then copper still looks good. We are seeing very aggressive production cuts and inventories not risen quickly in copper compared to other years, but from a historical perspective they are nowhere near an all time high in terms of relative demand.

GRR: To me, that sounds like the turnaround is in the offing somewhere beyond 2009?

BM: I think we’ll have a combination of a return to growth, but some surpluses, too, and we’ll have to eat through that inventory, so it is not going to be a quick run by any stretch. Unlike previous cycles this cycle didn’t have years and years of surpluses. This year we are looking at a 3% surplus, 300,000 or 400,000 tonnes judging by how quickly companies are cutting production.

Our projections for copper are around 3% growth over the next decade. You take derelict facilities into account and reduced orebody efficiency and yields, and you can imagine quite easily that in the next two to three years we are going to have very tight physical markets and it’s not all that risky to say that it could mean prices could jump because at this point what is happening is unfunded projects are being eliminated, you have heard the various announcements.

GRR: Would you say then, that down the road copper will come back strong?

BM: Yes. If you assume that the world is not going to collapse, and you view things the way we do, I think that growth globally will continue. You have to assume that if China continues to grow its infrastructure by 30% or so, that creates demand and if you have no projects moving forward at this point because of this price environment and credit crisis, then you are setting yourself up for shortages further down the road.

GRR: What is your outlook for nickel?

BM:  Nickel will do a little better because producers have cut so dramatically. We’ve had the Chinese smelters close down earlier last year, and at the same time we have steel production massively lower. We are estimating anywhere from 10% to 15% less steel being produced globally.

Nickel is a tiny market. We have essentially 20 days of inventory out there and I think that could be reversed quite quickly once production comes back. This is based on the fact that the fiscal and monetary packages will work, if they don’t we have bigger things to worry about than commodities, such as deflation.

Longer term, we are saying $9/lb for nickel, which seems quite high at this juncture but when nickel was $25/lb and we were saying $9/lb people were saying we were out of our mind, so there is just no pleasing.

GRR: Nickel demand has grown at a rate of 4% per year during the past decade at a rate most metals would envy, this has now slowed substantially. What do the supply and demand fundamentals look like for Nickel?

BM: We will likely see a nickel surplus this year. In 2007, there was a surplus of 52 kilotons; for 2008, it looks like a surplus of 20-25kT. This year, who knows but I would say there is going to be a surplus of more than we’ve seen. We’re projecting that as the year unfolds and demand picks up we see nickel moving from $5 per pound in the first half of the year to around $6 per pound or so in the second half of 2009.

GRR: What does it take to stop the bleeding, to stop these mines going on care and maintenance?

BM: We’re there already. Today nickel is at $4.98 per pound. At that price, I would say about 85% of producers are under water. So, today’s price implies, if one believes there is an equilibrium price that some 80% of demand is going to be destroyed.

I think prices have fallen certainly because supply and demand fundamentals have eroded them, but I think in no small way are they driven by the fact that this credit crisis has dried up liquidity and eroded confidence and basically forced people to liquidate their holdings of commodities and commodity based stocks a lot quicker than they thought they would.

GRR: Aren’t we in danger of going to the other extreme where there is just not enough cash available for exploration and mine development?

BM: Absolutely. And that is the thesis that BMO has essentially, that things look grim in the short run but the further out you go, and if you believe that the world is not going to collapse and that things are going to normalize, the current destruction of future supply could create what I call a “auction price environment”, where supply and demand are out of whack, where demand is outpacing supply, and the way you balance is through demand destruction, and that is where you set up a theoretical auction, like we’ve seen with nickel at $25 per pound, like we’ve seen with zinc at over $2 per pound, copper at over $4 per pound. I think there is a real danger of that happening again because these things are very inelastic. Once you shut down a mine, you don’t open it in a week or even a month. Once you take a greenfield project and you abandon it, that’s not coming back very quickly.

GRR: Based on that premise, a lot of this market will have reached its bottom at least in the base metals.

BM: I think we are very close to bottom of this stage.

GRR: How do you see molybdenum performing?

BM: We’re projecting $15 per pound by 2010, but we see moly at $12 per pound long term, which we define as after 2013 and we equate that with the price needed to bring on an incremental unit of supply to balance the market. So the long term price is based on the marginal cost of production. When we speak of the marginal cost of production, we’re talking about the price needed to bring an incremental unit of supply to the market, which is about $12 per pound. If you get below that level you can’t fund these projects and in fact we are seeing that right now with some mines cutting production, some going on care and maintenance and some development projects being halted.

GRR: Until recently, moly spent some time as the darling of the commodities industry and it has now dropped off a cliff. What happened?

BM: More sellers than buyers, I guess. Growth prospects have deteriorated, and the demand side has deteriorated greatly especially after oil dropped from $140 to $35 per barrel. Moly is a hardening agent for industrial uses and the demand there dried up.

Also, China’s power grid requirements were down about 17% last month, so a lot of moly projects will have to be put on hold. That’s what the market is discounting, but I think there has been a big overreaction not just on moly but on the vast majority of these metals.

GRR: So the fundamentals for moly are still strong?

BM: Yes, and I think the supply side looks particularly strong.

GRR: What are the main investment opportunities right now in base metals?

BM: I think zinc looks pretty good because inventories are fairly low in spite of the recent deep production cuts and mine closures. At this point, zinc is damn cheap. At $0.50 per pound, the vast majority of producers under water. You’ve had mines shut down, inventories are not all that huge, so once you turn those steel mills back on this can go towards the marginal cost of production in fairly quick order. When I say that, I mean within the next few quarters.

GRR: What other base metals do you see as strong right now?

BM: None of them are strong. Copper I think has performed the best. Zinc stocks are only nine days’ supply or something which is not high at all. And over 6% of mine production has been cut. When steel returns, you are going to have a very big jump in zinc requirements.

I like copper for the long term mainly because the supply is very elastic and it’s a staple for infrastructure. For China and the developing world, if they want to grow they are going to have to build infrastructure, which spells good news for copper.

GRR: So what else comes to bear on copper outside of housing?

BM: Power lines, telecommunications, natural gas systems. It’s all infrastructure. There are retail uses as well, as in automotive for radiators, heat exchangers in the chemical industry, you name it.

GRR: So, as the expression goes, it’s always darkest before the dawn, and right now it’s rather dark out there. Is now a good time to look for investments in base metals?

BM: I absolutely think it is the perfect time to do it. There is always a risk in the short run that you might go lower but I am not that smart and can’t figure out which specific moment in time we reach absolute bottom. I think prices are too low for virtually all the metals.

I may cut this due to space:

The world changed fundamentally after we saw the global banking and credit system implode. That sharp slowdown and the banking crisis brought down Chinese growth and exports sharply. Their exports dropped because the banks froze up and companies and people could no longer get credit. So global demand dropped and China got hit indirectly through its export conduit. I don’t think this is permanent—China has an awful lot of money and a huge economy. They will work it out but it’s not going to be a pretty few months ahead.

GRR: Well, China is like a big freight ship—it’s takes a while to build up speed, but once it’s underway, it’s not going to slow down quickly either.

BM: They have taken some right steps: They have spent $4 trillion on various infrastructure projects over 2 years. They have also made some monetary commitments keeping money supply growth at 17%, and they have eliminated restrictive monetary policies that dissuaded investment. With those steps I think we’ll see a return to stronger demand in the latter part  of the year. Also, I think commodity markets will start acting ahead of that growth demand, so I think we’ll see better things ahead in the second part of 2009.

About Bart Melek

Bart Melek, as a Senior Economist for BMO Capital Markets, has closely analyzed trends in global commodity markets, as well as in the Canadian and global economies for over a decade. He contributes to the Economics department’s strategic view by providing commentary on commodity pricing and how they relate to the economic outlook. Bark Melek is a key contributor to many of the department’s publications including Focus and AM Notes and is the author of “The Goods, a Report on Commodities”. As well, he is often quoted in the print media including the Globe and Mail, National Post, the Wall Street Journal and Barron’s.

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