15 mayo 2007

Zinc's Turn to Shine?

In December, we responded to readers’ questions about why the consistent drop in LME Zinc inventories had paused. Other than a one-day spike in June 2005, LME Zinc inventories had dropped nearly 90% in a very consistent pattern since April 2004, from 785,000 tonnes to a low of 84,825 tonnes, but that pattern appeared to have changed late last year.

From December through late March, a shallow uptrend developed, and media skeptics came out of the woodwork suggesting that the trend change in zinc LME inventories indicated a permanent shift in the supply/demand situation, as China became a “net exporter” of zinc. The truth was that a couple of short-term factors, delayed shipments from the world’s biggest zinc mine and a change in Chinese export tax law, had helped to create a short-term surge in refined zinc supply, causing a temporary pause in the downtrend.

Despite the media claims, China remained a huge net importer of zinc, as they imported more and more zinc in the form of zinc concentrate, which they then processed in their smelters to create refined zinc. Because they had dramatically increased their refining capacity via rampant smelter construction, China had decreased their refined zinc imports relative to their zinc concentrate imports, using their low-cost advantages to process the zinc raw materials from other countries to the extent that they were exporting more refined zinc than they imported. However, the huge consumption of zinc in China’s growing economy, far exceeding the capacity of their own mines, compelled them to remain huge net importers of zinc overall, importing enormous amounts of zinc concentrate from overseas mines. Conveniently, the media zinc skeptics never mentioned the fact that China was relying on other countries for much of the zinc concentrate they used to produce refined zinc, instead focusing only on the “net exporter” status for the refined zinc finished product.

We said in December that “We expect the zinc crisis to become very evident after the effects of the Red Dog shipment spike have dissipated by the end of Q1.” After the peak in LME Zinc inventories in late Q1, they have steadily declined to hit a new low, at 83,725 tonnes, below the December low of 84,825 tonnes, so we can see that the pause in the downtrend was only temporary. Since the current level represents only about 2 ½ days of inventory, there’s not a lot of room to move lower. There’s a “frictional level” of LME inventories required to maintain an orderly market. It will be interesting to see how the zinc price responds to lower levels of inventories, as at some point the price will have to move high enough to curtail the demand so that the LME inventories don’t get completely depleted.

In addition to the previously mentioned factors for the earlier surge in zinc supply, another factor may decrease future world zinc supply. China has taken actions to decrease their zinc production capacity, requiring new zinc mines to have at least an annual capacity of more than 30,000 tons and an operation life of 15 years, capping the country’s refined zinc production capacity, and reportedly removing the 5% tax rebate on exports of refined zinc. With the enforcement of these new regulations, China will likely need to rely even more on foreign sources of zinc concentrate, and other countries will need to step up their production of refined zinc to make up for China’s supply reduction.

Moving forward, we really like the fundamentals for the zinc market, as we explained in December: “After the short term surge in supply from these 2 temporary events is absorbed by the market, we expect zinc to remain very strong because of the dearth of sizable projects in the pipeline for the next few years combined with growing demand and depletion of reserves at existing mines. We believe the fears in the market that the recent short-term trend change in zinc LME inventories could indicate a permanent shift in the supply/demand situation are misguided, and we expect that to become apparent in coming months. If the downtrend resumes as we expect, we believe the only way the LME Zinc inventories will avoid complete depletion is with zinc prices increasing enough to curtail demand.”

The timing for strength in zinc mining companies is excellent. A year ago, one of the sharpest and most respected institutional commentators, Don Coxe, explained on a conference call that “there are 3 major movements in this metals bull market, and we're nearing the end of the first one. The second one will be a slowdown, where I expect the prices of commodities to correct after the initial big runup. The third one will be a dramatic move that lasts at least 5-7 years.” He specified that “the next 12 months would be 'great fun' but a very different game, and would provide the ‘last great opportunity’ for the next 5-7 years. The next economic cycle after that will be a giant.”

Over the past year, we’ve seen the second movement play out, with sharp corrections in the prices of commodities. Most zinc junior miners remain well off their highs of a year ago, and are poised to bounce back during the strong third movement. In his latest conference call, Coxe reiterated that he feels “as strongly as ever that the best is yet to come.” He also emphasized that although “because of compliance problems and the kinds of clients that we serve, we have to comment on the big cap stocks, that more money is made in any boom like this by buying small caps,” meaning “you’re better off if you can find small cap mining companies who have got reserves in the ground than you are buying big caps – the leverage is terrific, and you can also assume that they’re going to get taken out, if the stock market obstinately refused to bid them high enough.”

After the recent rallies in uranium, nickel, molybdenum, and copper mining stocks, we believe that it is now the zinc miners’ turn to shine. With arguably the best supply/demand fundamentals for at least the next few years, zinc is the only base metal whose price is still down on the year. We believe that laggard status will soon change as the zinc crisis becomes more evident, drowning out the media skeptics’ misguided claims. Quality small cap zinc miners may be the next group to shine in this bull market.

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