ETFs To Watch On The Industrial Metals Recovery [SPDR S&P Metals and Mining (ETF)]

new etfsSo far this year we have witnessed a downward trend in iron prices while the prices of non-ferrous metals such as aluminum and copper regained lost ground and have been on the rise since. This is in stark contrast to the 2013 scenario, when iron ore prices enjoyed a bullish run unlike other base metals, thanks to heightened demand from steel end-consumers, particularly in the Chinese construction sector. Let us have a look at what led to the disparity in circumstances:

Iron: The commodity has lost 33% of its value so far this year impacted by myriad reasons like excessive inventory, abundant supply of iron as mining companies increased their output, as well as tight credit and slow economic growth in China. Global steel production improved merely 2.4% in the first seven months of 2014, mainly dragged down by a slowdown in China’s output that affected demand for iron ore, its main ingredient.

Oversupply continues to be the nemesis of the iron industry. Major iron ore producers, Rio Tinto plc (RIO), BHP Billiton Limited (BHP), Vale S.A (VALE) and Fortescue Metals Group Limited (FMG.AX) have ramped up production, betting on continued strength in iron ore demand over the long term. Australia, the world’s top exporter of iron ore, will continue to increase its shipments followed by Brazil.

On the other hand, apparent steel usage is expected to increase a meager 3.1% in 2014 across the globe. Steel usage in China, the largest consumer of iron ore, is projected at 3%, a sharp deceleration from the 6.1% growth in 2013. Thus, the mismatch between the supply and demand for iron ore will keep iron ore prices subdued in the near term.

Aluminium: After aluminum prices bore the brunt of chronic surplus, the global aluminum industry is going through a substantial change in the supply-demand picture. Companies like Rusal and Alcoa Inc. (AA) have cut back on production and took up a number of restructuring measures (including closure of smelters), and are also aggressively pursuing cost-cutting measures.

Aluminium prices have recovered from the four and half year low of $1,675 per ton in February to over $2,000 in August. The upward trajectory was driven by a 10% drop in LME inventories so far this year and tightening of aluminum supply due to production curtailments by aluminium producers. Furthermore, production cut down in Brazil, as electricity prices surged to records this year, led to the supply constraint. (Read: Are Biotech ETFs back on Track?)

On the demand side, aluminum consumption is expected to improve throughout the world, spurred by the automotive and packaging industries ― the key consumer markets. The automobile market is becoming increasingly aluminum-intensive, given the metal’s recyclability and light-weight properties. The global push to make vehicles more fuel efficient is expected to more than double the demand for aluminum in the auto industry by 2025. The airline industry is also expected to boost demand for the metal.

Following China, which accounts for over 40% of the global aluminum consumption, India appears promising as its current low level of aluminum consumption and high urban population growth make a favorable combination for increased demand. With demand remaining strong and the industry pulling the reins on supply, the aluminum market is likely to witness deficits for a prolonged period which creates a supportive backdrop for high aluminum prices.

Copper: For most part of 2013, oversupply and lack of demand kept copper prices in check. In August this year, copper prices made a comeback, rising 3.3% last week amid signs of a strengthening economic recovery in the U.S, which is expected to support strong copper demand, being the world’s second-biggest consumer of industrial metals. However, weakness in the Chinese economy will continue to be a drag considering that it accounts for about 40% of the world’s annual demand.

Notwithstanding the current volatility in prices, we have a long-term bullish stance on copper, supported by its widespread use, limited supplies from existing mines and the absence of significant new development projects. In the near term, prices will be influenced economic activity in the U.S. and other industrialized countries. Revival in demand from China will also act as a catalyst. (Read:Play the Manufacturing Boom with this top ranked ETF)

Overall Outlook for the Industrial Metals

At the beginning of 2014, the outlook for industrial metals was bleak as increased supply and insufficient demand exerted a downward pricing pressure on commodities. But eight months into the year, the situation has changed with once laggards – aluminum and copper – showing signs of revival. These base metals prices will improve on the back of growth in the U.S. and an improving global macroeconomic scenario, as well as an improved supply and demand balance.

On the other hand, a glut in supply and current high inventories will keep iron prices in check. A revival of the Chinese economy and correction of the supply-demand imbalance will be instrumental in driving growth in the industry. Consequently, a similar recovery can be expected in case iron as has been noticed in aluminum and copper.

ETFs to Tap the Sector

An ETF approach can help spread out assets among a variety of companies and reduce company-specific risk at a very low cost. There are currently two ETFs available to play this sector, riding on the current recovery.

SPDR S&P Metals & Mining ETF (XME)

Launched in Jun 2006, XME seeks to replicate the S&P Metals and Mining Select Industry Index. With AUM of $525 million, XME is the largest and most popular fund in the metals and mining space. It has a trading volume of roughly 1.2 million shares a day. The ETF is a low-cost choice, charging a net expense ratio of 35 basis points a year, while the dividend yield is 1.20% currently.

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