Nickel: A Bellwether For Copper? (JJN, JJM, UBM, RJZ)

Lara Crigger:  Is this year’s worst-performing LME metal a canary in the coal mine for copper? And is there any hope in sight for nickel prices?

Tolstoy once wrote, “Happy families are all alike; every unhappy family is unhappy in its own way.” He might as well have been writing about industrial metals.

Not two weeks ago, we took a hard look at tin, a market struggling to resurface under the weight of the lackluster economic recovery. For any industrial metals follower, the story should sound familiar—most metals have lagged similarly.

But the base metals sector is far from a happy family right now, and the bearish conditions plaguing each of the metals are not all alike. Take nickel for example.

Nickel used to be the superstar of the base metals scene: Prices struck a three-year high back in February of $29,425/tonne, rising since 2005 on the back of emerging market demand.

But since then, spot nickel has tumbled about 27 percent, and the metal has become year-to-date the worst performer on the London Metals Exchange (LME). In fact, nickel briefly touched its lowest price since last November on Monday, before closing at a yawn-inducing $21,650/tonne.

So what happened for nickel to fall so far, so fast?

Mine Supply Overwhelms Demand

Like a true Russian hero, nickel has become a victim of its own success.

In dollar terms, the nickel market’s overall value is closer to silver than gold, but it’s a hard metal to substitute. Nickel demand is primarily driven by stainless steel manufacturers, as it’s a key ingredient in producing this corrosion-resistant alloy. More than 60 percent of all nickel mined annually goes straight to the production of stainless steel, used in everything from cars to kitchen appliances to skyscrapers.

Naturally, the emerging market boom has been kind to the metal. Since 2005 or so, increased demand from China, Brazil and other developing markets has driven nickel demand sky-high.

But miners have had trouble keeping up with the pace of this new demand. Indeed, construction delays, technology setbacks and higher manpower costs have kept worldwide nickel production stagnant for years; from 2008 to 2010, nickel saw essentially no net growth in mine supply.

But the days of supply playing catch-up to demand are over.

After years of delays, several new mines have finally come online. In Brazil, both Vale and Anglo American launched production at new sites earlier this year, while Xstrata plans to start production in New Caledonia next year. In fact, Vale is so optimistic about its new projects that it has projected a 56 percent increase in nickel output this year alone.

Indeed, new forecasts from Macquarie project that global nickel mine production should rise 10.1 percent this year, and 11.3 percent in 2012—the biggest increase in 17 years.

More than half of this supply increase comes from China, which has this year boosted output of so-called pig iron by 48 percent. (Pig iron is a low-grade form of nickel only produced in China.) As other new nickel mines elsewhere dallied on going online, pig iron has helped take up the slack.

What’s more, demand for the metal took a hit earlier this year, after the Tohoku earthquake in Japan wiped out a substantial amount of industrial production in the country for months—the country’s automakers (major consumers of stainless steel) are only just now getting back online. Lower demand has spread to other countries too; Acerinox, the world’s largest stainless steel producer, plans to cut its workforce in Spain, while Germany’s largest steelmaker, ThyssenKrupp, announced a restructuring effort to reduce costs and cut debt.

A Nickel Surplus?

No wonder the International Nickel Study Group (INSG) for months has predicted a massive nickel surplus. Back in April, it projected the 2011 nickel market would see a surplus of 60,000 tonnes, compared with last year’s 30,000 tonne deficit. That would be the highest surplus in four years.

If the surplus does materialize, however, it will need to happen in the second half of 2011. The most recent data from the INSG says that the refined nickel market has shown an overall 16,000 tonne deficit so far this year—neatly matched in the 20,000 tonne decline in LME stocks over the same period.

As we covered in last week’s Base Metals Report, LME inventories are now well below their five-year average. On Monday, LME nickel stocks fell to 110,880 tonnes; since the start of the year, inventories are down nearly 20 percent, to two-year lows. And generally speaking, falling LME inventories are usually a bullish sign for a given metals market.

Still, don’t get your hopes up, says Michael Widmer, Bank of America Merrill Lynch’s head of metals market research.

“The second half of this year is going to be weaker, by and large, than the beginning of this year,” he told Bloomberg. “You’ve got a slowdown in stainless-steel production and nickel demand growth, but you have got more supply as well.”

Prices: Stable At $20,000
Does nickel have much further to fall? In the same Bloomberg interview, Widmer estimated the marginal cost of production at about $17,500 to $20,00/tonne across the industry—and some miners are already hitting that, particularly in the pig iron sector. A note from Barclays released Monday stated, “Prices have begun to eat into the cost curve resulting in negative margins for some of these high-cost producers.”

What’s more, as Japanese automakers rev their production facilities back up, their demand for stainless steel should likewise recover. That too should support nickel prices against falling too much further.

Viktor Sprogis, deputy chief executive of Norilsk Nickel, told the Financial Times he thought prices should be supported at $20,000 a tonne. “Below $20,000, a lot of producers, not only Chinese and not only pig iron, will start suffering economic problems,” he said.

In fact, one Barclays analyst argues that nickel may have already fallen too far. “At these levels, nickel is looking oversold,” metals analyst Gayle Berry told Reuters. “From a fundamental perspective we don’t see any reason why nickel has underperformed to this extent … I think the market is pricing in expectations of a better outlook for supply in the second half of the year.”

The Canary In The Coal Mine?

Some have already begun to wonder whether nickel’s fall from grace offers clues to what might befall other industrial metals—particularly copper.

Many analysts predicted a copper shortage for this year—one such estimate called for the worst shortage since 2004—but so far, the shortfall has yet to emerge. In fact, the opposite seems to be true, as record prices have led to some demand destruction among industrial buyers. At 472,825 tonnes, LME inventories still hover around their highest levels in more than a year.

David Wilson, director of metals research for Société Générale, told the Financial Times he thought copper may already be in a similar situation to nickel.

“You’re beginning to get the miners’ response to the 2005-07 prices from next year,” he said. “There’s a lot of reason to think for the current cycle we’re not going to see any more price highs in copper.”

If so, then perhaps these unhappy families are more alike than it may first appear.

Playing Nickel

The iPath DJ-UBS Nickel Subindex Total Return ETN (NYSE:JJN) offers the market’s only pure-play option for nickel. Unsurprisingly, the ETN isn’t doing so hot year-to-date, having dropped 13.81 percent.

Still, given the February top in nickel prices, the fund is up 9.2 percent over a one-year period:

Nickel also appears as a relatively significant component of the iPath DJ-UBS Industrial Metals Subindex Total Return ETN (NYSE:JJM), the E-TRACS CMCI Industrial Metals Total Return ETN (NYSE:UBM) and the Elements Rogers International Commodity Index – Metals Total Return ETN (NYSE:RJZ). Percentages are 12.30 percent, 9.66 percent and 7.14 percent, respectively.

Still, as these ETNs are mixed baskets of metals futures, they’re naturally dominated by their much larger exposure to copper and aluminum (72.8 percent, 76.0 percent and 57.1 percent, respectively). So any investor looking to make a nickel play would do better to focus squarely on JJN.

Written By Lara Crigger From Hard Assets Investor (HAI) is a research-oriented Web site devoted to sharing ideas about hard assets investing. The site has been developed as an educational resource for both individual and institutional investors interested in learning more about commodity equities, commodity futures and gold (the three major components of the hard assets marketplace). The site will focus on hard assets investing without endorsing or recommending any particular investment product.

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