Base metals: What’s in store

With commodities being inherently volatile, should you avoid base metal stocks in your portfolio? We dissect the fundamental drivers of four of the most traded metals to get some answers

The year 2018 was quite disappointing for all base metals, in contrast to the good performance in 2016 and 2017. The LME (London Metal Exchange) prices of the five traded base metals — zinc, aluminium, copper, lead and nickel — have declined owing to global uncertainties triggered by trade tensions between the US and China.

Besides external factors, specific events that disrupted the fundamentals of metals too impacted prices through last year.

News of US sanctions on Russian aluminium firm, Rusal, spiked the prices of the metal, taking it to a multi-year high. Closure of Vedanta’s copper unit in Tamil Nadu impacted the price of LME copper. A 25 per cent hike in import tariff on steel by the US, made zinc prices fall steeply by almost 24 per cent, as zinc is the key input in the production of steel. Lead prices fell, following the price action in its sister metal zinc, though there was no specific event directly related to the metal.

Owing to the inherent volatility of these commodities, should you avoid base metal stocks in your portfolio? We dissect the fundamental drivers of four of the most traded metals to get some answers.

Copper: Margins could be under pressure

In line with the decline in prices of all metals in 2018, copper prices traded on the London Metal Exchange fell by about 17 per cent.

But the softening of trade tensions between the US and China and the decline in LME inventory of copper have lifted the prices since the beginning of this year. But is this good for the Indian copper industry?

Not really. This is because most of domestic copper players such as Hindalco and Vedanta import copper concentrate and convert it to the copper metal. The price of the copper concentrate is fixed by deducting the global treatment and refinery charges (Tc/Rc) on a particular day from the LME prices.

Movement of Tc/Rc charges is based on the global production of copper ore. If production is high, demand for smelting increases and the Tc/Rc charges also rise. But the non-availability of copper concentrate in the global market moderated the Tc/Rc charges in the last couple of years.

A recent report by Yes Securities says that global treatment charges slumped to $79 a tonne last December, from a high of $105 per tonne in 2016. Lower Tc/Rc charges increase the cost of imported copper concentrate for domestic players and reduce their margins. Performance of domestic players has, therefore, not been impressive so far in FY19.

Vedanta’s copper plant remains shut due to environmental issues and Hindalco’s copper unit is under pressure, because of lower volumes and declining realisations caused by lower Tc/Rc. The operating profit of the copper plant for the nine months ended December 2018 was ₹1,154 crore, down 5 per cent from a year ago.

However, to hedge against volatility in the LME prices and the Tc/Rc charges, Hindalco is increasing its focus on value-added products such as CC (copper cathode) rods. This has helped boost revenue, despite a fall in volumes and realisations in the third quarter of FY19. But it has failed to translate into similar growth in earnings, owing to the higher input costs of coal and fuel.

According to CRU (Commodity Research Unit), the global mine output is expected to grow at a compounded annual rate of 1 per cent between 2016 and 2022 compared with 4.7 per cent between 2011 and 2016. Slow mining output is expected to be an impediment to the rise in the metal’s Tc/Rc charges.

This would put pressure on the margins of Hindalco’s copper unit unless it significantly increases its share of value-added products.

In case of Vedanta, it would continue to lose about 5 per cent contributed by its copper unit to the operating profit, until it is opened.

Hindustan Copper, a relatively smaller but integrated copper company, would benefit from rising refined metal prices.

Aluminium: Higher cost, a dampener

While the tight global supply of aluminium is supportive to prices, weaker demand in the large consuming geographies — Europe, US and China — is expected to keep prices of the metal subdued.

Norsk Hydro, one of the largest aluminium companies worldwide, estimates global primary aluminium demand to grow by 2-3 per cent in 2019, down from 4 per cent in 2018.

Experts believe that the current deficit in the aluminium market is temporary, caused by shutdown in capacity on account of lower prices. Smelters in China would be reopened once the prices of the metal go up; this will again exert pressure on the prices.

In India, though the production and consumption of the metal are healthy, prospects of Indian players do not look very impressive due to increased production cost.

A report titled ‘Need for an Aluminium Policy in India’, published on NITI Aayog website, states that from 2003 to 2018, the cost of producing aluminium in India has increased 73 per cent. This was higher than the rise in LME prices of aluminium, which grew 64 per cent in the same period. The report states that India has the highest cost of production among the larger producers of aluminium such as Canada, Russia, Norway, and China, mainly due to higher taxes on mining and power costs. The rise in the cost of alumina, a key input, also dragged down profits. Power and alumina costs of an aluminium company accounted for about 80 per cent of sales in the first nine months of FY19, up from about 60 per cent of sales in FY17.

Companies are not able to pass on the increased costs to customers because sales happen at the LME prices of aluminium, which factor in the global supply and demand situation. Among the three major aluminium players in India — Nalco, Hindalco, Vedanta — Nalco seems to be better placed with higher margins. This is because Nalco is self-sufficient in alumina mining reserves. After meeting its own requirement to produce aluminium metal, it exports the balance at high margins; this boosts the overall profits.

Though Hindalco’s Indian aluminium segment is under pressure, the company’s US subsidiary, Novelis — producer of rolled aluminium and beverage cans — offers good prospects due to strong demand and cost-control measures.

Indian aluminium segments of Hindalco and Vedanta are feeling the pinch, recording de-growth in operating profits due to lower LME prices and higher costs. However, the companies’ increased focus on value-added products from upstream aluminium business, is expected to give a leg-up to profits.

Zinc: Watch out for production ramp-up

Zinc lost its sheen in 2018 as the metal’s LME prices fell steeply by about 24 per cent over the year. This impacted the top line of zinc-producing companies.

The fall in prices could be attributed significantly to the imposition of 25 per cent tariff on steel imports by the US.

Zinc prices are influenced by the steel industry as more than 50 per cent of zinc is consumed for galvanising steel.

In addition to lower realisations, India’s largest zinc producer, Hindustan Zinc, was also impacted by the reduction in output.

The company, which has a near-monopoly in the zinc market in India, has moved completely from open pit mining to the underground mining, since the beginning of FY19.

Affected by this transition, the company’s zinc production has fallen by about 11 per cent in the nine months ended December 2018.

During the said period, the company’s total operating profit fell by 14 per cent to ₹6,568 crore due to lower volumes and realisations and higher cost of production (CoP) in the zinc segment.

The CoP of zinc went up by 12 per cent Y-o-Y significantly on account of rupee depreciation, as two-thirds of the company’s costs are dollar-linked.

The production loss from the company led to India becoming a net importer of the metal after being a net exporter for the past few years.

In 2018, while zinc exports declined by 22.8 per cent to 217,000 tonnes, imports increased by 9.4 per cent to 186,000 tonnes, compared with 2017, as per CARE Ratings.

The LME prices of zinc are expected to move up due to deficit in the global market. Global zinc deficit in 2018 was 3,93,000 tonnes. Experts believe that zinc prices will rally to at least $3,000 per tonne, going forward.

Meanwhile, Hindustan Zinc is ramping up its underground mining and is confident of achieving a production target of 1.2 million tonnes in FY20, a growth of 20 per cent from FY19.

Consumption, which depends on the steel industry, is expected to be healthy with increase in demand in segments like pre-engineered buildings, general engineering, railway, and other government-aided infrastructure projects.

The recent GST rate cut announced on real-estate projects too should help revive consumer demand.

This, along with cost-control measures, will help Hindustan Zinc go back to higher operating profit levels.

Lead: stable outlook

The LME prices of lead have also fallen by more than 20 per cent in 2018, taking cues from its sister metal, zinc, and uncertainties in global trade. Like any other metal, lead is derived from primary and secondary (recycled metal) sources. Since recycled lead is as good as the primary output, 65 per cent of the global metal’s output is derived from recycling.

However, recycled lead and primary lead are traded at the same price on the LME. In India, while Hindustan Zinc is the only key player in the primary market, there are nearly 448 players for metal recycling, mostly from the unorganised sector.

In FY19 (nine months ended December 2018)Hindustan Zinc witnessed 20 per cent Y-o-Y growth in lead’s revenue on account of higher output and rupee depreciation, despite the LME realisations falling sharply. For Gravita India, a secondary lead metal-producing company that imports scrap and exports mainly the finished product, though revenue grew, margins were under pressure perhaps due to lower realisations and higher costs.

Demand for lead is driven mainly by lead acid batteries used in automotive and industrial sectors. The prices of lead are expected to move up due to limited supply of global lead concentrate. Consumption too may grow at 2-3 per cent per annum in the next five years.

‘Balanced to positive outlook for metals in the next one year’

Gopal Agrawal, Senior Vice-President - Equity, DSP Mutual Fund, closely tracks commodities and international trade. In an interview with BusinessLine, he says that the US and China will arrive at a middle ground in the trade war, and the outlook for base metals is balanced to positive in the next one year.

Excerpts:

What are your views on the on-going trade tensions?

The trade tensions currently are due to the imposition of 10 per cent tariff on goods exported from China. The effect, so far, has not been detrimental. The real issue will crop up when the proposed tariff of 20-25 per cent is imposed on goods valued at about $300 billion. We will feel the heat if negotiations fail. But in the end, the US needs China and vice-versa. They would, probably, find a middle ground.

But China’s February exports already seem at a multi-year low..

China’s trade in February was down because of early Chinese New Year. If we consider the trade balance figure for two months — January and February 2019 — on an aggregate, it was 5 per cent trade surplus. Trade balance is deteriorating, but I think the situation is still under control.

Will China’s stimulus measures help spur infrastructure growth?

China’s stimulus measures may not benefit infrastructure. Its focus has shifted from developing infrastructure to boosting consumption.

What’s your outlook on the prices of base metals in the next one year?

Every metal has a different dynamic. In the case of aluminium, the global output is almost balanced, as China has surplus, and the world, ex-China, faces a minor deficit.

Low energy prices due to deflation in the world limit the cost of production and increase metal prices. I expect aluminium to bottom close to $2,000 per tonne (including premium of $100 per tonne).

Coming to copper, though there is a global deficit, prices are not expected to flare up as there is a slowdown in the economy. Technically, copper prices should be three times that of aluminium’s.

Zinc is a metal for which there is a clear deficit globally. We are likely to see strong prices for this metal — $2,500 plus per tonne.

And, lead is a by-product of zinc. The primary driver for lead demand is lead acid batteries, which can be replaced by advanced batteries when electric vehicles take to the roads. And many countries are banning lead because it is carcinogenic.

Other than this, there is no big fundamental driver for lead. Prices of this metal will move in line with that of zinc, but should remain around $2,000+-$200 per tonne.

So, overall, I see a balanced to positive outlook for the base metals industry.

The only risk to my assessment is, if protectionism goes to greater heights, global trade will be affected and drag prices.

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