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"Fitch says base metals are a 'mixed bag' as costs eat into margins"

Despite describing base metals as a "mixed bag," Fitch Ratings has maintained a "stable" ratings outlook for base metals, citing some metals prices that have reached new highs this year despite new supply and weakening demand from the U.S. and Europe.

Noting that demand from China and other developing nations "continues to drive strong growth in consumption, Fitch analysts forecast that "price volatility, intensified by tight supply, is expected to persist over the short-to-medium term."

Nevertheless, Fitch noted that constraints to mining company earnings persist including: declining ore grades; rising energy and fuel prices; capital, consumable and labor cost inflation; and increasing governmental and non-governmental public action to curtail production. Fitch does not expect costs pressures to ease in the medium term.

"Persistent weakness in the U.S. dollar tends to adversely affect margins, especially where costs are incurred in Australia, Canada, Brazil and Europe. By-product metal credits-particularly from molybdenum or gold-should continue to strongly benefit earnings," the analysts said.

Recent Chinese production cuts due to weather, an earthquake, power shortages, and curbing pollution up to and during the Olympics are not expected to have a significant or lasting effect.

COPPER

Fitch expects copper consumption to grow about 4% over the next 18-24 months. Copper supply is forecast to grow about 3% annually in the short run given continued production disruptions. Overall the copper market should remain relatively tight over the next 18-24 months.

"Prices could moderate further but should remain at historically high levels," Fitch predicted.

The analysts said, "The copper market, at 18.1 million metric tons (mt) in 2007, is exhibiting continued tightness in the face of robust demand from China, India and Russia; declining demand from other industrial economies; and limited new supply." China, which accounted for 25% of international copper consumption in 2007, "should continue to show growth drive by the building of power generation facilities and the upgrading of urban infrastructure."

"Copper has been seeing demand destruction as a result of sustained high prices and short supply," the analysts advised. "In particular there has been substitution in plumbing applications with polyvinyl chloride tube, and replacement by thinner-walled narrower tubes in air conditioning applications."

Aluminum can be substituted for copper in power cables and electrical equipment, and optical fiber in telecommunications. Fitch estimated that 1 million mt of copper has been replaced by aluminum or plastics over the past five years.

Supply has been limited by strikes, natural disasters, declining ore grades and operating delays as production has undershot expectations by 4% annually over the past four years and by 5% in 2007. Additional production is expected this year from Codelco's Gaby (150,000 mt) and Andina (120,000 mt); Equinox Minerals' Lumwana (169,000 mt); and Oxiana's Prominent Hill (90,000 mt), according to Fitch

While copper production costs have benefited from moly, gold and other by-product credits, the analysts noted that "markets for consumables are exhibiting tightness and very high prices." For instance, sulphuric acid contract costs have incr5eased at least $100/mt due to high fertilizer demand. Meanwhile cash costs are up 10-cents per pound due to acid costs.

"On average production costs are up 60% over the past four years," Fitch said, adding that capital expenditures have increased 45% during the past two years.

NICKEL

Fitch expects nickel prices to remain volatile, "but to trend downward as new production comes on stream. Should prices remain below $10/lb. we would expect some supply destruction."

Primary nickel production is expected to increase steadily by 6% this year, according to Fitch.

In their analysis, Fitch said that new stainless steel capacity additions in China are expected to drive strong nickel demand in the medium term. Demand is expected to increase more than 6% annually over the next 12-18 months due to restocking as well as demand from Chinese stainless steel mills.

ZINC

"Currently, the market looks to be in surplus, but may become more balanced with reduced production or delays in development," according to Fitch. For example, AIM Resources suspended development of the Perkoa Zinc project in Burkina Faso until zinc prices and financing improve.

"With the price declines over the past year and expectations of a surplus, some high-cost operations are expected to be shuttered," the analysts advised, who also correctly predicted the decision to close the Lennard Shelf Pillara zinc mine in Western Australia. Meanwhile, mines comprising an eventual total capacity of 235,000 mt are scheduled for completion this year.

The analysts noted that zinc consumption through the month of May this year has increased 1% over the same period of 2007 despite weakness in North America and an 8% decline in Europe.

ALUMINUM

Fitch expects aluminum demand and supply "to show a slight surplus."

While aluminum consumption growth in China and other transitional economies is expected to continue to be robust, energy use to manufacture aluminum is now 40% of total costs. "Given this dominance, the industry cost curve has been both rising and flattening, tending to underpin current prices," according to Fitch.

South African and Chinese power production cuts on domestic aluminum manufacturing are expected to have an impact on overall global aluminum supplies.

The analysts produced the base metals report include Monica Bonar in New York, Sean Sexton in Chicago, Peter Archbold in London, Maurice O'Connell in Sydney, Su Aik Lim in Tokyo, Joseph Bormann in Chicago, Giovanny Grosso in Santiago, and Priyamvada Balaji in Mumbai.