Squirrels and Stents

In London this week I spoke with a private equity fund specialising in the mining and metals sector which has a keen interest in zinc. They cast a critical eye over the limited pool of development-track projects held by Juniors and the conclusion was that athose reviewed lacked quality and some had significant flaws or red flags.  This combined with the procession of zinc mine closures over the next few years tells me that we are looking at a train crash in slow-motion.  Why do I say this?  It takes seven to ten years of dedicated commitment from effective management teams and investors to discover and develop a new zinc mine.  For some time now it has been particularly difficult to finance earlier stage zinc exploration projects.  However there are some green shoots as can be seen this week with the positive market response to a Junior’s drilling results at a carbonate-hosted zinc-lead project in Turkey,  which I visited earlier this year, and I am quite taken by the potential for discovery of  relatively small but high-grade  deposit extensions and indeed completely new deposits within a little known but historic zinc mining district.

If you explore for a metal or mine ore and produce a concentrate then it probably makes sense to try and understand the market for the refined end-product.  The zinc market is more or less in balance and we have seen zinc prices relatively flat over the last few years despite historically high zinc inventories.  China which consumes about 45 percent of the world’s zinc supply and is also the biggest miner of zinc is the pivotal in supply-demand equilibrium going forward and the driver behind the medium-term zinc price. Or is it?

Squirrels gather and hoard nuts and although prone to greed the intention of this seasonal gathering of such a busy little animal is not to create a shortage for others but to survive the winter.  It seems that the human species can be more devious and calculating and indeed can hoard to create shortages and strangely this can be under the shady umbrella of legitimacy.

LME warehouse zinc stocks peaked in 2013 at just over 1.2 million tonnes and they are now at about half that level.  A critical parameter for stocks is the measure of how many days of global supply these stocks represent and it is this metric which seems to be more important to price historically than some prediction of a looming medium-term demand-supply gap, no matter how compelling.  However there is the visible and the invisible and within the visible the question of what is available and not bound up in financing deals and how quickly you can physically load the metal out of a warehouse.  It is the so called load-out-rate which is the problem and which may require a “stent” to unblock the arterial flow of metal to to galvanizer.  So for that reason let us take a glimpse at warehouse inventories and the part played by speculators and traders.  It is only a glimpse to whet the appetite as it is a complex world of intrigue.

Zinc technically went into slight deficit in the last quarter of 2013 but did not impact price much because inventories are still at relatively high levels.  In the last 30 days zinc stocks have declined by nearly eight percent.  This might seem good for the zinc price but there has been a disconnect between stocks and price over the last few years.  In fact exchange stocks have little relevance to price setting on the LME.  The fall in inventories has been driven by a rush to lock in financing deals for zinc while they are still profitable.  This erosion of zinc stocks is happening at a time when supply and demand is almost in balance and not as one might expect by strong surges in demand which cannot be met.  The reason is that only a fraction of the zinc inventories in warehouses is going to the end user for galvanising steel, most of the metal is underpinning financing deals.  So what are these deals?  Banks and investors store metal in warehouses to take advantage of very low interest rates and when a market is in contango where prices are higher for forward contracts than for spot contracts.  Non LME warehouses which offer lower storage rents attract stocks from the LME and then it becomes invisible.  The difference between the rates at LME-registered warehouse rates of 43 – 45 cents per day per tonne and 10 cents which can be negotiated at non-LME depots. So a question might be deficits in mine supply appear next year how much can be met by these invisible, unreported stocks?

Back in 2012 New Orleans played host to just over 63 per cent of the LME’s zinc and if you include Detroit, Chicago and Baltimore with another 128,000 tonnes this took the US share of LME warehouse stocks to 78 per cent which is a staggering amount of the global float.  This is a curious thing when you discover that the US accounted for only eight percent of global zinc consumption and just 1.8 percent of global refined zinc production in 2011.  So why would you ship zinc around the world to store it as far as possible away from the end users in Asia?  Why would anyone then move stocks from New Orleans where Goldman Sachs and Glencore own facilities to Vlissingen in the Netherlands which is owned by Pacorini, a warehousing unit of Glencore?  One reason is that you might get to start a new queue and a backlog of zinc coming onto the market.

There has always been daily limits set by the LME for the removal of metal from its warehouses.  LME rules allow warehouse operators to release much less metal per day than they take in.  This load-out rate gets further constrained with so much metal in stock and the physical constraint on availability of access, forklifts and trucks for the actual volumes that can be removed.  If you constrict supply by sucking up zinc stocks then you can attract a premium for your metal above the spot price.   The zinc premiums have risen from $120 to $130 per tonne in January in Rotterdam to $140 to $150.

If  I was a trader I might want primary production  to secure my supply and then if I was able to postone gratification I could even store the nuts until it was the most advantageous time to sell.  The trader is the guy in the market with the most intelligence of how it all works and leveraging that knowledge and building a dominant share of third-party traansactions is a smart way to manage the price and make money without taking your coat off. The miner has to wait till the lack of concetrate in the market bites to profit and cover the lean years but he can easily miss the cycle if it is a small mine with a relatively short life-of-mine.

So like many commodities where the bulk of the trade is between the producer and the end-user it is third-party transactions around the margins by dominant traders where not only prices are set but premiums are contrived.

PS   If you are interested have a look at my Post on May 7th entitled “We love zinc”