AR June 2006 -Peak price cycle for base metals continues

In a report marking the beginning of non-ferrous metals and mining coverage, United States investment bank Morgan Stanley said it expected base metals prices to remain at historically high levels given the number of factors constraining output.

Though many investors are focused on demand given the rapid escalation of metals prices recently, Morgan Stanley said it is focused on supply. “We think a [price] correction requires evidence of increased supply,” the bank said in a May 2 report.

Chinese metals demand and government efforts to cool the surging economy will be critical for mining equities, Morgan Stanley said. “However, we believe that a material retrenchment of metals prices will be driven by an increase in supply, which is not on the horizon. The industry has been running hard to take advantage of price strength. Supply disruptions due to operating problems and labor disputes are becoming commonplace and will restrict output, in our opinion.”

Historically, commodity analysts have assumed that prices following a cycle peak revert to trend pricing over two to four years, Morgan Stanley noted. In the case of copper, the historical profile forecasts average copper prices to fall sharply from $2.75/lb. this year to just under $1/lb. by mid 2008 and trend sideways to about 90 cents/lb. by 2014. But analysts appear to be revising their forecasts to current consensus levels, which represent a more gradual decline in the forecast curve.

That profile, however, still assumes that prices fall from current peaks levels and decay back to a long-term price over the next 5 to 6 years, in the case of copper to $1.10/lb. (i.e. extending the cycle by about two years). That consensus could still prove too conservative, Morgan Stanley said.

Instead, long-term price estimates need to adjust to structurally higher costs, with positive implications for mining equities, the bank said. “A substantial upward re-basing of industry capital and operating costs leads us to believe that either the extended peak or the bull case profile [in which average prices copper prices remain above $3/lb. until mid-2009 and decline to $1.50/lb. by 2014 is a much more likely outcome for prices over the next 5 to 7 years.”

Morgan Stanley defines the bull case scenario as one in which supply disruptions and strong near-term demand keep metals at elevated prices into 2008, followed by a gradual decline to trend pricing as new projects take an extended period to add to supply.

Though new projects are coming on-stream and exploration spending is on the rise, these are long-term fixes, the bank noted, “and we believe a number of factors will contribute to extended timelines for new supply.” Those factors include skilled labor shortages; greater ore body depth requiring underground mining; lack of large-scale deposits in the developed world; permitting delays; and higher costs for raw materials, energy and consumables.

Morgan Stanley said it favors the stocks of metals and mining companies with the best potential if metals prices overshoot consensus estimates. Those companies include copper miner Phelps Dodge, aluminium producer Century Aluminium, and iron ore-pellet producer Cleveland-Cliffs.