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March 03, 2006

Base Metals Mania?
by Scott Wright

There is no denying we are in the midst of a secular commodities bull market. Precious metals and energy have commanded the lion's share of attention not only on the contrarian front but from mainstreamers as well. But bobbing to the surface in this sea of commodities, base metals have recently garnered the spotlight.

Last month I wrote an essay that covered some of the fundamentals of this commodities bull and highlighted the increasing role and importance commodities play in today's global economy. The robust global economy necessary to support this fast growing world population has created a massive increase in demand for natural resources which in turn has significantly challenged the economic balance of these resources.

Because of the widening supply and demand imbalances we are witnessing today, many commodities are experiencing price levels that have recently peaked all-time and multi-year highs. Base metals actively populate this group as I will detail later. A big reason this is the case is they happen to reside amid a group of commodities that are finite in nature and require massive amounts of capital to extract from the earth.

This type of commodity requires large amounts of time and capital in order to increase its output. Because of swelling demand in recent years base metals have been zealously sought after in order to feed the furnace of this growing global economy reducing global stockpiles and placing mounting supply pressures on producers. Consumers, and in unison investors, are starting to open their eyes to the importance, value and necessity of base metals in today's economy.

With the emergence of the super economies of China and India in addition to the impressive economic growth of many other Central Asian and Eastern European countries, the world is experiencing a massive build-out and modernization of global infrastructure. Because of this there are increasingly more people vying for limited natural resources. Now we need to be aware of two major aspects to this observance.

First is the fact that due to enormous industrial and technological advances in the 20th century, the physical infrastructure of the world is greatly expanding. In addition to first-world upgrades and enhancements, as developing economies begin to taste and lust after the things of the western world and catch on to the financial benefits of capitalism and global commerce, this creates a widespread global build-out.

And second, there are nearly 2.5 billion more people on this planet since the last major commodities bull of the 1970s. But wait, not only are there more people in general, but the percentage of people competing for these natural resources is growing as well. Consider this: in the last secular commodities bull market the populaces of China, many of the Central Asian and Eastern European countries and for large part India were not competing for the natural resources that greased its wheels.

A commodities bull market was in progress for much of the world, yet the economies mentioned above were virtually closed to the outside. These countries commanded proportionally light import demands, hence creating very little influence on commodities prices.

Today as these countries instill capitalistic tendencies into their various forms of government, their economies quickly grow and a necessitated appetite for natural resources rapidly expands. After all, the economies mentioned above are indeed the up and comers pushing the envelope on the demand side of this commodities bull.

So take such major countries as those in the Americas, Europe and Japan that demand even more resources than they did in the 1960s and 1970s, add to this the 1 to 2 billion people in the developing countries mentioned above that were not involved in the last commodities bull, and consider the additional 2.5 billion people on earth today and what do you have? Well, I would venture to suggest this to be a formula for a commodities bull market unlike any we have ever seen in the history of mankind.

Because of this, even with the enormous gains we are witnessing today, we are still likely in the first half of this secular bull market in commodities. The supply and demand imbalances we continue to experience today mixed with the fundamental squeeze unfolding regarding the future resiliency of mining and drilling fully encompass the story of base metals.

Now as mentioned above, precious metals have garnered much of the attention on the metals front. Gold, silver and platinum have had recent bull-to-date gains of 124%, 142% and 161% respectively. These gains are spectacular on any scale and the stocks of the producers that bring these metals to market have enjoyed even better gains.

But base metals in the last few years have put together a rally of their own that in some respects may be even more impressive than those of precious metals. Some of the more popular base metals traded on the futures markets have recently achieved bull-to-date gains as follows:

- Aluminum +105%
- Zinc +230%
- Lead +263%
- Copper +287%
- Nickel +302%

Base metals indeed play an important role in the global economy. These metals are not as sexy, alluring or captivating as precious metals and they certainly don't have the same rarity and store of value. But their indispensable industrial and economic uses rank invaluable and in many cases irreplaceable.

As indicated by the gains we see above in addition to the picture the chart below paints, demand for these metals has skyrocketed in recent years. Even though there are allegedly ample resources within the earth for most base metals, the growing demands of the booming global economy have far outpaced the time it takes to find and bring them to market. Simply put, producers are struggling to keep up.

As you can see in this chart, base metals really became excitable in the middle of 2003 and have not looked back since. With the exception of platinum and perhaps nickel, the markets for most of these metals were flat up to this point. Then it finally became apparent that global demand, led by China's aggressive growth, was rapidly dwindling warehoused stock of these metals bringing true meaning to supply deficits.

Also looking at this chart you can see that from the start of this recent uptrend, these metals have exhibited volatility similar to that of gold. Fundamentals are ultimately what drives these prices to rise, but this volatility creep is natural as more investors and speculators throw their capital into the mix. It might be worth performing some correlation analyses in the future comparing the recent trends of base metals to that of their more popular sibling, gold.

And even though gold, silver and platinum rank as precious metals, I still chose to include them on this chart. Not only do they serve as good references, but in addition to their precious-metal qualities, each has important uses in the industrial sector and is similarly affected by the same economic pressures as base metals. As an example, gold is to computers, silver to photography and platinum to automotive as say copper is to electrical.

Speaking of copper, this base metal has seen global demand quickly escalate in recent years. I wrote an essay on copper last fall analyzing its fundamentals while taking a look at its strategic trend as it continues to exceed all-time highs. Lending to this is the fact that yet again in 2005 global copper production was unable to meet demand. This is despite an estimated 3% growth in production for the year.

China's voracious appetite for the metal has largely contributed to copper's economic imbalance. This caused warehoused stockpiles around the world to fall alarmingly low throughout 2005 as overall inventories continue their sharp downward trends as they are gutted to supplement this rising demand.

Some industry experts, such as metals pioneer Ross Beaty, believe we may actually be approaching a Hubbert's Peak for copper. Mr. Beaty cites many examples to support this theory including the fact that many of the large global copper mines have not only reached their threshold for expansion but will be exhausted in the next five to ten years. In addition to this he claims that only 56 new copper discoveries have been made in the last 30 years. This is hardly sufficient to keep up with growing global demand of which 2006 estimates are expected to exceed 17 million metric tons according to the International Copper Study Group.

Mr. Beaty also predicts that Chile copper production, which generates over one-third of all global mined copper annually, will reach its peak production in 2008. The famous Escondida and Chuquicamata mines in Chile together produce nearly 10% of global mined copper. When large mines like these exhaust their resources someday the only way to continue to keep up with global demand will be not only to mine lower-grade ore deposits but to make further major discoveries. The only way to encourage miners to make these discoveries and to sink more capital into mining will be for copper prices to continue to rise.

Mr. Beaty also brings up another excellent point that in addition to all of copper's current industrial uses, the energy problems of the world will only add to its demand. Hybrid vehicles require four times as much copper as regular vehicles and alternative energy infrastructure requires significant amounts of copper to construct.

Zinc is another of these base metals that has seen incredible gains in the last few years. Its main use is to galvanize steel, which increases steel's life by a factor of five. Among its other uses zinc is also prevalent in many other metal alloys, die casting, batteries, paints, rubber and interestingly since 1982 it has been the primary metal used in making U.S. pennies.

Zinc is the 23rd most common mineral in the earth's crust and is the 4th most common metal in use behind iron, aluminum and copper. Yet with a major global economic expansion underway, it is not immune to major supply pressures. Even though zinc production has been up 43% in the last ten years, it still suffered an economic imbalance in 2005 in which global consumption exceeded production. So much so that warehoused stockpiles managed by the London Metal Exchange were reduced by nearly a quarter of a million metric tons in order to meet this increased demand.

Interestingly, the largest zinc mine in the world is the Red Dog Mine located in Northwest Arctic Borough, Alaska. This desolate part of the world is at a latitude in which the sea is only passable about one month per year. So as it waits the good part of a year to be transported to its buyers, the zinc concentrate is trucked and stored at a giant warehouse at the shipping facility. This massive mine produces over 600,000 metric tons of zinc concentrate per year.

Similar to copper, major zinc discoveries have been few and far between for several decades. And many of the larger zinc mines are producing their zinc at cash costs much higher than that of many other metals. Only recently since zinc prices have risen have its suppliers started to see better margins. And as ore grades change at some of the bigger and older mines, costs will only continue to rise. Zinc demand is not likely to subside either. Construction has been zinc's fastest growing sector, but even if this tapers off a little there are other areas of use that are primed for rapid growth.

In this world of high energy prices, interestingly zinc fuel cells may find their way back into the limelight. Over the years many businesses have successfully tested and engineered these fuel cells and have proven them to be quite efficient. Unfortunately funding never became available for production to commence on a larger scale. As alternate sources of energy are seriously considered down the road, zinc fuel cells may find their way to popularity.

Lead is also a base metal that has taken the high road in this bull market. In his recent best-selling book Hot Commodities, legendary speculator and commodities guru Jim Rogers talks extensively about lead and the major production shortfalls the world will be faced with now and into the future. Lead mines are few and far between, and even more so than copper and zinc major discoveries have been extremely rare.

Only in 1998 did the largest lead mine in the world, which also happens to be the largest silver mine in the world, come into production. Refined as a byproduct of its lead bullion, the Cannington Mine in Australia produces a whopping 6% of the annual mined silver supply globally. And over 7% of the 3.2 million metric tons of annual lead production comes from this famous mine.

Just like most of the other base metals, demand has been outpacing supply in recent years. Once again China is the main culprit as it has been lead-hungry in order to feed its need to expand its vehicle fleet, for building construction, to produce batteries for export and to throw towards telecommunications and information technology.

Increasing car ownership in China alone will continue to add to demand for not only lead but a myriad of base metals. It was only recently that private car ownership in China was allowed. Up until the late 1990s, most cars in China were owned and operated by the government and corporations.

The floodgates have now been opened and the Chinese are on a furious pace to move from the bicycle age to the automobile age. As its economy has progressed, private car ownership in China has skyrocketed, yet only a very small percentage of Chinese citizens actually own a car today. As the highway infrastructure in China continues to evolve and its citizens are able to spend increasing amounts of disposable income, car ownership will continue to skyrocket and in a country of nearly 1.5 billion people, China may someday have the world's largest automobile market.

Nickel so far has been the standout among base metals as far as performance goes. Sounding like a broken record, it is yet another of these metals in which demand is outpacing supply. Nickel's main use is as an alloy in stainless steel, commanding over two-thirds of its use. But it is also popular in non-ferrous alloys, jet engines, manufacturing plant equipment, CD and DVD pressing and rechargeable batteries.

According to the U.S. Geological Survey, since 1950 stainless-steel production in the Western world has been growing at an average rate of 6% per year with overall world production in 2005 at an all-time high. Yet because Chinese demand has continued to skyrocket since the turn of the century, there continues to be significant supply pressures.

World nickel production in the last ten years has risen 63%, and supply still can't meet demand! This picture is the same for nearly all metals. Ladies and gentlemen, if somebody tells you we are not in a commodities bull market or that we are in the midst of a speculative mania, put up the hand, it is simply not true. Fundamentals like these are what drive bull markets.

Russia happens to by far contain the largest nickel deposit in the world at the enormous Norilsk deposit estimated at housing over 40% of the global resources. Up until recently it was mainly government controlled and only used its refined products domestically. But because of nickel's rise in price along with other valuable base and precious metals Norilsk produces, exports have risen sharply in recent years.

Norilsk is now the largest global producer of nickel and palladium. Interestingly, since there is little environmental regulation in this country, its onsite smelter for many years has released massive pollutants into the local atmosphere. It is so bad that it is economically feasible to mine its pollutant-saturated soil for the same minerals it mines underground. This may well redefine the roll of metal-squatters!

Now as investors and speculators ride this commodities bull market, base metals should certainly not be ignored. The wonderful thing about base-metals producers, just like precious metals and energy producers, is the companies that mine the underlying commodities are usually publicly traded in the stock markets. This allows the average stock investor to participate in this bull market by purchasing shares of their favorite base-metals producers.

In 2005 a few prudent mutual funds, hedge funds, investors and speculators took stakes in some of these base metals producers and have been greatly rewarded. But don't be frightened by the enormous gains we've seen bull to date. As mentioned earlier, probabilities are in favor of base metals still being in the early part of a secular uptrend in this commodities bull. It takes many years of rising prices and supply turn-up for commodity imbalances to correct themselves. The majority of investors are still unaware of the scope of this commodities bull, and as they gradually become aware, huge amounts of investor capital will drive prices even higher.

Now with many of these base metals peaking all-time highs, the financial media is trying to scare investors into believing we are at the end of the road and only a massive selloff will cure this "speculative mania". Fear not though, for it is fundamentals that shape and drive these bull markets, and they are still strong. In the last month or so there has been a minor selloff in base metals as people succumb to fear and capture their profits, but we think the fun is just beginning. Several opportunities have presented themselves recently and it is not too late to jump aboard.

There are many publicly traded companies out there that specialize in the exploration, development and production of base metals. Whether it is as a primary product or the byproduct of another, many companies are well positioned to leverage their production and position in the marketplace to take advantage of this bull market.

The metals detailed above are not the only ones out there either. As seen, aluminum has done quite well in recent years and other metals have enjoyed equal if not better gains. Consider this: those producers that produce molybdenum, which is a steel hardener, were able to sell this metal in 2005 for around $30 per pound. Compared to the $2 per pound they were getting in 2000, you can imagine the profit-margin changes in companies that produce it as well as the speculative capital thrown toward those that own future development projects.

So which companies do we choose to invest in? At Zeal we extensively research hundreds of companies of all sizes involved in the commodities markets. We include several stocks on our Watch List within our monthly newsletter that explore, develop and produce not only the common futures-traded base metals, but those that are a little more obscure.

Molybdenum and uranium are among the minerals not traded on the futures markets. One of the moly explorers we added to our Watch List several months ago has risen well over 200% since. And we recently initiated a buy recommendation for a junior uranium producer. Did you know there is a global cement shortage? Even industrial minerals such as those used in cement are a hot commodity. We are watching companies that are involved in that front as well.

At Zeal we have been diligently researching the tactical and strategic trends of the commodities markets and have been recommending the stocks of our most promising finds to our newsletter subscribers. We continually monitor trends within various sub-sectors of this commodities bull in order to successfully time our trades, and if you would like to receive cutting-edge analysis and stock picks on today's glorious commodities bull market, please subscribe today to one of our newsletters.

The bottom line is there is a significant increase in consumers competing for natural resources compared to what there was thirty or so years ago. This commodities bull market has a different flavor than the last. The recent highs we see in commodities of all types indeed reflect the economic imbalances of these resources that are so valuable in today's economy.

Base metals are among this elite group of commodities and investors are able to exploit this imbalance by investing in the stocks of those companies positioned to ride this bull.

Scott Wright
Zeal LLC.com

So how can you profit from this information? We publish an acclaimed monthly newsletter, Zeal Intelligence, that details exactly what we are doing in terms of actual stock and options trading based on all the lessons we have learned in our market research. Please consider joining us each month for tactical trading details and more in our premium Zeal Intelligence service at ... www.zealllc.com/subscribe.htm.

Thoughts, comments, or flames? Fire away at scottq@zealllc.com. Depending on the volume of feedback I may not have time to respond personally, but I will read all messages. Thanks!

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