Miners face further short term volatility

The big London-listed mining companies are this week expected to show earnings?recovering strongly towards the end of their financial years – and prompt investors to jump to their outlook statements for clues if momentum will continue throughout this year.

But the miners’ outlook on near-term metals demand and pricing may well amount to two words: “no idea”.

This year has already been marked by volatility that reflects confusion among market participants about what is driving prices and whether the forces represent fundamental demand that is capable of being sustained.

An index of volatility is the copper price, which reached a 12-month high on January 11 after China registered stronger growth than expected.

That date also saw 12-month highs in the share prices of Rio Tinto and rivals. Since then copper has fallen 17 per cent. The wider FTSE mining share index has fallen by the same amount.

The difficulty of relying on old indicators to predict pricing strength over the next year may be the deepest problem confronting the miners as they close their books on 2009.

Many analysts see metals prices themselves as unreliable, because of the speculative money embedded in the headline price. The search for “hard” asset investments amid depreciating currencies and stagnant returns has pushed pension funds, hedge funds and asset managers to increase their holdings in metals such as copper or zinc.

Julian Kettle, head of metals research at Wood Mackenzie, said: “Investment funds have become massive drivers for prices.

“The fund effect is increasing volatility in the short term and it is influencing prices so that there is a disconnect between prices and fundamentals.”

A sense of this disconnect has been growing among metals analysts, who point to the trend for prices of a metal such as zinc to rise while inventories of zinc increase. Even for students of basic economics this appears a supply-demand paradox, unless the purpose of industrial metals is shifting from its “fundamental” use – manufacturing – to investment or speculation.

In aluminium this trend is extreme. According to Brook Hunt between 75 and 90 per cent of the world’s physical aluminium stocks are effectively unavailable for consumption.

They are tied up in financial investments dependent on low exchange rates and the expectation that aluminium prices will rise. As interest rates rise, the wind-down of these deals could release volumes of metal that damp prices.

Investment inflows will not necessarily destabilise the entire metals and mining complex, say mining analysts at Citigroup, but they introduce volatility and uncertainty. “For mining equity investment, it’s like building model-foundations on shifting sand dunes,” they have written.

Another problem for the miners concerns “restocking”, or the tendency of economies at the start of a cycle to stock up on raw materials.

In the past nine months, restocking was evident in China, whose stimulus-boosted manufacturing helped carry metals prices around the world.

But as China has reined in such spending, there is little evidence that restocking is happening in developed countries in the way it once did. This could be because manufacturers are holding lower stock levels permanently to avoid being caught out as they were in 2008, said Deutsche Bank analyst Daniel Brebner.

“We believe that the inventory cycle in the western world will be a shadow of its former self.”

The views of Rio Tinto and Xstrata will be solicited by investors at results this week. Whether they have answers is a different story.