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Are metal stocks being dulled by metal prices? - Views on News from Equitymaster
 
 
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  • Jun 19, 2012

    Are metal stocks being dulled by metal prices?

    Metal stocks are one of the worst performers in FY12 with the BSE Metal Index losing 31%. Companies like Tata Steel, Sesa Goa, Hindalco, Sterlite Industries and Natinal Mineral Development Corporation Limited (NMDC) have incurred significant losses during the past fiscal year.

    This poor performance is due to a number of reasons such as concerns over global economic growth as well as domestic regulatory hurdles, and also importantly due to sluggish demand and softening of prices of key metals such as aluminium, iron ore and copper.

    Earnings of metal companies are very sensitive to metal prices. Even small changes in prices will have a major impact on profitability.

    In this article we explain some of the important factors that affect metal prices.

    Metal prices are notoriously volatile and influenced by a wide range of factors. Further, with markets for metals turning increasingly global, predicting trends of metal prices has become even more complex.

    Drivers of metal prices uncovered

    • Demand-Supply imbalance - Prices are naturally impacted by the demand and supply situation. China, symbolized by the dragon, is the largest consumer of major metals like copper, aluminium and steel. China now accounts for 40% of the world's consumption, and 35% of the global production of major metals. So, it has significant buying power, and it has single-handedly altered the dynamics of global demand and supply pattern. In less than 20 years, China has rapidly changed from being a price taker to a price setter.

      Supplies have not been able to keep pace with the surprising acceleration of demand growth in China, and the sheer global volume needed. Supplies have also faced numerous technical, labor and raw materials supply problems.

    • Speculators - Beyond demand/supply considerations, the volatility of metal prices also reflects excessive speculation. A speculator tries to profit from an asset by buying it in the expectation that its price will rise, or by selling it short in anticipation that the price will fall. Speculators usually focus on the short term rather than the long term. Over the longer term, the law of demand and supply will hold. But in the shorter term, in a market swamped by speculators who never intend to take delivery, the relevance and clarity of the demand/supply situation is reduced and hidden.

    • US dollar - The United States has long been the engine of the global economy and is considered a safe haven in times of stress. Even with the rapid GDP growth in developing countries like China and India which is shifting the balance of power, the US remains a strong influence. Importantly, metals are priced in dollars and are, therefore, exposed to exchange rate fluctuations. If the dollar strengthens, then the price of metals will decline and vice-versa. Thus whatever factors affect the US dollar, indirectly also affect metal prices.

    • Monetary policy - The US Federal Reserve, with its "quantitative easing" programme, has pumped a significant amount of money into the global financial system. Also, low interest rates have led investors to seek higher returns by investing other than in fixed income instruments - for example, in stocks and commodities. Essentially, the excess money generated by the government's policies was funnelled into the financial sector for speculative use rather than for the purchase of actual goods and services.
    So should one invest in metal company stocks?

    One needs to be careful when investing in metal company stocks with a keen eye on metal prices. Metal prices are determined by an interaction of many factors ... not just any one variable. Demand-supply, speculation, financial policies and the strength of the US dollar are some key drivers of metal prices. These are broad factors and other commodity specific factors will also come into play. Natural disasters, major political events can also indirectly cause variation in the prices of metals.

    So when investing in a metal company, it is always better to invest in companies with strong balance sheet which can sustain and shine through business downturns.

     

     

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