Why the price of this metal may be the next commodity to boom

The threat of an all-out trade war between China and the US has taken the shine off most metals but zinc could be the standout exception.

Citigroup believes the short-term outlook for the metal that’s used in alloys like brass is “screamingly bullish” as the price difference between front-month zinc futures contracts (for delivery next month) and those for delivery three months out is at the second widest on record in at least 10 years.

The three-month contract price for zinc on the Shanghai Futures Exchange (SHFE) is trading at a 6% discount to the front-month, or 36% on an annualised basis, while the 12-month to front-month is trading on an annualised 15% discount.

There are only two other occasions in the past decade where spreads were near this high. This was in January/February 2009 and June 2017. In both occasions, zinc returned 20% plus on three months holding period, according to Citi.

When near-term prices are higher than longer-term prices, the market is described as being in “backwardation”. It is unusual for most commodities to be in backwardation because in a properly functioning market, longer-dates deliveries cost more to reflect holding costs and the uncertainty about the future.

Backwardation usually points to the lack of immediate/near-term supply of a commodity. Citi believes that the large backwardation in zinc is probably due to output cuts by Chinese smelters following a 35% drop in the price of the mineral from February to mid-September.

“By the end of June a number of large Chinese smelters had committed to cutting production by 10% and they appear to be following through on this threat, with Chinese output declining 6% yoy over the 2 months to August,” said the broker.

“As a result, we raise our bullish prior 0-3 month point price target to $2,800/t (from $2,600/t) and our 4Q18 forecast to $2,650/t, from $2,500/t.”

The problem is there aren’t many large or mid-cap zinc miners that would benefit from this thematic. Diversified miner South32 Ltd (ASX: S32) is the only one that comes to mind, although there are a few zinc focused producers at the small end of the market that may benefit from rising zinc prices.

However, the expected price rebound in zinc may not last as Citi doesn’t think the rally will last through 2019 and it’s forecasting the price to fall to US$2,400 a tonne in 4Q19.

“Chinese zinc consumers are set to imminently end re-stocking on the ongoing rebound in prices, while eventually Chinese zinc smelters are likely to ramp up production,” said Citi.

“Furthermore, zinc deficits are set to unwind during 2019, as ex-China concentrate supply rises sharply in our base case.”

I like South32 and the volatility in the zinc price doesn’t take the shine off the stock given its diversified operations.

However, I prefer BHP Billiton Limited (ASX: BHP) and Rio Tinto Limited Fully Paid Ord. Shrs  (ASX: RIO) as they have a greater capacity to make capital returns, while I think bulk commodities like iron ore are safer bets than industrial metals due to rising global trade tensions.

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Motley Fool contributor Brendon Lau owns shares of BHP Billiton Limited, Rio Tinto Ltd., and South32 Ltd. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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