MS 2012 Outlook: Base Metals

MS 2012 Outlook: Base Metals We remain cautious on base metals as they are highly cyclical and tend to sell off sharply during global slowdowns. While we have seen a modest correction already, history suggests plenty of downside risk remains. Moreover, while base metals tend to trough before other commodities and thus may be the best subsector to own following a global correction, we think it is too early to play a recovery Beta trade. Copper We believe coppers constructive fundamentals will make it an outperformer among the base metals. Supply side difficulties remain, which should keep copper prices elevated and well above marginal cost until such time as the global inventory pipeline is replenished and a more reliable supply environment ensues (likely post-2014). Aluminum Although we remain cautious on base metals, we are relatively more constructive on aluminum given that 1) prices are below marginal cost and some high cost producers are already closing capacity and 2) high yielding inventory financing deals will keep metal availability tight. Nickel We remain wary of exposure to nickel in 1H12, until supply trends in NPI and laterite production become clear. 2012 nickel prices will likely be tied to trends in Chinese stainless steel production and exports, which we view as a negative given forecasts for a further slowdown in industrial production Lead Lead prices remain at risk. Chinas pollution crackdown on the domestic lead and battery industry has resulted in higher domestic prices and subsequently lower battery demand. In addition, the stock-toconsumption ratio has risen to levels not seen since 2002 despite strong demand from the automotive sector due to rising primary and secondary output. Zinc We are bearish zinc. The global zinc market remains in structural oversupply and with prices still above marginal costs, market volatility and falling industrial output make prices especially vulnerable to negative market sentiment. Copper: Supply Tightness to Underpin Relative Outperformance Supply We expect copper prices to remain elevated over the next several years. Until the global inventory pipeline is replenished and a more reliable supply environment ensues, copper prices should stay well above marginal cost. We do not expect sustained relief from this supply constrained condition before 2014-15. The enduring narrative of chronic supply-side difficulties remains a key feature in the copper market. The significance of the outage at Freeports world #2 Grasberg mine cannot be understated. Global copper production growth already faces several structural problems (lower grades, increasingly complex new projects, adverse weather conditions and enhanced geopolitical risks). Even if demand slows, tight supplyside fundamentals should provide price support. Declines in commercial inventory likely to spill into 2012. We believe the tightness in global concentrate is prompting greater demand for stocks of refined metal,

particularly in China. After peaking in September, LME copper stocks have steadily declined, and are now at levels nearly comparable to those at the beginning of the year. Physical market data reinforces our constructive view on longterm fundamentals. The combination of the most recent market balance data and the continued strength in Codelcos regional surcharges suggests to us that the producer/consumer community retains a positive view on the market outlook.

Copper: China Buying Likely To Provide Counter-Cyclical Demand Support

Aluminium: Higher Inventory Financing Yields, Low Prices Constraining Supply Supply Given yields on inventory financing are rising, their prominence in 2012 will be high. The confinement of ~85% of global aluminium exchange inventories under inventory financing deals remained a primary feature of the market in 2011. This dynamic should continue to provide pricing support in 2012 by constraining metal availability. We note that the longer dated deals remain most attractive, implying the phenomenon is set to continue to influence market conditions well past next year. While the market is concerned about a potential unwind should interbank interest rates rise on increased risks to European banks, we view this as a low probability risk. Cost pressures should begin to weigh on supply. Aluminium prices have remained below the marginal cost of production since August 2011, pressuring the higher cost producers. In the final week of November, the LME aluminium price traded between the 45th and 50th percentile on the cash cost curve, meaning around half of the worlds smelters were not turning a profit. Costs of production have primarily been pressured by rising power costs. At least two major producers have delayed restarts or advanced maintenance and/or

closures. Marginal cost has generally been supportive of prices. Historically, marginal cost of production has provided a relative floor for LME prices. We believe this relationship will limit the downside risk to aluminium prices in the event of a more protracted downturn resulting from the sovereign debt crisis in Europe.

Aluminium: China Consumption, Transport Demand Will Dictate 2012 Demand Demand Chinas shift toward net importer will support prices in 2012. We believe aluminiums price outperformance relative to the rest of the base metals complex in 2011 was underpinned by the absence of any large volume of primary exports from China. Chinas 2011 trade in primary aluminium is estimated at 108Kt of net imports. This shift suggests China is advanced in its transition to becoming a sustained, but moderate, net importer of primary aluminium. While strong domestic demand is certainly a driver, rising power costs, government restrictions on energy-wasting industries and reduced availability of funding for energy-intensive projects are all structural challenges that should encourage greater imports going forward. Packaging demand to support Chinese demand in 2012. While the auto and construction sectors have been traditionally supportive for demand in China, use in the packaging sector is set to increase sharply. According to CRU, beverage can making plants have been growing aggressively in China over the last few

years as urbanisation and changes in lifestyle preferences have increased demand for canned beverages. Outside China, near-record high spot regional premiums hint at consumption resilience. We believe this reflects continued demand from the transportation sector (in DM and EM), especially in the automotive and aerospace markets. Importantly, the Japanese auto industry has managed to increase production earlier than expected. However, wed be remiss if we didnt acknowledge this source of demand could be at risk with global growth slowing. The packaging sector has also been strong in G3 markets with food and beveragedriven demand forecast to rise by 3.7% YoY in 2011 (per Wood Mackenzie Brook Hunt).

Nickel: Substitution in China a Major Factor in Falling prices Supply With LME prices trending below marginal cost, Nickel Pig Iron (NPI) shut-ins increasingly likely. NPI became the dominant source of nickel for use in stainless steel production in China during 2011. However, NPI producers dwell in the upper end of the cost curve as a result of the industrys high level of energy intensity and high sensitivity to changing coke prices for blast furnace producers. As a result, NPI production cost trends have become increasingly intertwined with trends in LME nickel prices. With LME nickel prices trending below the estimated marginal cost of NPI of US$19,500/t (US$8.80/lb), we would not

be surprised to see evidence of NPI shut-ins in 1Q 2012 perhaps to the support of the nickel price. Nickel stocks will begin 2012 at the lowest starting point in three years. Despite rising NPI production, a declining trend in LME inventories throughout 2011 has been evident. LME stocks have declined 35% YTD. In our view, this points to two important developments: 1) Demand ex-China has remained sound in 2011 as evident by record annual stainless steel production. 2) Chinese imports are helping to draw global inventories. According to CRU, some of this material has been shipped into China in anticipation of increasing demand, and may be stored away in bonded warehouses (i.e., off-market). Production growth dependent on highly complex projects, making delays likely. Outside of China, the fate of the new and highly complex high-pressure acid leach projects will also shape the global market balance. Projects such as Goro, Ambatovy, Ravensthorpe and Ramu will account for an increasingly larger share of global production by 2016. The successful ramp-up of these four projects in 2012 will be paramount to the global nickel market. Given the chequered history of these and similar projects, we remain dubious on the commission timing provided by the operators. Current LME nickel prices are below NPI marginal costs

Nickel: Stainless Steel Demand Remains Challenged Demand Troubling stainless steel demand trends make us wary of exposure to nickel in the first half of next year, at least until supply trends in NPI and laterite production become clearer. In fact, 2012 nickel prices will likely be tied to trends in Chinese stainless steel production and exports both of which are likely to struggle heading into 2012. Stainless steel producers have been highlighting difficult market conditions since 2Q 2011. The combination of melting rate cutbacks in 1H11, low distributor inventories and sharply lower nickel prices will likely lead to delays in the seasonal re-stock in 4Q forcing stainless mills to maintain low melting rates. Indeed stainless steel price declines have accompanied that of the raw materials, namely nickel. Macroeconomic stress in Europe is affecting demand. According to Steel Business Briefing, European final demand remains relatively stable, but appears to lack growth. Distributors remain nervous, with activity largely confined to buying only what is absolutely necessary to fill gaps in inventory. Therefore, any further downgrade to GDP expectations will likely translate into declines in forecast stainless steel consumption and production in the USA and Europe. Chinese stainless steel flat product exports, which are mainly delivered into Asia, have also fallen sharply. In October, total stainless steel exports of 100k were the second lowest monthly volume this year. The combination of weakening import demand in Asia and soft conditions in the European market are not good omens for stainless steel demand for primary nickel going into 2012.

Lead: Prices Back To Fundamentals Not Good News Supply High stock levels weighing on lead prices: While the ongoing global macro concerns were largely responsible, the 2H11 downward trend in refined lead prices was also driven by rapidly rising inventory partly a reflection of strong supply growth. As a result, the combined total of LME and SHFE stocks is higher than any previous peak in our data history (going back to 1984). 2012 should herald greater market balance. We believe the combination of price-induced lower production growth and a seasonal pickup in demand will help bring the global lead market closer to a balanced position than at any time in the past four years. Encouraging in this context is the fact that China, the worlds largest producer, has reported 2011 lows for refinery utilization rates since September. That said, a weaker global economy could challenge fundamentals further. Demand Chinese battery and auto demand a source of weakness. The net effect of the Chinese governments 2011 crackdown on the domestic lead and battery producing industry, because of pollution concerns, has turned out to be lower battery demand. The lower demand is primarily as a result of higher domestic prices due to

local scarcity. As a result, Chinas annual demand growth for 2011 is estimated to be around 8% compared to a 2000-2010 CAGR of 19.6%. One of the pillars of Chinese demand growth, E-bike production and use, remains robust, although the higher cost of replacement batteries is prompting battery reconditioning. Finally, automobile production growth has slowed in line with the moderation in 2011 GDP growth. Seasonal demand pick-up expected into 1Q 2012, but macro looms large. We expect a seasonal pick up in demand in 4Q11 and 1Q12 given global demand for replacement batteries, with lower prices expected to encourage buying. Chinas annual demand growth for 2012 is estimated to be around 9.6% compared to a 2000-2010 CAGR of 19.6%. Lead Global Supply Demand Balance

Zinc: Lack of Supply Discipline, Inventory Overhang Too Much to Overcome We remain bearish zinc as 2012 demand is unlikely to be enough to rebalance the market. Although a recession-induced sharp pullback in prices would perversely benefit the global zinc market from a supply perspective, a healthy demand rebound would be required to reduce near-record-high levels of stocks expected to accumulate in 2012 and 2013. Supply The global zinc market remains in structural oversupply, a condition that has prevailed since 1Q08 and should persist until 2013. However, since 2008, prices have not fallen to levels that would trigger a supply-side response. The consequence of this continued growth in output and the excess stock built in the wake of the Global Financial Crisis has been a two-decade high in the stock-to-consumption ratio. Little supply relief expected in 2012. We believe that mine closures in the coming 2-4 years will be the main catalyst for improved market conditions, but this will not be soon enough to tighten 2012 supply. The planned closures of Century in Australia, Brunswick in Canada, as well as several other operations, will result in the net loss of 312Kt and 440Kt of contained zinc and bulk concentrate in 2013 and 2014, respectively. Demand Global zinc demand has held up well in 2011, driven primarily by Chinese and other EM consumption growth. The construction and auto sectors remain robust in most emerging market economies, sectors in which galvanized use is high. However, consumption prospects for 2012 are rapidly dimming. ArcelorMittal, the worlds largest zinc consumer, idled a number of blast and electric arc furnaces across Europe in recent months and, according to Wood Mackenzie Brook Hunt, has hinted that galvanizing lines, particularly those reliant on Europes struggling construction sector, will be idled. Steel Business Briefing has also reported emerging excess capacity in Europes hot dipped galvanizing capacity due to weakening demand.

Zinc Global Supply Demand Balance vs Price