Commodity Market ForecastingCommodity Market ForecastingWhat know and what we don’t know What know and what we don’t know

about the futureabout the futureGlobal Insights 40Global Insights 40thth AnniversaryAnniversary

22 October 200322 October 2003

31 Mt Pleasant,31 Mt Pleasant,London WC1X OAD, UKLondon WC1X OAD, UKTel: +44+20 7278 7788Tel: +44+20 7278 7788

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Additional offices and representatives: Additional offices and representatives: Philadephia Philadephia (Exton), (Exton), Rio de Rio de JanieroJaniero and Sydneyand Sydney

ResourceStrategies

Slide 2

ContentsContents

1) The Lessons of History

2) Commodity Markets Today

3) Key Issues for the Future

ResourceStrategies

Slide 3

There are two incompatible approaches There are two incompatible approaches to commodity price forecastingto commodity price forecasting

Fundamental Technical

• Demand is derived from economic activity

• Supply takes place in response to resource availability

• Imbalances are resolved by inventory changes which drive prices

• Used for both long-term and short-term forecasts

• All relevant market information is contained in the price

• Price trends are the key to price forecasting

• Prices forecast by purely statistical techniques and chart analysis

• Used mostly for very short-term forecasts

ResourceStrategies

Slide 4

Commodity futures prices are no Commodity futures prices are no substitute for a decent forecastsubstitute for a decent forecast

• Example: average absolute error using LME 3 month aluminum price as a forecast is $100/t

• this is 3-4 times the average absolute error of forecasts by Chase Econometrics/Resource Strategies/CRU

• “Future” price is actually today’s price for a physical delivery in the future

• This incorporates today’s market expectations• new information obviously affects expectations in the

mean time; so outcomes are not as predicted

• But: futures prices happen to be a statistically unbiased predictor of actual prices

ResourceStrategies

Slide 5

Three equally “unbiased” forecasts Three equally “unbiased” forecasts ––but one is clearly better !but one is clearly better !

Price

80

90

100

110

120

1 2 3 4 5

Forecast A Forecast B Forecast C Actual

Right direction 75%

of the time

ResourceStrategies

Slide 6

Statistical trend analysis and fundamental Statistical trend analysis and fundamental research yield similar results for copperresearch yield similar results for copper

Real Copper Price

1000

2000

3000

4000

5000

6000

7000

Jan-8

0Ja

n-81

Jan-8

2Ja

n-83

Jan-8

4Ja

n-85

Jan-8

6Ja

n-87

Jan-8

8Ja

n-89

Jan-9

0Ja

n-91

Jan-9

2Ja

n-93

Jan-9

4Ja

n-95

Jan-9

6Ja

n-97

Jan-9

8Ja

n-99

Jan-0

0Ja

n-01

Jan-0

2Ja

n-03

Statistical trend Median - LRMC

SRMC

ResourceStrategies

Slide 7

The same is true for nickelThe same is true for nickel

Real Nickel Price

0

5000

10000

15000

20000

25000

30000

Jan-8

0Ja

n-81

Jan-8

2Ja

n-83

Jan-8

4Ja

n-85

Jan-8

6Ja

n-87

Jan-8

8Ja

n-89

Jan-9

0Ja

n-91

Jan-9

2Ja

n-93

Jan-9

4Ja

n-95

Jan-9

6Ja

n-97

Jan-9

8Ja

n-99

Jan-0

0Ja

n-01

Jan-0

2Ja

n-03

Median - LRMC Statistical trend

SRMC

ResourceStrategies

Slide 8

But the aluminum trend is improbably low But the aluminum trend is improbably low due to structural shift in power marketsdue to structural shift in power markets

Real Aluminum Price

1000

1500

2000

2500

3000

3500

4000

4500

Jan-8

0Ja

n-81

Jan-8

2Ja

n-83

Jan-8

4Ja

n-85

Jan-8

6Ja

n-87

Jan-8

8Ja

n-89

Jan-9

0Ja

n-91

Jan-9

2Ja

n-93

Jan-9

4Ja

n-95

Jan-9

6Ja

n-97

Jan-9

8Ja

n-99

Jan-0

0Ja

n-01

Jan-0

2Ja

n-03

Statistical trend

Median - LRMC

SRMC

ResourceStrategies

Slide 9

Similar result in zinc, probably due to Similar result in zinc, probably due to Europe exit barriers & Chinese competitionEurope exit barriers & Chinese competition

Real Zinc Price

500

1000

1500

2000

2500

3000

Jan-8

0Ja

n-81

Jan-8

2Ja

n-83

Jan-8

4Ja

n-85

Jan-8

6Ja

n-87

Jan-8

8Ja

n-89

Jan-9

0Ja

n-91

Jan-9

2Ja

n-93

Jan-9

4Ja

n-95

Jan-9

6Ja

n-97

Jan-9

8Ja

n-99

Jan-0

0Ja

n-01

Jan-0

2Ja

n-03

Statistical trend

Median - LRMC

SRMC

ResourceStrategies

Slide 10

The really important decisions tend The really important decisions tend to require fundamental forecaststo require fundamental forecasts

• New project feasibility studies are not “bankable” without a fundamental forecast

• Long-term fundamental forecasts are required for asset valuations and for effective implementation of value based management

• Critical technical issues (definition of reserves, life of mine planning) require fundamental forecasts

• Industry stakeholders continue to make or buy fundamental forecasts despite their mediocre accuracy record

ResourceStrategies

Slide 11

Forecasting methods have adapted Forecasting methods have adapted to the market environmentto the market environment

Period Market Environment Forecasting Trends

First formal econometric forecasting models; classic market clearing; aggregated data

Strong demand growth, nationalization to secure economic rents, stable or rising prices

1960-1973

Highly disaggregated forecasting linked to detailed macroeconomic models

Oil crisis, severe cycles in demand and price, threat of hyper-inflation

1973-1982

Focus on supply side forecasting and understanding production costs

Reduced inflation, high interest rates, weak demand, sharp fall in prices, privatization begins

1982-1989

Hybrid forecasting techniques geared to understanding structural issues

Collapse of communism, sustained growth based on globalization and low inflation, prices still fall

1989-2001

ResourceStrategies

Slide 12

The market clearing model The market clearing model –– a a simplified versionsimplified version

Demand

Market Balance

Supply

Operating Rate

Capacity

Inventories

Production Costs

Prices

World Economy

ResourceStrategies

Slide 13

The demand side lessonsThe demand side lessons

Demand

Market Balance

Prices Capacity

• Far richer macro forecasts –but more detailed is not necessarily more accurate

• Minimal progress on understanding price elasticities

• Cost culture has weakened link between demand and investment

World Economy

ResourceStrategies

Slide 14

The supply side lessonsThe supply side lessons

Market Balance

Prices

Supply

Production Costs

Operating Rate

Capacity

• Comprehensive mine by mine, plant by plant databases

• Sophisticated understanding of cost structures

• Investment dynamics have experienced structural change

World Economy

ResourceStrategies

Slide 15

Commodity markets have Commodity markets have asymmetrical pricing dynamicsasymmetrical pricing dynamics

Condition Required Signals Price Implication

Prices rise to large premium over costs of even the highest cost producer; reflect short-run opportunity cost of the marginal consumer

All available capacity is operating but stocks are low and falling; auction market until marginal consumer defers demand

Deficit markets

Prices fall to the industry’s short-run marginal costs (SRMC)

Demand is fully satisfied and stocks are high and rising; market signals the need to cut production

Surplus markets

Prices reflect SRMC plus a premium based on future expectations; in equilibrium this equals industry long-run marginal costs (LRMC)

Demand is satisfied and producers who wish to operate are doing so; inventories are reasonable and/or trends are unclear

In between markets

ResourceStrategies

Slide 16

Prices are more often predictably below Prices are more often predictably below trend than unpredictably abovetrend than unpredictably above

Al Cu Pb Zn NiAverage of 5

MetalsMonthly DataBelow Average # 142 193 191 147 140 163 Average Deviation -12.2% -19.9% -19.4% -11.8% -18.5% -16.4% Max Deviation -28.7% -40.1% -40.0% -33.1% -43.4% -37.1%Above Average # 141 90 92 136 143 120 Average Deviation 23.3% 16.6% 22.9% 22.1% 34.2% 23.8% Max Deviation 106.7% 55.5% 122.8% 98.6% 191.7% 115.1%

Annual DataBelow Average # 11 13 15 13 12 13 Average Deviation -10.9% -22.8% -19.2% -8.7% -16.6% -15.6% Max Deviation -21.9% -35.5% -35.2% -29.8% -32.8% -31.0%Above Average # 12 10 8 10 11 10 Average Deviation 21.0% 10.9% 20.7% 23.5% 34.5% 22.1% Max Deviation 70.4% 29.6% 76.2% 68.0% 104.3% 69.7%

Metal Price Deviations from TrendJanuary 1980 to July 2003

ResourceStrategies

Slide 17

“Fan Charts” illustrate the role of “Fan Charts” illustrate the role of expectations in determining pricesexpectations in determining prices

1000

1200

1400

1600

1800

2000

2200

2400

2600

Cash 3-month

15-month

27-month

39month

54-Month

1000-10991100-11991200-12991300-13991400-14991500-15991600-16991700-17991800-18991900-19992000-20992100-21992200-22992300-

Structure of Forward Aluminum Prices Since 1989

ResourceStrategies

Slide 18

ContentsContents

1) The Lessons of History

2) Commodity Markets Today

3) Key Issues for the Future

ResourceStrategies

Slide 19

The big picture across commodity The big picture across commodity metals reflects the global economymetals reflects the global economy

• Commodity metal prices peaked between Q3 2000 and Q1 2001

• reflecting a global slowdown that predated 9/11

• The period of decline lasted 18-24 months• basically flat to recovering since mid 2002

• The recovery has been very uneven to date• well over 50% of volume growth in most metals is

coming from China

• most of the rest from other Asia and North America

• CIS has turned round, but absolute volumes are low

ResourceStrategies

Slide 20

Prices, however, are still well below prePrices, however, are still well below pre--recession averages recession averages –– except nickelexcept nickel

-30%

-20%

-10%

0%

10%

20%

30%

40%

Copper Lead Zinc Aluminium Nickel Tin

Average 3-month price: June 2003 vs 1993 - 2002

Special case reflecting the failure of new technology which deterred investment in late 1990s

ResourceStrategies

Slide 21

Normal (inverse) relationships between Normal (inverse) relationships between inventories and prices except for nickelinventories and prices except for nickel

LME stock and price changes, Dec ’02 – June ’03

-30%

-20%

-10%

0%

10%

20%

Zinc Aluminium Lead Copper Tin Nickel

LME stocks

LME prices

ResourceStrategies

Slide 22

CRU CRU HeatchartHeatchartTMTM

2003: Nickel hottest2003: Nickel hottest

-30%

-20%

-10%

0%

10%

20%

30%

40%

50% 75% 100% 125% 150% 175%

Stock:consumption ratio versus 15 year average

Surp

lus/

defic

it to

sto

cks

ratio

Nickel

Aluminium

Zinc

Lead

CopperTin

The “The “heatchartheatchart” shows considerable ” shows considerable divergence among metalsdivergence among metals

ResourceStrategies

Slide 23

We forecast that there will be We forecast that there will be relatively few changes in 2004relatively few changes in 2004

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

50% 75% 100% 125% 150%

Stock:consumption ratio versus 15 year average

Surp

lus/

defic

it to

sto

cks

ratio

Nickel

Aluminium

ZincLead

Copper

Tin

CRU CRU HeatchartHeatchartTMTM

2004 Forecast2004 Forecast

ResourceStrategies

Slide 24

ContentsContents

1) The Lessons of History

2) Commodity Markets Today

3) Key Issues for the Future

ResourceStrategies

Slide 25

There are four major issues that There are four major issues that we can now identifywe can now identify

• The impact of China on demand and supply

• Globalization versus protectionism

• The ability to manage the cycle and deliver shareholder value

• The impact of new technologies

ResourceStrategies

Slide 26

Chinese risk is now a critical factor in Chinese risk is now a critical factor in virtually every commodity marketvirtually every commodity market

• China accounts for 50%-70% of the annual growth in global demand (greater impact than Japan inn the 1960s)

• will coastal prosperity spread to interior China?

• when will the growth rate mature?

• China is a major producer and exporter of key commodities

• most ferroalloys, zinc, magnesium etc

• unsustainable development of power-intensive sector

• Potential exists for unexpected and severe swings in net trade balances

ResourceStrategies

Slide 27

The triumph of globalization over The triumph of globalization over protectionism is not a done dealprotectionism is not a done deal

• Steel sectors continue to be heavily protected• will be increasingly challenged by technology change in

upstream iron and steel sectors

• Non-ferrous smelting and refining is being subsidized via tariffs on imports, especially in Asia

• copying traditional Japanese practices which contribute to excess capacity bias

• Emerging problem of deindustrialization starting to affect highly efficient, competitive downstream sectors in North America

• will be a problem in Europe in next 5-10 years

ResourceStrategies

Slide 28

Good news and bad news on cyclical Good news and bad news on cyclical management potentialmanagement potential

• Industry consolidation is producing stronger and more disciplined corporate entities

• Alcoa, Alcan, Rusal etc in aluminum

• Diversified companies like Rio Tinto, BHP-Billiton, Anglo American and Xstrata in other markets

• Governments have basically exited these sectors

• Potential loss of North American swing capacity reduces overall industry supply flexibility

• devastating experience of zinc (no US swing capacity) in the current cycle

• virtually no progress in Europe towards flexible production concepts

ResourceStrategies

Slide 29

New technologies potentially trigger New technologies potentially trigger structural shifts that disrupt marketsstructural shifts that disrupt markets

• Inert anode technology in aluminum• potential drop of 25% in real cost of producing

aluminum

• Leaching of primary copper sulphide deposits• fundamental reduction in costs, scale and entry

barriers

• Similar developments in other markets• Mt Isa’s zinc technology, APL in nickel etc

• New technologies for primary iron production• Rio’s Hismelt project and its rivals threaten integration

of iron and steelmaking

ResourceStrategies

Slide 30

The challenges have escalated at least as The challenges have escalated at least as fast as the lessons have been learned!fast as the lessons have been learned!

Global and national

economic risk

Technology change

Industry management issues and challenges

Political, social and

environmental constraints

The “Renaissance Man” challenge