Will nickel recover its former lustre?

As we saw with many other metals, nickel prices were hammered earlier this year due to anaemic demand. Although the metal has rallied recently thanks to an uptick in stainless steel demand (among other factors), nickel prices are still a far cry from their early 2007 peak. We believe changes within the nickel industry could prevent a repeat of the 2006/2007 bonanza. Namely, a shift toward lower-nickel-content stainless steel has important implications for long-term nickel demand, while the emergence of Chinese nickel pig iron (NPI) production has introduced a swing producer to act as a pressure release valve when demand and prices are high.

Nickel Basics
Roughly two thirds of total nickel consumption goes into the production of stainless steel. Given its anticorrosive properties and the fact that it's easy to clean, stainless steel is widely used in food and chemical processing equipment and food service. Other uses of nickel include alloys for the aerospace, power generation, and automotive industries. As with many other metals, China has become a major consumer of nickel, accounting for approximately one fourth of global demand. The five-year period to 2006 saw rapid growth in global nickel consumption (5% per year, on average, according to the International Nickel Study Group). After 2006, however, nickel demand fell significantly due to weakening economic activity and increasing substitution of lower-nickel-content stainless steel. On the supply side of the equation, nickel production is relatively concentrated, with the top four producers (Norilsk Nickel, Vale, BHP Billiton, and Xstrata) contributing approximately half of the world's total supply. Nickel prices have been quite volatile in recent years, with a surge in demand driving prices to heights of nearly $55,000 per metric ton in early 2007. This spring saw prices drop as low as $9,000 before recently recovering to about $21,000 in August (although prices have now pulled back somewhat from the August highs.)

Nickel pig iron
An important development in the nickel industry in recent years has been the emergence of NPI production in China. NPI is produced from low-grade nickel ore, and this higher-cost production method sits primarily in the upper quartile of the global supply curve. Therefore, NPI production makes sense when nickel prices are strong, and this source can add to global supply when demand surges. NPI production can contribute roughly 200,000 metric tons per year, or roughly 14% of global primary nickel production. NPI production costs vary depending on ore prices, electricity and energy costs, and integration with a stainless steel plant. Estimates for what level of nickel prices "turn on" NPI production vary widely--Xstrata has stated that lower-cost producers need prices of only $11,000, while Australian Bureau of Agricultural and Resource Economics notes prices of $26,000. In other words, this part of the cost curve seems steep. Speaking in aggregate terms, however, given recent decreases in input costs, the nickel price necessary to justify NPI production is probably lower now than it was during the recent commodities boom.

Stainless steel
Changes within the stainless steel market have been a key dynamic for nickel demand. Given $50,000-plus nickel prices, it made sense for stainless steel manufacturers to substitute away from higher-nickel-content stainless. Indeed, in recent years higher-nickel-content stainless has lost share to lower- and no-nickel-content stainless. For example, the market share of "200 series" stainless (a lower-nickel-content variety) increased from roughly 5% in 2001 to over 10% in 2007, according to BHP Billiton and the International Stainless Steel Forum, while the market share of "400 series" stainless (no nickel) increased from about 25% to approximately 30%. This came at the expense of "300 series" stainless, the variety with a higher nickel content, where market share deteriorated from over 70% in 2001 to less than 60% in 2007.

Production cuts
Given weak demand and subsequent collapse in prices, nickel producers responded in the last year with substantial production cuts to attempt to bring the market back into balance. Xstrata estimates that production cuts and disruptions (such as strikes) have amounted to over 20% of global capacity. While these production cuts are necessary to balance supply and demand, some represent idle capacity that could be brought online as nickel prices rise.

Conclusion
We believe two important changes have occurred since dynamics in the nickel market brought about prices of nearly $55,000 per metric ton. High prices taught stainless steel manufacturers to use less nickel, which could have permanent implications for demand. In addition, China had the incentive and the means to ramp up NPI production, which now represents a swing source of supply. In combination, we think that these shifts have created pressure release valves that could limit the upside to nickel prices in the future when the supply/demand balance begins to tighten.

Sources: American Iron and Steel Institute, Anglo American, Australian Bureau of Agricultural and Resource Economics, BHP Billiton, BrookHunt, International Nickel Study Group, International Stainless Steel Forum, London Metal Exchange, Norilsk Nickel, Xstrata.