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SAN FRANCISCO (MarketWatch) -- It's zinc's turn to shine.
Spot prices for high-grade zinc have more than tripled on the London Metal Exchange in the last two years -- and the price rally won't likely end soon with demand for the industrial metal far outpacing supplies, analysts said.
After many years of languishing at low levels caused by abundant supplies, spot prices for high-grade zinc climbed to over $4,400 per metric ton as of Wednesday on the LME -- up almost 270% from 2004's levels.
That's quite a change for the metal that's mostly used to coat steel and to act as a rust inhibitor.
"Zinc has been perhaps the worst investment in major metals during the past several decades, which has resulted in significant underinvestment in exploration," said Dr. Harlan Meade, president and chief executive officer of both Pacifica Resources Ltd. (CA:PAX: news, chart, profile) and Yukon Zinc Corp. (CA:YZC: news, chart, profile) .
"The addition of several large mines in the mid 1990s simply flooded the market with zinc," he said.
New zinc output, in part, was made possible because of byproduct credits such as copper and silver that sometimes provided enough added revenue to offset zinc prices that really weren't high enough to encourage exploration or development, he said.
Now the zinc market faces a supply deficit, "caused by the depletion of many of our large mines," Meade said.
Exacerbating the problem, China, "who dumped zinc on the market during the 1980s and 1990s, became a net importer of the metal in 2003 as the country's consumption took off," he said.
China's influence
Indeed, China's zinc demand has been "rising at an amazing rate," said Eric Coffin, co-editor of HardRockAnalyst.com, which offers publications focused on resource stocks.
He blamed "extremely high capital investment growth," much of which is centered on construction, for the increase in Chinese consumption, which climbed 35% between 2003 and 2005.
"Zinc is a pretty basic industrial material," said Lawrence Roulston, editor of Resource Opportunities. "Most consumers would not even be aware that they come in contact with it many times a day," he said, pointing out that a typical car uses about 22 pounds of zinc.
"Car makers will pay whatever they need to pay to get enough zinc to keep making cars," he said, and "an extra dollar on the zinc price will not reduce demand for cars."
Similarly, demand won't slow even if "couple of tens of bucks" is added to the cost of a new house because of the zinc used in galvanized steel for construction, he said.
The recent run in the zinc price has "demonstrated ... the critical shortage of metals supply coming from the mining industry," said Roulston. "There are many small new mines constantly being developed, but no big mines."
Meanwhile, "mines are constantly being shut down as the ore bodies are depleted, [so] the net result is that production has been flat at a time of rising demand," he said.
Overall, the zinc industry will "have a hard time at any price bringing on enough new supply to balance supply and demand in 2010 and thereafter," Meade said.
Eating up supply
Against that backdrop, warehouse stocks of zinc have been depleted.
On the LME, supplies were down to around 85,750 metric tons as of early December -- down from 450,000 a year ago and close to their lowest level since March 1991, according to Martin Hayes, a senior correspondent at London-based BaseMetals.com.
And inventories are "set to keep on falling," he said.
The supply deficit this year will likely be close to 300,000 metric tons, he said, with supply of 6.8 million metric tons not enough to satisfy 7.1 million metric tons of consumption
In fact, at the current rate of supply declines, Coffin expects the LME warehouse to "be bare in about 3 months."
"There is very little potential supply enhancement that we know of," said David Coffin, Eric's brother and co-editor of HardRockAnalyst.com.
"At a practical level, what will happen is that the high zinc price will bring metals out of unknown stores and mining companies will push as much as they can into the market," he said.
So "while we do expect the decline to continue, that does not mean we actually expect to see a '0' stocking," he said.
Even so, zinc will likely follow the same pattern as other metals with stocks declining "to the point where there is only a fraction of a day's usage in warehouses," he said.
Hayes expects the shortfall in zinc supplies to ease in 2007 to closer to 40,000 metric tons, from 300,000 in 2006 as "the supply-side response to record prices kicks in."
"Nevertheless, there is still upside potential for prices in the medium term, as inventory draw downs will continue, with a major reversal unlikely until much later in 2007," he said.
Roulston argued for a longer-term inventory deficit. "The projected pace of new mine development shows a big supply gap extending for years into the future as demand grows and some of the big, old mines are shut down," he said.
Taking advantage
So what's the best way for a metals trader to invest in zinc?
"There is a futures market for zinc," said Roulston. But "you are not really 'investing'."
"The commodities markets are highly speculative and the realm of professional traders," he explained. "Neophytes in the commodities markets typically get eaten alive."
On the other hand, the higher zinc price is already factored into the share prices of producers, he said.
The "best way to invest in zinc, or any of the metals, is to look at the fundamental driver, which is the shortage of supply," he said.
And "the exploration and development companies that are advancing metals deposits offer exceptional investment potential, as their values will increase as the deposits are advanced toward production."
It's certainly timely that, on Tuesday, Australia's Zinifex and Belgium's Umicore (BE:000362637: news, chart, profile) agreed to combine their zinc smelting and alloys business, a deal that will create the world's largest zinc producer. See full story.
For now, most of the large producers such as Teck Cominco (TCK : teck cominco produce many commodities, and are "therefore not pure plays," said Meade.
"Even the mid-tier, best zinc-leverage companies such as Lundin Mining
LMC37.60, +0.85, +2.3%) and Kagara Zinc (AU:KZL: news, chart, profile) have significant byproduct credits that make them less than a pure play," he said.
So "investors should look at the mid-tier producers that have abundant zinc production and are low-cost producers due to significant byproduct credits due to silver, lead, copper and gold credits," he said. Meade owns large positions in Pacific Resources and Yukon Zinc.
At the moment, these are already "highly valued," he warned. Take a close look at these to "see who has new production going on that is not factored into current valuation to get the extra zinc leverage."
Eric Coffin said he follows Lundin Mining as well as Teck Cominco. "I can't call [Teck Cominco stock] cheap, but its very well run, well diversified and has, arguably, the best zinc mine in the world -- Red Dog in Alaska," he said.
And for those traders who want a "more speculative type of situation," Coffin said he follows, and owns a position in, Selkirk Metals (CA:SLK: news, chart, profile) .
The company is exploring a number of projects in British Columbia, reporting high-grade zinc from drilling in Ruddock Creek, he said. Coffin said he thinks there's probably "10 million tonnes and possibly a lot more" there.
"That would be a good play on next year's drilling programs, which will be extensive," he said.
Myra P. Saefong is a reporter for MarketWatch in San Francisco.