LONDON An abundance of nickel could see already swollen stocks surge to new record highs over coming weeks and hit prices of the metal used to make stainless steel.
But losses are expected to be capped by expectations of stronger demand later this year and financing deals -- that have tied up nickel inventories -- to release cash for producers.
Stocks of nickel in London Metal Exchange warehouses on Wednesday touched a record 161,550 tonnes -- about three times the level seen in September 2008, when the collapse of Lehman Brothers reinforced recession fears.
"If you've got a cumulative surplus this year and next year of 80,000 tonnes, it's likely that much of that would be on the LME, so 200,000 tonnes is not beyond the realms of possibility," said Stephen Briggs, analyst at RBS.
"Nickel is the weakest link of the base metals ... We've got it going back to $14,000 a tonne over the course of this year."
Nickel prices at around $18,000 a tonne are nearly double the levels seen in March 2009 when markets were talking about the chances of a full-blown 1930s-style depression.
Higher prices can be attributed partly to the weight of investment money flowing into industrial metals, looking for diversification and high returns.
Prices have also been buoyed by demand from stainless steel mills -- said to account for about 70 percent of global demand estimated at about 1.3 million tonnes this year -- particularly in China, the world's largest producer.
But those purchases have left mills with too much stock.
"Between January and September, the Chinese probably built more than 100,000 tonnes of (nickel) inventory," said Jim Lennon, analyst at Macquarie.
Analysts think about 25,000 tonnes were used in the fourth quarter, leaving China with stocks of about 75,000 to 80,000 tonnes. That overhang will damage sentiment as will the lack of necessary production cuts to reduce supplies.
Brook Hunt, the metals arm of consultancy Wood Mackenzie, in its latest nickel industry cost service estimated about 93 percent of producers had average annual cash operating costs below the average price -- $14,675 a tonne -- for last year.
"Prices didn't go low enough for long enough, that's the bottom line," said Andrew Mitchell, analyst at Brook Hunt.
Looking into 2010, stainless steel production is expected to grow at a robust rate -- analysts cite numbers above 10 percent. But having overproduced in recent months, steel mills first have to use up their stocks before ramping up output.
At that point prices could get a real lift from financing deals, which have tied up about 60 to 65 percent of nickel stocks in LME warehouses. The metal is thought to be tied up until at least the middle of the year.
Financing deals involve banks buying nickel now and selling it forward at higher prices, generating a return that far surpasses the interest they could earn on money markets where interest rates are very low.
For the market these deals mean a potential lack of availability should demand strengthen significantly.
"We expect interest rates will remain low, and thus the sustainability of this trade could be quite high," Daniel Brebner, analyst at Deutsche Bank said.
"(But) we don't believe that much of this arbitraged metal is locked up in rent/storage deals (as it is in aluminum) ... If the forward curve flattens sufficiently, metal could rapidly become available."
The forward curve represents prices for nickel at different points in the future. Rent/storage deals are a reference to aluminum financing deals with agreed storage costs for a fixed length of time.
Also a strong support will be marginal costs of production or highest cost producers. If prices fall below marginal costs, estimated to range between $12,000 and $17,000 a tonne, some producers facing the prospect of steep losses could cut output.
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(Additional reporting by Karen Norton in London, Chris Kelly in New York and Polly Yam in Hong Kong; editing by Sue Thomas)