Zinc backwardation to stay on Chinese smelters cap

The backwardation in zinc contracts traded on the London Metal Exchange (LME) is likely to persist, with the capacity cap on Chinese smelters continuing as part of China's environmental restrictions.

China is the biggest zinc-producing country in the world, but its refined metal output has been falling as a result of the country's environmental clampdown on polluting industries since late 2017. Smelters which did not meet emission standards were either shut down or forced to cut production.

Refined zinc production in China fell by 0.6pc to 2.27mn t between January and May this year, while output in 2018 decreased by 3.2pc year on year to 5.68mn t, according to data from China's national bureau of statistics.

As a result of the reduced utilisation rate, smelters are not consuming as much concentrates, leading to an excess supply, especially when mining operations globally have ramped up.

Global zinc mining output rose by 2pc to 12.9mn t last year, driven by higher production in Australia, data from International Lead and Zinc Study Group (ILZSG) show. Mine output is expected to grow by a further 6.2pc to 13.48mn t this year, said ILZSG.

Two producers and a number of traders said that the wide backwardation was likely caused by concentrates suppliers rolling their position because of the unsold stock.

Concentrates sellers will often hedge for the value of the zinc ores, but the delayed sales meant that they had to roll the delivery date of the futures contracts further away. This created nearby selling, which pushed the prompt contract prices higher.

The cash three-month LME contracts last traded at $114.75/t backwardation at 16:28 BST. Cash three-month backwardation has gradually narrowed since reaching a high of $157.25/t on 28 May.

Refined zinc production in China is set to normalise as some smelters restart after maintenance to meet environmental standards, but it is unclear when this will happen as the Chinese government will continue to monitor pollution levels throughout the country and adjust industrial output accordingly, especially in key producing regions such as Hunan and Henan.

"The million-dollar question is — when will these stocks start hitting the market in a big way? People want to go short on the spread, [but] being too short and too complacent is like putting the cat among the pigeons," said one warrant trader.