* Off-exchange commods fail to match rally in futures market
* Lag suggests investment demand buoys exchange metals
* Still gloomy demand outlook, a correction is likely
By Humeyra Pamuk
LONDON, April 23 (Reuters) - Investors betting on a demand recovery in China have pushed exchange traded metals to multi-month highs, but the rally may be on shaky ground as off-exchange commodities point out a different reality.
Considered as good gauges of economic activity, off-exchange commodities such as steel and iron ore have further declined, failing to replicate the rally in the exchange traded commodities, such as copper, which has added some 60 percent this year.
This failure, analysts say, highlights the lack of a recovery in underlying demand for these commodities and suggests that the rally is vulnerable to a correction.
"They (non-exchange traded commodities) reflect much better the realities of demand," said analyst Rebecca O'Dwyer at Investec. "A lot of the price movement in the exchange traded commodities has come from speculation rather than from underlying demand."
On the London Metal Exchange, key steelmaking ingredients
zinc
But steel products, priced in a mature physical market and traded in a rather illiquid futures market, have either stayed flat, or lost further 10-15 percent in some cases, after a nearly 70 percent tumble since mid-2008.
Prices of iron ore, one of the biggest non-exchange traded commodities in the world, has has been flat since mid-March, after dropping some 30 percent since February, while ferrochrome is down around 16 percent since the start of the year.
BATTERING AHEAD ?
But that discrepancy could also herald a possible turnaround. "There is a risk that investor sentiment could turn negative again. We could see an unwinding of positions, which would obviously lead to a price correction in the exchange traded commodities," O'Dwyer said. Copper owes much of its gains to investment demand buoyed by the anticipation of further buying from China's State Reserve Bureau (SRB), estimated to have purchased some 300,000-350,000 tonnes of copper cathode in the first quarter.
But the metal fell to $4,360 a tonne this week, dropping more than 11 percent since it touched a six-month high of $4,925 a tonne last week.
"Last week we felt that copper was overbought," said Michael Lewis, global head of commodities research at Deutsche Bank. "We've said previously that there would be a lot of false rallies in this market, as it moves from euphoria to despair and back again," he said.
Many analysts believed SRB's buying was for restocking purposes and did not reflect a broad recovery in demand in China. In addition, prices, having risen significantly, may not look very attractive any more.
"The Chinese are unlikely to be buyers at any price and we think the 60 percent rise in the copper price year-to-date could deter additional buying in the near term," analysts at Citi said in a research note.
"Although economic indicators are improving, we are concerned that the copper price is being driven more by SRB stockpiling, future expectations and speculation rather than real underlying demand," it said.
While the futures outlook does not look very bright, the light at the end of the tunnel for non-exchange traded commodities is still very dim.
"At least for the next quarter the outlook is not particularly positive for something like ferrochrome, for example," Investec's O'Dwyer said. "We struggle to see a significant price increase."
The same picture is true for steel and iron ore, which have both seen drastic price falls from their peaks last year, after steelmakers reduced production sharply, in turn, slashing demand for iron ore.
(Reporting by Humeyra Pamuk, Editing by Peter Blackburn)