Merrill Lynch analysts warn that the honeymoon may soon be over for both nickel and aluminium stocks.

Turning to nickel first, Merrills suggests the market (and indeed their own analysts) will shortly need to upgrade nickel price forecasts once again, and subsequent mining company earnings. The upcoming reporting season should be a cracker for nickel miners.

However, the risk is that the nickel price will subsequently fall sharply, as it did in mid-2005, due to stainless steel destocking.

Last month Merrills warned that a destock would likely commence in the first quarter of 2007. Since then, the nickel price has risen a further 20% due to a lack of inventory, strikes, and general production problems. US stainless steel supplies now exceed six months, notes Merrills. Before the 2005 destock, supplies exceeded five months. Four months is the norm.

News from Europe is that while stainless steel demand has been strong, inventories are also building and demand growth is beginning to slow. The world's most voracious consumer of nickel – China – has driven the nickel price in 2006 but has now found a new source of lower grade ore out of the Philippines. This indicates the Chinese are definitely price sensitive, says Merrills.

These factors add up to a potentially sharp fall in the nickel price. However, the reality is that actual inventories of nickel metal are still low and declining and there remain supply disruptions and delays. This can offset the stainless steel destock. What to do?

Merrills suggests investors crystallise some gains in nickel stocks. There is a delicate balance, and one wouldn't want to be caught out either way.

In the case of aluminium, the problem is a rise in the price of alumina. Demand for alumina has risen in China, while in the meantime one significant exporter of bauxite – Guinea – has seen its supplies disrupted by a general strike (which has also seen fatalities).

To make matters worse, the supplier of 95% of China's imported bauxite – Indonesia – has moved to ban the export of all unprocessed minerals. This will be on the basis of a general wind-down, over 5-7 years, but it will become an important long term issue for China, Merrill Lynch suggests.

The price of bauxite has been rising, putting pressure on Chinese alumina margins, and this is why refiners have banded together to increase alumina spot prices.

A higher alumina price is negative for the aluminium market, says Merrill, as China is churning out alumina at the low end of the cost curve and is ramping up while the aluminium price is rising. Production should thus continue to grow strongly. At some point it must come to grief. Aluminium inventories are beginning to rise.