For investors spooked by May's manic metals meltdown, the long-term outlook for nickel may be better than plunging prices would suggest. And merger activity in Canada's nickel patch suggests insiders agree.

The recent 20% drop in nickel from its all-time high of $22,200 a metric ton on May 26 belies extremely tight supply, dangerously low stocks and a voracious Asian appetite for the metal, according to a new industry report.

"Although prices are some 20% lower

..., the physical nickel market remains strong," CRU International, a London-based specialty consulting company, wrote in a report on Friday. "This is illustrated in particular by the continued heavy decline in

London Metal Exchange stocks," which shrunk to about 15,000 tons from 36,000 tons at the beginning of the year. The annual world nickel market is about 1.3 million tons.

In another bullish signal, two miners with no real nickel operations,

Teck Cominco

and

Xstrata

, are trying to break into the business by derailing the merger of two huge Canadian producers with competing bids. On May 8, Teck made a $16 billion hostile offer for

Inco

(N)

, trying to block its proposed $17 billion merger with

Falconbridge

(FAL)

.

And, on May 17, Swiss miner Xstrata launched a $14.6 billion bid for the 80% of Falconbridge that it doesn't already own, putting a value on the full company at $18 billion. The Xstrata proposal was conditional on Falconbridge not going through with the Inco proposal.

Gary Mead, senior commodity analyst at Virtual Metals, a London-based specialty consulting company, explains why the bids make sense. "They're looking at ways to spend money for the future," he says. "Nickel is a good bet relative to other metals, and the latest forecasts from the International Nickel Study Group suggests there might be a very tight nickel market

this year." Mead said the future looks very promising as China continues building up its stainless steel industry.

The proposed mergers also make sense from a scale-economics viewpoint. "The capital cost of getting a new nickel project off the ground is vast," Mead said. "Unless you are really gigantic, it's difficult."

Still, that hurdle becomes an advantage, once it is cleared, because it provides a meaningful barrier to entry to new supply coming on line. Mead notes that there is a two-year waiting list to purchase the heavy moving trucks needed in the extraction of nickel ore, and each one has a $200,000 price tag.

Both Inco and Xstrata would benefit from synergies by purchasing Falconbridge, although in this respect, not all buyers stand to gain in the same way. "Xstrata seems to think they can get the same synergies by forming a simple joint venture," says Charles Bradford of New York-based Bradford Research. "They probably can get something, but not as much as Inco."

In a prepared statement issued Wednesday, Mark Cutifani, president of Inco's operations in North America and Europe, says, "We have well-developed plans that back our $550 million synergies target and we can see some other very exciting possibilities."

The CRU report's author, Tony Warwick-Ching, believes that long-term opportunity exists in nickel. "

It's only towards the end of the decade we have surpluses coming back," he says, saying that two-thirds of all nickel output is used in the production of stainless steel, with China a particularly strong buyer right now.

"Material is in short supply, reflecting meager growth in new mine output and a steady stream of unplanned disruptions to production at existing operations," the CRU report says.

Another recent study from Virtual Metals says that in 2005 there will be only 20,000 tons of production in excess of the 1.3 million tons of supply, or 1.5%. The report states "

it is a tight scenario with little room for the unexpected," meaning that any interruption to supply could easily eliminate the surplus.

The demand side of the equation also looks bright, because although the price of nickel is dramatically up compared to 2005, when it traded in the range of $12,000 to $16,000 a ton, manufacturers of stainless steel have a hard time substituting other materials for the nickel.

"Unfortunately there aren't many alternatives

to nickel," says Peter Kuck physical scientist with the U.S. Geological Survey. He explains that for reasons of structural integrity, nickel must be used to manufacture stainless steel. Without it, the steel would at best develop pits on the surface or even rust away.

"Double the price of nickel and people would still buy," Kuck said.

And that can't be bad for anyone owning a nickel mine.