The supply and demand outlook of surging base metal markets is much tighter than previously thought, although investors are overreacting, Citigroup Inc. (C) said in a report Saturday.

"Whilst not forecasting a continuation of the rally in spot prices, we are nonetheless more optimistic that underlying fundamentals will support metal prices in the medium term," the investment bank's commodity analysts said.

In upgrading its price expectations over the coming years, Citigroup becomes the latest commodity forecaster to underestimate the constraints faced by producers to meet the China-led surge in demand.

Producers' ability to lift output continues to disappoint due to past under-investment when prices were low combined with shortages of labor and materials.

Citigroup raised its expectation for the price of flagship base metal copper this year by 52% to $2.81 a pound, although that is still around $1 below the current near-record price.

It also lifted its 2007 estimate by 50% to $2.25 and its long-term call by 16% to $1.10.

The stronger-than-expected outlook is based partly on "supply and demand becoming inelastic to price at this stage in the bull market, contributing to a prolonged cycle."

Citigroup also increased its aluminium forecast by 15% to $1.17 for this year and by 11% to $1.00 for next year, while raising its nickel and zinc estimates by 23% and 28%, respectively, for this year.

The bank also upgraded its long-term forecasts as fast rising production costs combine with materials-intensive economic growth in China.

"Production costs having increased by 30% over the last two years, 40% of which we estimate is structural," it said.

And higher operating and capital expenditure costs for new projects are set to continue as "ore grades resume their trend decline, smaller mines are developed, existing operations go deeper, and sustainability costs increase."

For producers, however, the stronger-for-longer price scenario is expected to offset rising costs, with significantly improved profit expectations for the likes of BHP Billiton Ltd. (BHP) and Rio Tinto plc (RTP).

Citigroup lifted its earnings expectations for BHP Billion by 6% to US$10.65 billion in the current fiscal year and by 34% to US$14.32 billion for fiscal 2007.

It also noted growing merger and acquisition potential, especially for Rio Tinto, based on the continued swing in economics favoring buying rather than building assets.

Citigroup analysts warned, however, that commodity investors are overreacting to the super-cycle, driving prices higher than fundamentals would dictate and creating an investment bubble.

Nevertheless, for now there is little sign of metal consumers being put off by record metal prices, partly because prices of alternatives are also increasing, they said.