* Correction expected after gains of over 50 pct this year
* Indonesia ban akin to cut-off of Saudi supplies in oil
* Stainless steel firms able to pass on higher nickel costs
By Eric Onstad and Melanie Burton
LONDON/SINGAPORE, May 14 (Reuters) - Nickel is likely to see a deeper retreat than Wednesday's 5 percent fall, but it is also due to bounce back as long as top exporter Indonesia keeps squeezing supply and stainless steel producers can absorb higher prices.
Nickel surged over 50 percent this year to touch a 27-month peak of $21,625 on Tuesday. That steep upward trajectory has raised worries that a wave of speculative buying is fuelling a financial bubble.
Prices fell 5.3 percent on Wednesday, but an even sharper pullback would still not signal the end of nickel's sizzling rally due to the game-changing nature of Indonesia's ban on unprocessed ore exports, traders and analysts said.
"The effective removal of Indonesian ore exports is akin to the removal of Saudi Arabia from crude oil exports in terms of importance to the nickel market," analyst David Wilson at Citi in London said. "The nickel market is clearly undergoing a dramatic and very fundamental change."
Last year Indonesia accounted for 28 percent of mined nickel output, and that figure will fall to 7 percent in 2014 following its ban in January, Wilson forecast in a note.
The market will flip from a surplus of 162,600 tonnes last year to a deficit of 140,100 tonnes in 2015, according to Grant Sporre, head of metals research at Deutsche Bank.
The market this year is seen as largely balanced as healthy stocks of ore in China and metal in LME warehouses are worked off. The physical impact is only gradually being felt, which is leading to worries that the price gains could prove to have overshot.
"History shows you when you're in a bull market like this, especially such a dramatically quick one, nothing goes in a straight line, and usually at some point there's a correction," said Stephen Briggs, a metals strategist at BNP Paribas. "The market needs a breather at some point."
Such a correction could be sharp and quick - exceeding Wednesday's drop - partly due to the heavy use of options by investors to limit their downside exposure.
During the first four months of the year, 364,900 lots of LME nickel options were traded, 28 percent more than were traded during the whole of last year.
Traders warn that the surge in options business accentuates price swings as holders of options react to price moves by buying and selling futures to hedge their exposure.
Wilson expects a price pull-back in late May or early June, when a seasonal decline in restocking of stainless steel is expected, but he regards any move towards $18,500 as a good opportunity to buy.
Others say prices could drop to $16,000 before bouncing back.
The pricing power of companies that make stainless steel, which accounts for about two-thirds of nickel consumption, is another argument for higher nickel prices.
Because stainless steel makes up a small proportion of overall costs for the companies that manufacture equipment, cars and buildings, they are more able to swallow rising prices, industry sources and analysts said.
China is the world's top consumer of nickel, and around 60 percent of its stainless steel demand comes from construction, transport and industrial equipment such as oil and gas pipelines, according to Morgan Stanley.
"You're not going to get a situation where higher nickel prices cause financial distress to consumers," said commodities strategist Ivan Szpakowski at Citi in Shanghai.
"As a percentage of their entire cost, it's usually pretty small. A 20 to 30 percent increase in nickel prices is not going to dramatically impact one of these projects if you're building a new refinery," he added.
The one sector that may have more trouble is consumer goods and kitchenware, such as toasters or stove tops, which accounts for around a third of demand, according to Morgan Stanley.
So far, higher stainless steel prices have not blunted demand.
Top Chinese stainless steel producer Shanxi Taigang is producing more metal now than a year ago, and that production is currently profitable, a source at the equity division of the firm said. It plans to increase production to 4 million tonnes this year from 3.23 million in 2013.
He said high prices of nickel pig iron and refined nickel in China had not affected Taigang's production and that it had sold all its output.
Like Taigang, most stainless steel mills in China are maintaining normal production rates after seasonal consumption pushed up spot purchases by end-users and merchants, said Han Jianbiao, an analyst at information provider Umetal.com in Beijing. (editing by Jane Baird)