FT Alphaville (via Standard Chartered) has recently uncovered action in the copper markets than can only be described as speculation gone wild. Following a strategy trip to China the SC Research team notes some peculiar action in the metal. They said:
We visited China last week, with the aim of gauging Chinese sentiment, the impact of monetary tightening measures on consumers and also investigating the scale and implications of copper’s use as a financing tool. We were already fairly bearish towards copper’s near term prospects before the trip. That negative feeling has intensified, with significant downside risks to copper prices emerging.
- Anecdotally, something in the region of 600,000 mt of refined copper is currently sat in bonded warehouses in Shanghai, with perhaps another 100,000 mt in the southern ports. This is equivalent to around 11% of China’s total refined consumption and around 40% of China’s net refined copper demand.
- Bonded stocks have climbed by around 300,000 mt since the beginning of this year, pointing to the absence of end use demand at the moment. The amount of metal is so high, that spare capacity at some bonded warehouses is running out, with some metal being stored outside.
- The scale of the refined inventory casts into doubt the size of the expected refined deficit in the copper market this year, and raises the prospect of a balanced market, or even a small surplus.
- More worryingly however is that the primary use of copper in bonded warehouse appears to be as a financing mechanism to provide cheap working capital for various types of business often unrelated to the metallic industry. Initially via a letter of credit and then by using deferred payment LC, they create a borrowing vehicle. Estimates for the amount of metal tied up in such a way range from 40-80% of total bonded stocks. Our estimates are towards the upper end of this range.
- Property developers (or the property developing arms of conglomerates), appear to be behind the lions share of this type of activity, driven by an unwillingness by domestic banks to extend finance, or the imposition of interest rates of anything from 10-20% when they do. On that basis, interest rates on metal of LIBOR + cost of funding look very attractive indeed.
- A scenario of falling Chinese property prices, perhaps combined with a government clampdown on alternative sources of funding, would therefore be a devastating outcome for the copper market, simultaneously robbing the metal of an end-user and leading to a mini credit crunch. The obvious home for the bonded material would then be the LME warehouses in the Asian region, with very negative implications for sentiment towards copper prices.
We’re all aware of the commodity boom in China, however, this just wreaks of irrational exuberance.
Source: FT Alphaville
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.