Reserve Management Parts I and II WBP Public 71907

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Reserve Management The Commodity Bubble, The Metals Manipulation, The Contagion Risk To Gold And The Threat Of The Great Hedge Fund Unwind To Spread Product To: Global Central Bankers at the World Bank Executive Forum From: Frank Veneroso April 17, 2007 Revised as of today July 19, 2007 Introduction Thank you for this second invitation to speak at your treasury management conference. Last year I was asked to speak only because Larry Summers, who was scheduled to speak, could not make it at the last moment and I was asked to fill in. I chose to speak on the subject of the global commodity bubble as well as the U.S. housing and housing finance bubble and their eventual bursting. My presentation was a bit on the histrionic side, and I know it was greeted with a certain amount of amusement. But I certainly did not expect that it was of enough interest to warrant a second invitation to speak on the same topic particularly with the more august speakers available such as Larry Summers. Perhaps I am reading more into this invitation than I should, but it seems to me that the events that have transpired over the last year must have intrigued some of you with the thesis that we have had a commodity and a housing bubble, that they may be in the process of bursting, and that this may have some relevance to central bankers and to reserve management. Last year, I did not really focus on central bank reserve management, but I thought that this year I might direct my train of thought to some reserve management issues. So, in what I have to say today, I will try to work towards two assessments: first, the outlook for gold as a reserve asset, and second, the outlook for spreads and the yield curve, which is obviously very relevant to reserve management. The following paper is very long. So let me give a road map of where I will be going. In the first part of this paper on the Commodity Bubble, I make the case that, in real terms, we have had an unprecedented commodity bubble in this decade. This bubble has occurred because of unprecedented investment and speculation in commodities, largely by way of derivatives. The far more important engine of this bubble has been leveraged speculation by hedge funds. Over the last two years prices have climbed even though the microeconomic fundamentals of commodities have deteriorated. There lies ahead a bursting of this commodity bubble. It is now being triggered by deteriorating fundamentals and it will be exacerbated by eventual investor revulsion which will reverse the extraordinary fund flows that have created this bubble.
World Bank Presentation
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In part two, Metals: A Speculation to the Point of Manipulation, I turn to the leading edge of this cycles commodity mania metals. In base metals and to some degree in white metals hedge fund speculation has extended beyond derivatives to purchases of the physical. This has resulted in several variants of classic market squeezes across the metals sector. These squeezes in the context of a runaway speculative fervor have resulted in increases in real prices for some metals that are far in excess of anything that has ever occurred before for these metals, in particular, and almost all commodities in general. Because of the extraordinary amplitude and duration of these price moves, the microeconomic responses will be stronger than ever before, generating record surpluses that will ultimately lead to reversion to the mean or marginal cost. Investor revulsion toward this commodity subsector should prove to be greater than for other commodities. A consequent reversal of fund flows and the eventual liquidation of physical stocks held by hedge funds should lead to severe undershooting of marginal cost in the years to come. In the third part of this paper, I consider gold. Golds fundamentals are far better than those of base and white metals. Unlike other commodities, there is zero mine supply growth in gold. Unfortunately, growth in physical demands for gold in jewelry, small bar and official coin has been surprisingly negative over the last decade plus, especially in former gold loving Asia. The net flow of gold from official stock liquidation in all its forms, which had been depressing the gold price, has now disappeared, eliminating a former potentially bullish factor for gold. The last advance in the price of gold since mid 2005 has been driven by funds. Gold and other metals have been especially closely correlated in this cycle, perhaps because funds have similar portfolios driven by a similar psychology toward all metals. Therefore, a revulsion by institutional holders from commodities in general and the metals sector in particular constitutes a serious contagion risk to the gold price.
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Part I: The Commodity Bubble Microeconomic Dynamics Dictate Commodity Cycles
Let us first consider the bull market in commodities in this cycle. That is a first step toward drawing some implications regarding the outlook for gold as a reserve asset. I will start with a recap of my thesis from last year. Commodity prices move in cycles. Their cycle tends to be strongly correlated with the business cycle. However, since the end of the 1970s our business cycle expansions, in the United States at least, have been longer than in the past. The expansion of the 1980s lasted eight years. The expansion of the 1990s lasted ten years. Commodity cycles have not tended to be this long. G 75 CRY Reuters
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GSCI Commodity Spot Index
Note: The GSCI chart is very heavily weighted with energy, hence the brief spike in 1990 with the onset of the Gulf War and the rally in 2000 when most commodity prices were very weak. The CRB chart tracks most other commodities including metals. The above charts make this clear. In the 1980s there was a recovery in commodity prices from the depths of the deep global recession. But it did not last for long. The microeconomics of the supply and demand for commodities led to a sharp correction in the mid 1980s, despite an uninterrupted global economic expansion. Around 1984 industrial metals were the first to sink back to close to the recession lows. The price of oil, held up by OPEC supply cutbacks into 1985, was the last commodity to undergo a severe correction in the middle of that decade. Later in the decade sustained global growth along with restrained supplies owing to the fall back in prices put upside pressure once again on the prices of commodities, though not uniformly. When commodity prices went up again later in the expansion the rise in metals prices was particularly strong, while the price of oil barely recovered as it bounced along its new bear market base (until the 1990 Gulf War). In any case, late in that decade most commodity prices started down once again by 1989, well before the 1980s business expansion ended.
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A similar pattern whereby the commodity price cycle was much shorter than the business cycle occurred again in the 1990s. A rolling global slowdown from the U.S. recession to the Japanese and European recessions delayed the onset of a new full fledged commodity bull market until the middle years of the decade. A few years later peaks were reached in 1996 and 1997. Then, once again, long before the end of the U.S. economic expansion, and for that matter the global economic expansion, commodity prices started down. The severe economic weakness of Asia in 1998 contributed to this decline. However, it was not enough to take global economic growth below its trend. Nonetheless, the price of crude oil fell to $10 a barrel in 1998 a multi-decade low and the prices of industrial metals fell to close to multi-decade lows in 1999 even though the U.S. economic expansion remained in full force. I believe it is safe to say that commodity bull cycles tend to be shorter than the unusually long U.S. economic expansions that we have had since the onset of the so-called Great Moderation that began in the early 1980s. Why was this the case? I think the answer is very simple. Although cycles in global aggregate demand greatly influence commodity prices, in addition to these macroeconomic determinants of commodity prices there are the microeconomic determinants of supply encouragement and demand rationing. A global economic expansion may pull commodity prices up. But once prices are well above marginal cost, supplies are encouraged and substitution and economization lead to the rationing of demand. These microeconomic dynamics in the end drive commodity prices lower, even if a global business expansion remains intact. At least, until this cycle. Until Now. In Real Terms, The Biggest And Longest Commodity Bull In History The commodity bull market of this decade has been unusually high in amplitude. By some measures real (inflation adjusted) commodity prices have risen more in percentage terms than they have in any prior half-decade bull market. As we will see later in this document, the percentage rises in price in some industrial metals have broken all historical records. The bull moves in some commodities in this cycle have also broken records for longevity. By one compilation only two of the commodities traded on U.S. futures exchanges have ever had single cycle bull moves in a century and a half of economic history that have lasted as long as some of the most persistently bullish commodities in this cycle like nickel and lead. It would seem that the microeconomic dynamics that have reversed commodity prices in the past have either been absent or overwhelmed. Let me illustrate these points.
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Look at the above chart of commodity prices over two and a half centuries. What is most important about this bull cycle is that it is a commodity price rise that is without an accompanying generalized inflation. This makes it larger in real terms than any in history over a single cycle. It is the amplitude of this bull in inflation adjusted terms that makes the current cyclical bull move in commodities anomalous indeed. In nominal terms, this cyclical bull move exceeds in percentage terms the move from 1968 to 1974 and, again, the subsequent move from 1976 to 1981. To be sure, the entire nominal price move from 1968 to 1981 exceeds that of this cycle but the time period involved was twice as long. Also, there was a huge increase in the general price level from 1968 to 1981. Then almost all indices of general price inflation increased by almost three times. So most of that overall increase in nominal commodity prices was due to inflation in the general level of prices and not to the relative price of commodities. By contrast, inflation has been minimal since late 1999, making the increase in the real price of commodities in this cycle greater than even that of the very long 1968 1981 super cycle.
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If you look across this chart youll see that most of the big moves in commodities were due to inflations that were related to wars. That was true for the bull move at the time of the Vietnamese War from 1968 to the mid-1970s. It was true of the increase in commodity prices from 1939 to 1951 a period that spanned the Second World War and the Korean War. The bull market in commodities that ended in 1920 resulted from the monetary issuance associated with the First World War. Again, the bull move that ended in 1864 was associated with the inflation of the Civil War. And the moves that ended in 1815 and in 1781 were associated with the War of 1812, the Napoleonic Wars, and the aftermath of the US Revolutionary War. What this look back at history tells us is that price spikes in commodities have always been due in some way or other to the onset of generally inflationary conditions, usually as a result of war time finance or its aftermath. Inflation adjusted or real commodity prices simply have never had long and lasting bull markets. Again, until this cycle. The New Era Thesis In my experience, when a cyclical price trend persists for longer and to a greater degree than has happened in the past, market participants declare a New Era to not only explain this unusual continuation but to also justify the persistence of the trend forever forward. This has certainly happened with regard to commodity prices in this cycle. There has emerged a host of New Era advocates who share the following common arguments. The very healthy growth of the emerging economies and the super strong growth of China and India have made world economic growth different this time. We are in the midst of a new global supercycle in commodity demands that has relegated the fairly short commodity price cycles of the past to a history that is no longer relevant. The same New Era thinking extends to the supply of commodities. We are most familiar with such thinking as regards the oil market. The Peak Oil thesis says that discovery of all the easy to find large oil reservoirs with low extraction costs are behind us. Yes, there are smaller, higher cost oil reservoirs to be found and exploited. But declining production from the large mature fields we largely rely upon offsets these new sources of output. For all the new drilling and development we do, we find ourselves simply running fast to stay in the same place, as decline rates on our old reservoirs pull the ground out from underneath us. New Era commodity bulls extend this supply side thesis as it applies to oil to many other commodities. In agricultural commodities, we are facing limits to the expansion of arable land. In industrial metals the easy to find deposits have been found and, in existing mines, ore grades are declining, and so forth.
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It is my belief that these many claims for a New Era of explosive demand growth and supply constraints are largely erroneous. This is best argued by looking at individual commodity markets, for there we can document in detail if trend demand growth has accelerated or if rapid supply increases have become impossible. I will do that in what follows. We will see that the analysis of individual commodity markets shows clearly that the New Era hypotheses are wrong. But one can also make a few generalizations that are pertinent. Two decades ago I participated in a huge study of the copper market under the auspices of the IFC and the other partners in a project called Escondida a project which was to become the largest copper mine in the world. We had the resources of the World Bank, BHP, RTZ, and an array of the worlds best consultants. If I go back to that copper price forecasting exercise at that point in time it becomes very clear that, despite the high economic growth in the emerging world in this decade, we are not in a New Era, we are not in a new supercycle in commodity demands. Making long term commodity price forecasts is largely an exercise in extrapolation. At that time, two decades ago, we were extrapolating based on the economic growth trends of the prior several decades. The emerging world was growing very fast, though the contributors to its growth were somewhat different. In those days Brazil was a 7% grower, Mexico a 6% grower, Korea an 11% grower. Their economic growth rates today are perhaps half of what they were. This is something of an offset to the recent high 9% growth rates of China and India. But, you will respond, the economies of the emerging world overall are now a much larger share of the world economy overall. And, to be sure, that is true. But offsetting this is the fact that the large developed economies were then far faster growers. Japans economy grew at a 9% rate in the 1960s and almost at that rate in the 1970s. It now has a secular growth rate of perhaps 1.5%. Europe overall had a growth rate of 4%-5% in the 1960s and 1970s. It now has a secular growth rate of perhaps 2%. For the largest share of the global economy the attainment of the technological frontier, which implies lower productivity rates, plus adverse demographics, has now reduced its economic growth rate dramatically. If you take all the economies in the world, valuing GDP based on exchange rates, the overall global growth rate has not significantly changed since the mid 1970s. And so the demand pressures on commodities should not have significantly changed either. And, in fact, as the chart below indicates, global economic growth and hence growth in commodity demands were higher in the period immediately prior to the mid 1970s. Then much of the global economy was still recovering from a prior war ridden epoch when the disasters of wartime had set back so many economies from a greater potential made possible by the interim advance in the technological frontier. Now these industrialized economies have matured technologically and demographically. Other emerging economies are following their former path, providing the new leadership to global growth. But the overall pace of that global growth has not appreciably changed since the
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mid 1970s and is considerably lower than the growth that was achieved in the first post war decades. Global Real GDP, % Annual Change (Exchange Rate Based)
40000 35000 30000 25000 20000 15000 10000 5000 0 1900 1905 1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Series1 Series2
0.08 0.07 0.06 0.05 0.04 0.03 0.02 0.01 0
Source: IMF, Contributed by Lars Pedersen Mega Speculation and The Explosion In Commodity Derivatives So if it is not a new era of supercycle demand growth and supply restraint, what has led to such a high amplitude and long duration bull market in commodities in this cycle. My answer is speculation nothing more. And speculation on an unimaginable scale. Our first clue to the scale of this development is data compiled since the mid 1990s on over the counter commodity derivative positions held on the books of the worlds banks. Compiled by the Bank for International Settlements, it shows striking growth over the past several years.
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Integrated Oil Update, Mike Rothman, ISI, December 19, 2006 Though the six-fold increase in such positions over a few brief years is dramatic , it is the magnitude of these positions that is most alarming. From what we know of this data there is considerable double counting. But, offsetting this, this compilation is incomplete. It excludes the positions of some investment banks who are extremely important intermediaries in the commodity derivatives markets. And it excludes all futures and options positions on commodity exchanges, which may add another $2 billion or more to the global total. Taken all together the global total for all commodity derivatives is probably much more than $10 trillion. It is hard to know what to make of this data. But it is noteworthy that several years ago, at the then prevailing lower commodity prices, the entire above ground stock of all commodity inventories was only in the hundreds of billions of dollars. Even if only a fraction of the increase in global commodity derivative aggregates in recent years corresponds to a net long position of investors or speculators, implying speculative and investment positions of a few trillions of dollars, it would appear that this increased demand for commodity derivative positions has overwhelmed what have been relatively small markets.
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No wonder, then, that this cycles bull market in commodity prices has gone higher in inflation-adjusted terms and for longer than in all prior uninterrupted half-decade cycles in the past. Investment Or Speculation? The question arises, who are these new investors or speculators in world commodity markets and what is their behavior? Investment in commodities today probably refers above all to pensions and endowments who have made long term strategic allocations to commodity futures index baskets for diversification purposes. However, the total assets of all these baskets is somewhere between $100 and $200 billion up from perhaps a total of several tens of billions at the start of this decade 7 years ago. These investment positions are quite straightforward; there is little in the way of spread products or options or leverage that would augment this overall position. If so, one is hard pressed to explain the increase in recent years in commodity derivative positions in the many trillions of dollars by citing such strategic allocations into commodity baskets. There is another alternative: speculating hedge funds. It is estimated that the total assets of hedge funds of all types globally now approaches $2 trillion (up from several hundred billion 6 years ago) and many of the types of funds who speculate in commodities employ huge leverage. The increase in gross assets of those speculators could account for much more of the growth in commodity derivatives. But do they? We got something of a window on this world at the end of the third quarter of last year with the collapse of the hedge fund Amaranth. Apparently, this fund lost perhaps $6 billion or more in one commodity U.S. natural gas in a matter of weeks. The magnitude of this loss and the change in natural gas forward prices at the time implies a gross position in that commodity that was at least a small whole number multiple of the $6 billion loss. By contrast, the nominal value of all the U.S. natural gas derivative positions of all outstanding commodity baskets was not much larger than Amaranths loss. Clearly, in natural gas one speculative hedge fund, Amaranth, was many times larger in the gas forward markets than all the worlds investors in commodity baskets. And Amaranth was only one hedge fund. According to one compilation there are now hundreds of hedge funds dedicated solely to the commodity sector, and all kinds of more diversified funds like global macro funds who speculate in commodities. So hedge fund positions in commodity derivatives outweigh pension and endowment investment positions, and by a very large margin. So if unprecedented speculation is responsible for the amplitude and duration of this commodity bull cycle, it can be attributed, for the most part, to hedge funds.
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How Investment And Speculation In Commodities Inflates Commodity Prices In the above discussion there is an implied assumption: hedge fund speculation in commodity derivatives has overwhelmed commodity markets and has driven commodity prices way beyond levels justified by fundamentals. Also implicit is the assumption that hedge funds can employ vast leverage using such derivatives, so that limited pools of speculative capital can create huge demands for commodities. I believe these assumptions are valid. But there is a widely held and respectable counter argument. Derivatives are simply contracts for future delivery between two parties. To be sure, a speculator can take a long position in a commodity with only a small margin commitment by going long a derivative contract. But, for his long position, there must be a counterparty short position. The counterparty taking the short position need put up only a small margin also and can apply the same degree of leverage. So the two sides of the contract balance out. And the leverage employed using a derivative by both the long and the short balance out. Hence the proliferation of derivative contracts does not influence market prices, despite their leverage potential. Because the longs and the shorts basically have the same access to leverage and take offsetting positions. Since the mid 1990s Fed chairman Alan Greenspan and Treasury Secretaries Robert Rubin and Larry Summers were pushed repeatedly by Congress to bring the OTC derivatives market under regulatory scrutiny and control. The concern of some Congressmen was that the shadowy world of OTC derivatives could increase the leverage of speculators and thereby the risks to markets and ultimately to economic activity. Greenspan, Rubin, and Summers fought off these efforts by Congress with unfailing determination. Their argument was that derivatives simply reallocated risk; they did not increase risk. And this reallocation spread risk among a greater number of market participants, including participants who were better suited to bear it. Therefore, derivatives were reducing- not increasing- the risks to markets. This sounds like a solid argument with theoretical underpinnings. But, for many market participants, it just does not seem realistic. We know of too many instances where speculators have used derivative contracts to take on very large leveraged positions and have thereby exaggerated price movements which ultimately led to crashes. There are two famous examples. The first is the 1987 stock market crash which resulted from the widespread adoption of portfolio insurance which was based on the relatively new introduction at the time of derivatives and synthetic derivatives on the stock market indices. The second example is provided by 1998. In that episode it was not just LTCM which experienced severe difficulties; many of the large dominant macro funds at the time took very large losses in only a matter of a few months. And Bankers Trust suffered such losses it had to be merged into Deutsche Bank. These funds and prop desks had pushed a whole set of markets to extremes which then all violently reversed in unison. In
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many of these markets, like the fixed income and currency markets, the price distortions were aided by the use of derivatives and the subsequent crashes were exacerbated by the unwinding of derivative positions. Many have argued that the explosion in fixed income and forex derivatives in this decade which one sees via the published reports of participating commercial banks- has not resulted in market excesses as a result of their explosive growth since the end of the 1990s. That is probably correct. For so far, at least. So, the experience of these markets and their derivatives can be marshaled to support the Polyanna thesis of Greenspan, Rubin, and Summers. But one can do this only if one conveniently chooses to forget the derivative-related debacles of 1998. How does one settle this dispute? By looking closely at the interaction of derivatives, the underlying, and the price mechanism in specific markets. So let us look at all these in the commodity space. First, we must decide on what constitutes the underlying. Commodity derivatives tend to arise through the hedging of the stock of commodity inventories and anticipated future production. Before the commodity bubble of this cycle- when commodity prices were close to marginal cost- the total money value of all commodity inventories worldwide was on the order of several hundred billions of dollars. Some of this was hedged, giving rise to commodity derivatives. And a small part of future production was hedged, giving rise to yet more commodity derivatives. Taken together all of these commodity derivatives were comparable to a portion of the money value of the outstanding stock of commodity inventories and a little forward production. The worlds commodity derivative aggregates made sense. As a result of the bubble in commodity prices in this decade the money value of the outstanding stock of commodity inventories and physical production has doubled or tripled. But the outstanding commodity derivatives, partly visible through the window of commercial bank books, has gone up by more than six fold. Now the commodity derivative aggregates seem to be outsized relative to the underlying. Has this explosion in commodity derivatives distorted prices and increased market risk? It is apparent from my use of the term bubble and the way I have framed the above that I believe it has. Let me explain the process whereby it has. Roughly four or five years into this decade- and two or three years into this cyclical economic expansion- commodity markets experienced a big bull run. Without going into the details, I think it is easy to make the case that microeconomic and macroeconomic fundamentals were responsible for the first stage of this bull move. But once it was underway the superior performance of commodity prices attracted attention. Long-term investors like pensions and endowments began to consider commodities as a new asset class and hedge funds, always looking for fast action to justify their costly 2% plus 20% compensation arrangements, began to chase commodities.
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As is apparent from the above chart, the first phase of the commodity bull move occurred without huge growth in commodity derivatives. But from the beginning of 2005 onward there has been a vast explosion of hedge funds and pensions and endowments who have tried to get longer and longer commodities by way of the purchase of long positions in commodity derivatives. Looking at the pattern of expansion of commodity derivatives one can make a prima facie case that the investment and speculative flows into commodity derivatives with their huge implied leverage pushed commodity prices further than they otherwise would have gone after 2004. How could this have happened? Initially, before the explosion in commodity derivatives, the structure of commodity derivatives markets was as follows: speculators tended to be net long, commercial consumers tended to be net short as they hedged some of their inventory, and producers were mostly net short as they hedged some inventory and some future production. The speculators were able to increase their long positions in commodities by way of derivatives because commercials, who were natural hedgers of some of their inventory and some of their nearby future production, were willing to increase the volume of their hedges. How did this come about? Speculators wanting to go long had to create a price signal that would lead to an increase in the supply of these derivatives, since for every long there must be a short. Buying pressure by the longs through commodity derivatives raised the price of commodities above their marginal cost which is their long run price equilibrium. Commercials, recognizing where marginal cost lay, were encouraged by higher prices to hedge more of the outstanding stock of inventories. They were also encouraged to sell more of their future production forward. In past cycles, when commodity prices soared, spot prices tended to rise much more rapidly than forward prices. Hedgers did not forget that the long run price equilibrium was still marginal cost. As a consequence these markets went into steep forward discounts or backwardations. But, in this cycle, so great was the buying pressure of the longs in commodity derivatives that, starting in 2005, far forward prices were pushed up along with spot and nearby forward prices. When speculators and investors go long derivatives they are going long the forward price. If speculators want to take on positions that are ever larger relative to the underlying they have to push up far forward prices further and further in order to induce producers to sell future production ever further forward- and thereby provide the increasing supply of derivatives that accommodates the new speculative demands. In keeping with the unprecedented explosion in commodity derivatives in this cycle, this entire process has happened in spades. Most striking has been the case of crude oil. In the past, whenever crude oil was at marginal cost, the forward market was in a small backwardation. When the crude oil price rose sharply the backwardation became huge. In this cycle it has been totally different. As investors and speculators bought more and
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more oil by way of derivatives the far forward crude oil price was driven to a huge premium over the spot price- something that had never, ever happened before. Why? Because this is what it took to get commercial hedgers to generate the unprecedented crude oil derivatives supply that rabid investors and speculators now demanded. Let us go back to the Pollyanna thesis of Greenspan, Rubin, and Summers; in derivatives, for every long there is a counterparty short, and therefore behavior in the derivative market is price neutral. To be sure ex post there is always a leveraged short to match every leveraged long. But the process is not price neutral. Ex ante the rabid demands of investors and speculators overwhelm the commodity markets and push up the forward price. And it is only that price signal that brings forward the commodity derivatives supply that ex post completes the identity of longs and shorts, supply and demand. Does this price impact create a market risk? Of course. How? If a tsunami of rabid investment and speculative commodity derivative demands hits the commodity markets, it must drive the forward price more above marginal cost than in a normal bull cycle. The higher the price is driven above marginal cost the more new supply will be encouraged. These high prices will also lead to a more assiduous effort by commodity consumers to economize and substitute, thereby rationing demand. If unusual commodity derivative demands take prices very high and on a sustained basis, the resulting surpluses that will eventually take down these prices will be all the larger. But there is another facet to the increase in risk in commodity markets created by derivative tsunamis. It is the financial risk created by the vast implied leverage of derivatives. Speculators, by putting up only limited margin, can take on huge leveraged positions. Pyramiding speculators can employ ever greater leverage as prices soar. For those leveraged speculators it takes only a partial correction of the price rise to wipe them out. In this way hedge funds can fail, as LTCM would have totally failed without its bailout, and as Amaranth almost failed a mere seven months ago. The Pollyannas about derivative leverage always emphasize symmetry in the derivative markets: for every long there must be a short, the leverage of the longs must be matched by the leverage of the shorts. But in the commodity markets there is not symmetry of behavior. How so? The pyramiding leveraged speculators in commodity derivatives must meet margin calls when the price eventually goes against them. They may not be able to do so. Then there will be failures. There is no parallel to this with regard to hedging commercials who are short by way of derivatives. Yes, they may be leveraged, but they have the commodity in inventory on the shop floor or on the production site or in a warehouse somewhere. Or they have future production secured in the form of extractable reserves in the ground or the wherewithal to produce another crop. Whoever are the dealers the hedgers have their margin position with, the odds are that they have the stuff to deliver against their forward sale when it comes due; hence, there is no margin call or the margin call will be financed by their dealer.
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It is this situational and behavioral asymmetry between the leveraged longs and the leveraged shorts in commodity markets that creates financial risks and the potential for crash dynamics when derivative leverage creates excessive bull moves in prices. For the speculative longs who are leveraged, when the leverage goes against them they get margin calls. And when the margin calls come fast and furious they must sell or be sold out. Not so for the hedgers who are short and who are carried by their dealers on price rises that go against them. More importantly, when prices fall such commercial hedgers often just sit with their shorts. They know they have the stuff to deliver when the delivery due date comes, and they may simply wait until that due date and then deliver their stuff against their short. So the longs are forced to liquidate. But the hedging shorts may not be inclined to accommodate them by buying in their shorts. It is this behavioral imbalance that creates crashes. A Brief Note On Oil My objective is to get in the end to our topic of reserve management which are gold and credit spreads. But it is probably worthwhile to touch on the single most important commodity first, which is crude oil, before we go on to metals and gold. The price of crude oil has appreciated almost as much in this cycle as the most bullish of all the commodities the base metals. So, one may ask, is it a bubble? Two years ago the noted money manager Jeremy Grantham posed this question in an interesting way. He presented a chart of the real inflation adjusted oil price going back to 1875.
He then noted: Over the years we have asked over 2000 professionals for an exception to our claim that every asset class move of 2 sigmas away from trend had broken, and not one of the 2000 has ever offered an exception! This should be scarier than the fact that GMO has tried so hard to find one and failed. But we always have said that intellectually you can imagine a paradigm shift in an asset class price, even if we have been unable to document one yet in history. Exhibit 5 shows the price of oil and 1 and 2 standard deviation bands. If the new price averages $50 and above, it will look suspiciously like the real McCoy. Chinese growth and supply problems could do it. Its the best
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possibility Ive seen in my career. But the investment desert is littered with the bones of those who bet on new paradigms. So for Grantham any asset class that moves more than two standard deviations from trend is apparently a bubble and history says that such markets absolutely always mean revert, such bubbles always burst. This happened with the bubble in oil in the 1970s. But Grantham opens the possibility that crude oil this time could be the first exception. Why? As alluded to above, it is a popular view (the peak oil thesis) that, in this cycle and maybe forever forward, the supply of oil will be severely constrained. And that this will be even more so if there is an adverse geopolitical development in the Middle East that disrupts global oil supplies. If oil is the first exception in history to the bursting of all bubbles, this will be why. Let us look at oils fundamentals. When one looks at the supply/demand data for crude oil over this cycle it falls within ranges that I would regard as reasonable relative to history. Demand growth, which averaged perhaps 1.6% per annum in the prior decade, was elevated in 2004 to a 4% rate by a synchronous global expansion led by the emerging world and by a power generation shortage in China that led to a transitory need to use large quantities of diesel to supplement the coal fired power grid until new power plants came on line. That rate of global oil demand growth has since been tempered. This has been due in part through conservation and substitution (price rationing), as one might expect. It has also been due to less reliance in China on diesel for power as the coal fired power grid has expanded. So based on the global demand data, the emergence of China as an economic power has not changed the global demand trend by that much. On the other hand, so far at least, we have not seen any of the severe demand rationing that occurred after the 1970 bull market in oil which led to a very large outright decline in oil demand in the early 1980s. On the supply side, the depletion of the large mature oil fields found decades ago that the world now relies upon and the absence of comparable sized new discoveries has surely constrained supply. Global capacity growth has been positive, but it has only risen from a 1% annual rate to only a 3% plus rate this year, despite the high prices that have prevailed in this cycle. So the fundamentals of oil supply suggest more supply restraint than in the past. But so far there is no peak oil; high prices still encourage some supply growth. So if one looks at the global oil market, demand growth exceeded capacity growth early in the decade by a small margin (2%-3%). Now, in response to the very high oil price, demand growth has come down by two or three percentage points, capacity growth has gone up by perhaps 2 percentage points, and a buffer of unutilized capacity has slowly emerged and is gradually on the rise. In the case of the oil market we are looking at modest changes in the supply and demand growth rates. This is typical of most commodity markets. There is nothing really shocking about any of the fundamental developments in this sector. There is none of the
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huge increases in primary supply that we are now seeing in base metals, as I will illustrate later. And there is none (so far) of the massive demand destruction that hit metals and oil in the 1970s and 1980s respectively. That said, I believe that much of the explosion in overall commodity derivatives over the last half-decade must be attributable in part to investor and speculative long positions in crude oil. This investor and speculation pressure is most apparent in the emergence of a supercontango a premium in the futures and forwards curves that recently has sometimes been several times the cost of carry. Theory says such forward premiums or supercontangos should not occur because arbitragers should buy the physical and hedge with a forward, locking in an enormous riskless arbitrage profit. I believe that such a super contango can exist only if investment and speculative demands in the forward market are so large that virtually all available storage is filled by arbitrageurs, making it impossible for them to arb away any further such a supercontango. For this reason I believe that investment and speculation in crude oil derivatives has materially inflated the price of oil, even though the supply and demand fundamentals are not seriously out of whack. The tsunami of hedge fund speculation in commodities is responsible for much of the amplitude and duration of the bull move in most commodities in this cycle. This no doubt applies to crude oil to some degree. But not to an absolutely overwhelming degree, as I believe is the case in the metals sector.
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Part II Metals: A Speculation to the Point of Manipulation without Precedent in the History of Commodities Preface Before proceeding with this section, which is replete with extreme statements about the current state of the metals markets, I believe a reminder to the reader is in order. A decade ago a famous manipulation of the copper market was revealed. This led to a big bear market in copper and many class action lawsuits against the perpetrators as well as dealers and banks who were peripherally involved. That these things happen in these markets seems to be forgotten in todays euphoric market environment. But, at this very time, after many prior settlements of similar claims with large awards to the injured, the last such case is now being taken to court. I think it is worthwhile to quote a recent description of this coming court case and its claims to remind the reader that what follows does not lie outside the realm of plausibility in metals markets. Last legal action from 1996 copper scandal to go to trial Metals Insider - 3 May 2007 A US federal judge in Wisconsin has ordered a trial next month in a long-running antitrust lawsuit claiming J.P. Morgan & Co. Inc. conspired with Japanese trading house Sumitomo Corp to manipulate the copper market in the mid-1990s. It is the last legal hang-over from the 1996 copper crisis with most of the other claims long settled out of court. This action is a consolidated law-suit brought on behalf of around 20 US copper consumers seeking an estimated $1 billion in damages from J.P. Morgan Chase & Co., the successor to J.P. Morgan. "We're going to show a jury of good Wisconsin citizens the chicanery and manipulation that went on and how manufacturers of copper wire and copper rod suffered," Atlanta lawyer James Bratton, who represents Southwire Co. and Gaston Copper Recycling Corp, told local media. "We're looking forward to getting a big verdict." The centrality of the allegation against the bank is that it provided financing to Sumitomo to artificially inflate the copper price. The bank argued in court documents that its transactions with the Japanese company were proper and did not have an impact on copper prices. However, its motion to dismiss the case was rejected by US District judge Barbara Crabb and the trial is scheduled to begin on May 29. Introduction In every market bubble there is some cutting edge where the greatest extremes are to be found. In retrospect, the extent of the speculation has always seemed almost impossible, though, amidst the fury of the bubble, very few recognized it for what it was. The chronicles of bubbles in the past like Charles Kindlebergers Manias, Panics, and Crashes, and Edward Chancellors Devil Take the Hindmost show that, in almost all such bubbles, at such a cutting edge speculation is not only unimaginable but involves some measure of fraud and manipulation.
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I alluded to some such behavior in the metals sector in my presentation to you last year, though with little specificity. This year there will be no allusions. I think we know enough to say that speculation in metals markets in this cycle has gone further than in any other cycle in history. What we have been undergoing is a speculation to the point of manipulation, perhaps involving collusion, across a whole array of related metals markets.1 I argue that it is as though the famous episode of the Hunts in silver decades ago has now been taken to a power. I understand that these are very strong words. To back them up I will discuss a few base metals where it has become quite apparent that something like this is happening. I will then touch briefly on a few others as well as the white metals before we get to the subject of gold. My reasons for making such an unusually strong claim are many. Some come from inside reports about the activities of hedge funds and others operating clandestinely in these markets. Some come from analysis that points to large anomalies in these markets over recent years. And some come from claims and analyses about extreme speculation to the point of manipulation that has fallen into the public domain. In fact, since I last spoke to you a year ago, a great deal of commentary has surfaced in the public domain. We have put together a compilation of this commentary which we are attaching as an appendix. In what follows I will avoid all inside information and confine myself to analysis and a small subset of this commentary that we have culled from the public domain. But let me just say, we have many, many reports from market participants that are more specific than the statements we have culled from the public domain. Also, many of these reports are from investment firms who distribute bullish metal market assessments supposedly based on facts to their clients when, at the same time, they privately report manipulation and collusion as the dominant force in these markets. In analyzing base metals one has to bring up an all important and unsavory but perennial feature of these markets: the emergence again and again in past bull cycles of squeezes or attempted corners. (In this regard, see the quotes from Paul Krugman in a later section entitled, The Risk of Revulsion II, Revulsion From A Hamanaka on a Massive Scale.) In the past metal merchants, faced with a bull market environment, often hoarded physical metals. By taking metal out of circulation prevailing shortages were exacerbated. This amplified panics by consumers caught short of physical, which in turn fueled further the bull market move. This happened in many cycles in base metals since the late 1960s. But in these past cycles such merchants usually sold when the markets had not yet gone into significant surplus. In effect, they tended to get out when the going was good.
Am I going too far with these words? The head of the enforcement at the CFTC just issued a warning: Regulators need more funds to guard against fraud and manipulation. Why this choice of words? See the above preface. And see more on this later in this text. Page 20 6/14/2007
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A squeeze operation like this, by taking metal out of circulation, always distorted the supply, demand and stock data. As hidden stocks were built, visible stocks declined faster and fell further. Market conditions appeared tighter than they really were. Not only was the stock data distorted, so was the data on demand. We define the demand for a metal commodity not as the demand for that metal in all the products that incorporate it which consumers buy that measure of demand is far too hard to calculate. To simplify, statisticians in commodity markets define demand as simply the absorption of metal by first stage processors. Take for example copper. The primary product a copper cathode is put into a furnace by a wirerod mill or a brass mill. The wirerod mill produces wirerod which is then turned into wire. And that wire is incorporated in many products that consumers buy. Copper demand is defined as the absorption of the metal by a wirerod maker rather than a wire manufacturer or the maker of final products that embody wire. But even this concept of demand is hard to calculate for almost all economies. It turns out it is simply too taxing to monitor the purchases of metals by first stage processors. To simplify yet further statisticians, for the most part, use a concept of apparent demand. Demand is defined for a given country as domestic production plus net imports (in other words overall supply) adjusted for the change in visible stocks in that economy. The residual produces the estimate of apparent demand. It follows that, if there are builds of unreported stocks (due to commercial inventory building or merchant squeeze operations), total supply from production and imports will have to be higher and the residual, which is apparent demand, will have to be correspondingly higher. So squeeze operations, with their typical hidden stock builds, not only portray less inventory than actually exists; they inflate apparent demand relative to the true level of demand. Earlier in this paper I described an almost unimaginable explosion in commodity derivatives due to massive investment and speculation by pensions and endowments and hedge funds. It would not be out of keeping that some of these investment and speculative demands would have spilled over into the accumulation of physical stuff rather than just derivatives. But, remember, all the physical commodities in the world at the prices of several years ago only had a total value of several hundred billions of dollars. At todays prices the value of these above ground stocks is much higher. But it is still a very small fraction of the total mountain of commodity derivatives and probably the total net investment and speculative claims on commodities by way of derivatives. If this is so, even a moderate spillover of such investment and speculative demands into physical stuff could involve an accumulation of physical inventories which is large relative to total inventories and the flows of supply and demand. Has such a spillover occurred? Yes. There are now commodity-oriented hedge funds that make it clear in their documents that they purchase physical commodities as well as
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commodity derivatives.2 It has also become fairly clear from detail provided on the ownership of metal on warrant with the commodity exchanges that hedge funds hold very large amounts of these physical stocks a point I amplify on below. So if hedge fund documents declare that such funds may own physical, if exchange reports suggest they sometimes own very large amounts of visible exchange warranted physical stocks, it is certainly possible they own off warrant material as well. So the issue is not one of whether we have investment and speculative holdings of physical stuff in the cycle; it is rather a question of how much and in what form. Unless the holdings of physical commodities by institutional investors and speculators take the form of exchange warrant claims on exchange stocks, there will be no record of such physical holdings. These stocks will be hidden. Increases in such hidden stocks are recorded by statisticians as increases in apparent demands that exceed the increase in real demands. In effect, just as with our case of the merchant squeezer, the spillover of fund speculation into physical commodities may result in an understatement of the true level of above ground stocks and an overstatement of the level and growth rate of demand. Where markets are balanced, they will appear to be in deficit; where markets are in surplus, the surpluses will be understated. Given the possible magnitude of such investment and speculation in physical commodities indicated by the new Mount Everest of commodity derivatives, these distortions in the stock data and the supply and demand data could be very large. Now, let us put together the historical behavior of merchant squeezers and the more recent behavior of institutions speculating in commodities including the physical. A question arises, have hedge fund forays into physical commodities, and particularly into metals, occurred simply as passive investments or have they occurred with the objective of conducting squeezes and corners as merchants and speculators have done in the past? The answer is clear in many cases the motive must have been to squeeze or corner. Why is it so clear? Because there is considerable evidence that, in the metals markets, hedge funds have taken positions in exchange warrants, which are physical holdings, even though these markets have been in significant backwardations. And, as so many of the commentators in our appendix indicate, these funds have held off warrant material as well. In a backwardated market holding a forward (which is at a discount to the spot) provides a positive return as one rolls ones future or forward into a successor contract. In the last two years, there have been periods when this roll yield into a significant backwardation has been extremely high perhaps as much as 20% -30% annualized. By contrast, holding exchange warrants and off warrant physical provides no positive roll yield; rather, one must pay the cost of financing plus storage and insurance. Why would any fund hold physical at a considerable carrying cost rather than a future or forward
2
Even Britains Financial Services Authority has acknowledged this. In a recently published paper, the FSA observed: A more recent development into the market is the arrival of specialist commodity hedge funds that are trading in just a single commodity, and in some instances are willing to play the physical underlying market by taking delivery of physical commodities for future resale on exchange/OTC.
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with no such cost but with a handsome positive roll yield instead? The only reason I know of is to conduct a squeeze or corner operation that yields other returns if the squeeze succeeds. (Again, see Paul Krugmans comments later in this paper.) If hedge funds decide to conduct squeeze plays and attempted corners as merchants traditionally have but with their far vaster financial resources we face the possibility of builds of hidden stocks and distortions in our measures of inventory, apparent demand, and market balances that could be far greater today than they were at any point in the past. It is my position based on much information that this is in fact what has occurred over the last two or three years. As I have said above, I am not alone in this regard by any means. Just scan the appendix with our compilation of commentaries on such speculation and manipulation of metals markets from many market observers. And, as an example, look at his recent commentary on this very subject by J.P. Morgan: This week we examine the tension in the metals market between (visible signs of weakness in) industrial trends and the impact of the now super larger and super leveraged commodity funds. We test the water to ask if there is manipulation or collusion of if the sector has inadvertently become a price support and inventory sterilization mechanism without consciously planning to be. The author then cites two historical examples where price support was done through the accumulation of physical commodities: De Beers in the diamond market and a producer cartel in tin during the early 1980s. Excess inventory gives consumers pricing power and low inventory gives producers pricing power. This is something that the tin cartel realized and for years that industry thought that it may have found the holy grail of production, inventory and price control but the eventual and inevitable demise of that cartel was a history lession showing that such systems cannot last forever, even if they can last for quite some time. In the current base metal markets it is possible that such a system is operating either unintentionally, by default, or intentionally. Whenever there is a possibility that commodity funds with huge cash flow decide to make their investments not only via futures and options but by holding metals then there is the risk that a crude De Beers type inventory limitation is in place. The Nickel Market: How Speculation To the Point of Manipulation Makes The Impossible Happen. On to examples. Today the price of nickel is close to $50,000 a tonne. Its historical mean is more like $7,000 a tonne. The price of nickel in this cycle has now risen almost 900% from its prior cycle low. Above I showed Jeremy Granthams chart of the real oil price over
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130 years. The move in the real nickel price is an even greater deviation from the mean than was oil in the 1970s. That is really amazing since, with oil in the 1970s, there was the very inflationary psychology of the era which fostered hoarding, there was the loss of roughly 10% of global output with the revolution in Iran, and there was the price support provided by the OPEC cartel. If Jeremy Granthams observation that all such two sigma plus departures from the mean eventually end in reversion to the mean, if this rule proves right once again in regards to nickel, we will see in the years to come that nickel will be $7,000 a tonne again. Or lower. How did the nickel price get to such a lofty level? The Wall Street analysts will tell you that it has done so because demand is super strong because of the booming economies of China and India. They will tell you that supply growth has been restrained for many reasons. As a result, the market has been in an acute deficit and prices have soared. On the face of it this argument seems to have some merit. There have been many primary nickel projects that have been delayed. Demand for stainless steel, which is the principal market for nickel, soared an amazing 16.7% last year. And the official statisticians of the market the International Nickel Study Group calculates the market was in a deficit last year of 30,000 tonnes which was a little more than 2% of global supply/demand of 1.3 1.4 million tonnes. But people close to the nickel market argue otherwise. About two years ago there was a meeting of nickel producers and consumers in Portugal. That meeting ended in a dispute between nickel consumers and producers that was disorderly to a point approaching pandemonium. At the time nickel consumers claimed there was no shortage of nickel and that an artificial shortage had been engineered by hedge funds. They claimed that speculation by funds on the LME had divorced the price of nickel from reality and that the LME had ceased to function as a mechanism for price discovery. These claims have never ceased. You will see in our appendix references in the press to hedge funds that own all the physical nickel. Only recently at an industry conference there were calls to delist LME nickel. Metal Bulletin Kyoto 5/21/2007 9:24 Take nickel off the LME, stainless forum told
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The latest surge in nickel prices has sparked renewed calls for the contract to be removed from the LME and replaced by a system of bilateral negotiations between suppliers and buyers. Officials at several major stainless producers told MB they were growing increasingly concerned at what they said was the inability of the LME price to correctly reflect the fundamentals of the nickel market, and its supposed vulnerability to speculators. The LME has become a big casino. Funds withdraw money from the LMEs ATM and its stainless steel people who have to pay the price, said Horng-Sheng Sheu, senior gm at Taiwans Walsin Lihwa Corp. One of the most interesting complaints has been made by Chinas largest nickel producing company, the Jinchuan Group. This company is largely owned by the Chinese state and is the fifth ranking nickel producer in the world. Jinchuan says more than once on its website that the LME nickel market is excessive of speculations and with a suspicion of manipulations, the LME is no longer a place for fair dealing of metals but a paradise of speculations. It warns customers not to be puzzled by deceptive information of nickel stock, conditions of supply and demand, as well as price released irresponsibly by a few foreign agencies. Part of its ire seems to be directed at the LME which allows such shenanigans to run amok. Lots of doubts were aroused in a survey about LMEs fairness, justice and openness, and also about its role in price discovery. As I have said, the Jinchuan group is not alone. Speaking about the last run up in the nickel price to its peak the Russian nickel producer Norilsk made the following comment: David Humphries, chief economist for Norilsk Nickel, said hedge funds had moved in for the kill, triggering a violent short squeeze on the futures markets. Implying that physical stock is being hidden, ABN Amro notes, The task of the nickel longs is to keep inventories at these critical levels. They will then be rewarded with acute pricing tension. Since that conference in Portugal two years ago, those who have complained about an unrelenting short squeeze by hedge funds and merchants, often suggested to be operating in collusion, argue that the market is ceasing to function as a market. This may be true. Recently, the nickel price made a new high above $50,000 a tonne. An LME trader reports it was done on no volume, with the usual comments about the lunacy of the market. Nickel's three-month price broke the $50,00 mark at 9am London time on Thursday morning when 1 lot traded at this level in a market traders have dubbed "lunatic". The price of the alloying metal has not traded below $49,200 since the start of the trading day, after it closed at $49,400 on Wednesday, but volumes have been extremely thin, with only 28 lots having traded by 9:29am on Thursday morning.
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"This is lunacy," said a physical trader. "I better close shop and come back when we are at $40,000 again. The phone has not rung once this morning. But we're heading for a fall at these levels. Material is coming from consumers now offering to us. Not small little consumers. The big [stainless] producers." He said the market lacked natural sellers, and the price surges are on speculative trading only. "It's completely artificial. There is no connection whatsoever between the LME and the physical market now. The LME has its own life." (Metal Bulletin, April 5, 2007) The nickel squeezers which allegedly encompass hedge funds may have pressured so many short side participants out of this market that it has been reduced to the trading of a mere handful of lots on what would seem to be a price pivotal day. Let us assume that much of this is correct. Then hedge funds and/or merchants have built hidden stocks. The metal is not as scarce as it seems. More importantly, apparent demand has been inflated by the build of hidden stocks. Most statisticians and analysts like the International Nickel Study Group assume the nickel market was in a small to moderate deficit last year. But, instead, if there was a build of hidden stocks, the market may have been in a surplus rather than a deficit. Jinchuans website goes far beyond complaints about speculation in, and manipulation of, the nickel market. They provide documentation of a very rapid move towards lower nickel bearing stainless grades and non-nickel bearing types of stainless steel. They cite a proliferation of primary nickel projects down the road which they believe will not be needed. They fret that todays price distortions will lead to permanent demand destruction for nickel producers and a painful glut when the speculation is over. And that point may be not far off. Stainless steel demand was up 16.7% last year. Part of that was a rebound off a prior year where there was a global stock liquidation. But even so, it is a growth rate of perhaps three times the past trend. It must have reflected very substantial stock building in stainless. This is what is now being reported by many stainless producers and the service centers that distribute stainless. The very pronounced inventory cycle of stainless may have now gone so far that a reversal is probably underway. MEPS, an industry statistician, reflecting this, is predicting a 4% decline in stainless steel demand this year. Add to this the economization and substitution in nickel use that Jinchuan and many others talk about and a significant decline in nickel demand should be at hand. How great can such substitution and economization be? The steel giant Posco has just announced that it will use 14% less nickel in stainless production this year as it turns to non-nickel bearing stainless. Posco has developed a new process for developing stainless without nickel with better properties than existing non-nickel bearing stainless. Part of the reduction in its use of nickel is due to the initial introduction of this product this year.
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It expects good customer acceptance and more extensive recourse to this product next year. And other stainless producers are expected to follow. Is this all happening? Apparently it is. In Europe there are excess inventories. The European stainless producers report falling orders. The price of stainless has fallen from 1900 euros a tonne to 1300 euros a tonne in six weeks. If one treats the steel, chrome, other metals and the cost of processing as constants, the implied price of nickel embodied in stainless, which accounts for 70% of all nickel production, has fallen in half in these mere six weeks. Not surprisingly, major producers like Outokumpu have announced 10% production cuts. But the turning point dynamics do not end there. Last year China, looking to bypass high nickel prices and the alleged shortage of nickel, began to access already mined laterite ores, largely from the Philippines. At first they used idle blast furnaces to process these ores. The investment involved was minimal, as the ores have been mined and there was ample blast furnace capacity everywhere in China. Last year nickel output from such laterites rose from almost nothing to perhaps 30,000 tonnes. Early this year a Chinese consulting firm, Antaike, predicted an increase to 60,000 tonnes, representing a surprising 5% increase to global nickel supply in a mere two years from this new unconventional source. But the story does not end there. There has been a series of disclosures that point to production from nickel laterites by China and Japan could be much higher than 100,000 tonnes this year. How can this supply surge come out of nowhere? This is an interesting case study in the microeconomic response of supply to a large rise in a metal price. It is worth looking into. First, a bit of background. Nickel has been produced from laterites since the late 19th century. However, in the first half of the 20th century most nickel production came from the processing of nickel sulfides and by 1950 almost all global nickel production was sulfide based. In the late 1960s there was an enormous spike in the price of nickel. This led to an acceleration of renewed interest in nickel laterites as a source of primary nickel. These laterites are a surface material resulting from weathering. They are abundant in tropical zones. In fact, they are simply a kind of red dirt, and one analyst has quipped, find a tropical island with red dirt and you probably have found nickel laterite. Being mere dirt, these deposits are very cheap to mine. The problem is that the grades are on the low side (1% to 2% usually) and extraction of the nickel from the laterites is not easy. The upper layer of the laterite, called limonite, is more difficult to process than the deeper laterite. Hence, most of the nickel laterites that have gone into production removed the limonite as overburden and only mined and processed the deeper laterites. Starting around 1970 there were many major nickel laterite projects. The total addition to nickel capacity resulting from these projects was very large; the laterite projects from
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1970 to 1986 represented a 43% addition to outstanding global nickel mine capacity in 1970. As I said, in these very substantial laterite operations over the last several decades the limonites were, for the most part, overburden that was pushed off as waste. It is these already mined limonites that the Chinese began to import at the end of 2005 and threw into blast furnaces to create a nickel pig iron which can then be processed into stainless steel. To an increasing degree they have also been importing the deeper nickel bearing saprolites as well which have been thrown into electric arc furnaces to produce a higher grade nickel pig iron. Most of todays conventional nickel laterite projects have very high capital costs. By contrast, the production of nickel pig iron has virtually no capital cost as the limonites have already been mined in projects with established infrastructure. Also, China, as a result of modernization of its steel industry, has a huge amount of unutilized blast furnace capacity and some unutilized electric arc furnace capacity. When the Chinese first began to produce nickel in this way, analysts assumed it was a small and transitory development. After all the previous efforts to economically process nickel laterites it was assumed that such a simple process of extracting the nickel in a blast furnace must have limitations; if it did not, why was this method not used earlier? There were other sources of skepticism. It was widely argued that the process is too polluting to be done on a major scale. Many thought it was an extremely high cost process with production costs of $15 a pound. Lastly, nickel laterites contain phosphorus. Phosphorus is anathema to the production of steel and stainless steel. So why have the Chinese moved ahead with this process of converting nickel laterites, especially limonites, into nickel pig iron? First, the Chinese claimed to have solved the phosphorus problem. Second, they assert that production costs are now down to $8 a pound and are falling. Many of their contracts for obtaining nickel ore appear to be tied to LME price of nickel. So, if the nickel price crashes, as it eventually will, the ore component of total costs will fall. Third, the Chinese are apparently improving their operations. New larger scale blast furnaces and new electric arc furnaces are being commissioned which supposedly will reduce operating costs. Lastly, as to the pollution problem, it seems that this process is not as polluting as many think. The Chinese producers claim that the blast furnaces they will be using to produce nickel pig iron will all meet the new Chinese national environmental standards on emissions.
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How much nickel will be produced from laterites in the form of nickel pig iron? As I said earlier, three months ago many expected that China would double its production of nickel using this process from 30,000 tonnes last year to 60,000 tonnes this year. However, recent high volumes of laterites imported into China indicate the increment to Chinese production will be much larger. In 2005 China imported 500,000 tonnes of laterites, mostly at the end of the year. Last year, they imported 3.6 million tonnes of laterites. In the first four months of this year China has imported 3.5 million tonnes of laterites. On first pass, this might seem to imply an almost tripling of its nickel production from laterites over the 30,000 tonne level of last year. However, closer scrutiny suggests an even Greater Leap Forward. It appears that China is now accessing higher-grade ores with higher nickel content. Last year China imported mostly from the Philippines where ore grades are about 1.2%. This year they have been importing more ores from Indonesia and New Caledonia which more typically grade 1.5% to 2%. Also, this year China will have greater recourse to electric arc furnaces, which have much higher recoveries than blast furnaces. The combination of the further steep rise in import volumes, a mix shift to higher grades, and higher recoveries suggests that there could be far more than a tripling in Chinese production of nickel from laterites by some time later this year. In addition, to this the world will finally see a significant ramp up in the primary production of nickel from more traditional sources in 2007 perhaps on the order of 3% 4%. This implies an overall increase in primary supply of 10% and possibly significantly more. When I look at all these impacts on the balance a reversal in the stainless inventory cycle, substitution and economization, increases in conventional and non-conventional supplies it would seem that the market balance in nickel could swing from 2006 to late this year by 15% of demand/supply. And more of a surplus will be forthcoming next year. Conventional and unconventional (nickel pig iron) supplies will continue to soar. CVRD, with one sixth of global market production last year, expects to double its output over the next five years. This one conventional producer alone will add 3 percentage points to growth in global nickel output on average over the next five years. As for nickel in pig iron, more Chinese companies are entering this business and there is some talk about imports of laterites into Japan for this purpose. The crazy high nickel price has set into motion a new way of profitably processing super abundant ores. This business will grow as long as prices are high enough to make it profitable. And when prices fall every effort will be made by the new producers to cut costs and still survive. The size of the current and coming future swing in the nickel market balance is extraordinary. At the same time, adjusting for distortions in the apparent demand data,
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the market may have already been in balance or surplus last year despite a likely large stainless inventory build associated with that 16.7% rise in stainless demand. In effect, the nickel market may already be moving into a vast unprecedented surplus. And yet, owing to the LMEs paradise of speculation and manipulation the nickel price has been soaring ever further beyond its two standard deviation bubble status threshold. Copper The price of nickel in this cycle has gone up almost 900% from it prior cycle low. The rise in the price of copper has not been quite so extreme. It rose 570% above its cycle trough at last Mays $4.07 a pound high. It rose well in excess of five times in real terms, and is within 10% of last Mays price peak almost a whole year later. This deviation of the real copper price from trend may also surpass that of crude oil in the late 1970s despite the generalized inflation psychosis of the 1970s, the Iranian revolution that shut down one of the worlds biggest oil producers, and the support of OPEC, the most famous commodity cartel in history. By Jeremy Granthams criteria, copper in this cycle is a two standard deviation bona fide bubble event.
You can divide copper cycles in different ways depending on your choice of endpoints. If ones choice of end points is half decade cycles in inflation adjusted terms, the increase of the copper price in this cycle was already greater than in any cycle since 1900 once we got to $1.90 a pound in 2005. By this measure no rise in the inflation adjusted copper price has ever approached what has since happened in this cycle.
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The above refers to cyclical moves in the copper price in real or inflation adjusted terms from 1900 forward. I have found a similar analysis of copper cycles in nominal dollars since the year 1860. This analysis considers longer duration cycles, out to as much as ten years. This period, starting in 1860, encompasses the Civil War, the First World War, the Second World War, the Korean War, and the Vietnamese War. Wars tend to consume a lot of copper. Wars also spawn generalized inflations, and this period since 1860 encompassed the inflations of the Civil War, the First World War, the Second World War, the Korean War, and the persistently inflationary period from the mid 1960s to well into the 1980s. This period also encompassed the advent of electricity and telecommunications in the late 19th century. This was the most important technological revolution and economic engine of those decades. Copper was the material essential to that New Era industrial boom. Even though this history since 1860 encompassed all these wars and inflations and a copper critical industrial New Era the largest percentage increase in the nominal dollar copper price in any of these past cycles was only 246%. BY CONTRAST, IN THIS CYCLE, IN A MERE FOUR AND A HALF YEARS INTO MAY 2006, THE COPPER PRICE ROSE 575% AMIDST THE LOWEST INFLATION IN THE U.S. GENERAL PRICE LEVEL IN ANY ECONOMIC EXPANSION IN ALMOST A HALF CENTURY.
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Some will say, this must surely be because of a new era of super cycle copper consumption led by China, India and the emerging world. In fact there is absolutely ZERO evidence for this in the official data on global copper consumption.
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Global Copper Consumption Average Annual Growth 1980 2005 2.3%
1990 2005
2.6%
2000 2005
2.6%
2006 Source: ICSG
2.3%
Simon Hunt, Simon Hunt Strategic Services In general, when confronted with this data, people simply refuse to believe. It is obvious, they say, that copper consumption in China has been booming; therefore, such data must be wrong. But what has been happening is something that has been going on for decades. As I described above, base metals consumption is defined as the absorption of metal by primary processors. Since the 1960s the primary processing of copper cathodes has been migrating from the first world to the emerging world because such fairly low tech manufacturing makes more economic sense in emerging economies than in higher cost developed economies. Now that China, with its super high investment ratio, is displacing more and more manufacturing that heretofore had been done in the U.S. and other advanced economies, its booming copper fabrication industry is displacing at a dramatic rate this industry in the advanced countries of Europe, the United States and Japan.
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World Consumption 2000 2006 Average Growth Per Annum W. Europe USA Japan China -1.5% -5.5% -0.6% 12.6%
Contributed by Simon Hunt, Simon Hunt Strategic Services In the end, amidst all this furious migration of the primary processing of copper cathodes from the first world to China, the trend in the overall global consumption of copper has remained basically the same. If this is so, why has the price of copper soared way, way beyond all historical precedents in this cycle? Is it a constraint on primary supply unlike the world has ever seen? In fact, that has not been the case either. Yes, a reduction in new investment in primary production and a closure of mines followed the period of depressed prices at the end of the 1990s. This resulted in a lagged production response when this global economic cycle took off, thereby creating a deficit in 2003 and 2004. But, despite that lagged supply response, the trends in copper supply growth look, if anything, more positive than in the past. Primary copper production comes in two forms: the production of ore concentrates which must go to smelters and direct on site production of refined cathode using solvent extraction (SXEW).
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World Concentrate Production Growth Rates Per Annum
2000 2006
2.4%
2007 2010
4.1%
2007 2015
4.3% Contributed by Simon Hunt, Simon Hunt Strategic Services
World SxEw Production Growth Rates Per Annum
2000 2006
3.9%
2007 2010
8.9%
2007 2015
4.1% Contributed by Simon Hunt, Simon Hunt Strategic Services
Last year was a year marked by an unusual number of work disruptions in copper mining. The global mine capacity utilization rate was very low. Nonetheless, copper mine and refined production grew at or above the long term trend. Based on a recent return to a higher capacity utilization rate and a round of mine start ups and expansions early this year we should expect in 2007 much higher mine output growth and continued well above trend growth in refined output. Looking further ahead, almost all compilations of future total primary production (both SXEW and concentrates) based on what has been announced to date results in a supply trend of close to 5% for years to come a rate that is almost two times the historical average rate.
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It should be noted that such projections are based on what has been announced. When prices are high exploration budgets rise. Exploration produces results. Existing deposits become larger, additional investments are therefore made, and surprise expansions tend to proliferate. Also, new low cost projects are found. In the past, at least, these unforeseeable successes have proved to be the most important engine of supply expansion over time. So what then has caused the copper price to soar? Once again, unprecedented speculation to the point of manipulation. In the case of nickel, I gave you accounts of the role of speculation according to Chinas leading nickel producer Jinchuan and analysts from investment banks. In this case of copper I will provide you with an account based on two recent presentations of Nexans, the largest copper fabricator in the world. Nexans operates in 33 countries and accounts for about 7% of all copper wire manufactured globally. Nexans has laid out its analysis of the copper market in two power points used in two recent public presentations Nexans starts their market analysis by noting the difference between official statistics based on apparent consumption and real consumption that is, what is going into furnaces. Nexans believes the copper market has been in an increasing surplus, possibly since autumn of 2004. Where has this surplus gone, since there has only been less than a 200,000 tonne increase in visible exchange stocks over this period? February 8, 2007
Who hoovered away so much physical copper? February 8, 2007
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Again, in a second presentation: April 20, 2007
In our appendix you can find many references from the public domain that correspond to Nexans claims. But, we should ask, is there any analytical basis for such a claim that the copper market, which ICSG and WBMS official statistics3 admit was in surplus last year at a significant rate of 350,000 tonnes, has in fact been in a larger surplus and for years and which has been masked by a hoovering away into hidden locations of a million tonnes by the end of last year? My answer is yes. If such a build of hidden stocks by speculators has occurred, it might be discernable in trade data which reflects the flow of metal across borders. We have looked into this. In the case of the United States and Canada combined we compared total supply from imports and domestic refined production with fairly good proxies for domestic consumption. Provisionally, these respective data series embody a positive residual of supply over consumption in 2006. This residual is considerably greater than the rise of visible stocks in the United States during the period. The implication is that there may have been a hidden stock build of perhaps 100,000 200,000 tonnes in North America
I realize one must be careful about this ICSG estimate. Since early 2005 ICSG produced initial estimates of a surplus only to revise them away. Well, well after the fact the initial deficit for 2004 has been revised up, thereby shifting subsequent year balances in the same direction. Another statistical agency, WBMS, was carrying a surplus for 2006 through November that projected perhaps a 500,000 tonne surplus for the year. Suddenly there are revisions and, based on the last report I have received, the estimated surplus for 2006 including December is now 377,000 tonnes. More striking is the WBMS estimate of a 115,000 tonne surplus for the first two months of this year. Demand is probably a bit above average in January and February; the seasonally adjusted surplus for these two months combined might be 150,000 tonnes. That annualizes out to a 900,000 tonne surplus for 2007, which is huge relative to supply/demand by historical standards. Obviously, one cannot reconcile such a large surplus with a copper price of close to $4. I think in time we will see efforts being made to tweak and fudge the data toward something that is more consistent with the prevailing sky-high price. As I say elsewhere in this report, the copper bulls including the mining companies who fund them will look at the statisticians and say, how can you mere bureaucrats estimate a large surplus in the market when the market says otherwise. Hence the tweaking and fudging. Page 37 6/14/2007
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over the last year. I may add that the same calculations hint toward something similar at the end of 2005 and the very beginning of 2006. Last year the import-based ICSG apparent demand data on the copper market in Europe showed an anomalously high rate of copper consumption. They estimated an 8% year over year increase. If you look back at the first table in this copper section you will see that, owing to the migration of copper manufacturing out of Europe, this European demand growth rate is usually negative. The analyst Simon Hunt has taken the ICSG data on European copper consumption and has compared it to a measure of true consumption based on reports from Europes fabricators. These two measures of consumption correspond over the early years of this decade. Then, suddenly last year apparent demand based on imports soared relative to the above demand data. Again, implying a build of hidden stocks by someone. The situation with China is less clear. Last year Chinese imports of refined copper fell very sharply. As a result, ICSGs estimate of Chinese copper demand showed great weakness. It is widely argued that a liquidation of hidden stocks by commercials and the Chinese Strategic Reserve Bureau was responsible for this. And there is probably some truth to this. On the other hand, if one looks at the two years prior, the ICSG demand data, again based on imports, showed double digit growth in apparent demand. At the same time, all other demand indicators suggested that demand growth was much lower. Chinas National Development and Research Commission (NDRC), its government affiliate Minmetals, and the data we have on copper semi-fabrication in China all suggest that actual copper consumption growth was in the single digits. The difference between the growth in Chinese apparent demand for copper and the growth in semi production is quite striking. Copper cathodes eventually result in production of semis. On a smoothed basis the two should move together. Below are three bar charts. The first shows growth in apparent demand for copper cathodes. The increase over the time period portrayed is huge almost doubling from the first bar to the last. By contrast the production of semis rises only moderately over the same time period. As does the apparent consumption of semis. All three data series no doubt have their flaws. But the contrast suggests that the data on apparent demand for copper in China in recent years probably overstates the increase in real demand. Chinese Refined Copper Apparent Consumption
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500,000 450,000 400,000 350,000 tonnes 300,000 250,000 200,000 150,000 100,000 50,000 0 Aug-04 Aug-05 Aug-06 Jun-05 Jun-06 Oct-04 Oct-05 Feb-05 Feb-06 Oct-06 Apr-05 Apr-06 Feb-07
Jan-07
Dec-04
Dec-05
Chinese Copper Semis Production

600,000
500,000
400,000 tonnes
300,000
200,000
100,000
0 Jul-04 Jul-05 Jul-06 Nov-04 Nov-05 Sep-04 Sep-05 May-05 May-06 Sep-06 Nov-06 Jan-05 Jan-06 Mar-05 Mar-06 Mar-07
Chinese Apparent Consumption of Semis
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Dec-06
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600,000
500,000
400,000 tonnes
300,000
200,000
100,000
0 Jul-04 Jul-05 Jul-06 Jan-06 May-05 May-06 Jan-05 Sep-04 Sep-05 Sep-06 Nov-04 Nov-05 Nov-06 Jan-07 Mar-05 Mar-06 Mar-07
The difference of course is an implied build in hidden stocks. If one takes the several years combined it would appear that there have been hidden stock builds in China over the last several years. It appears that analysts and the ICSG have inflated numbers on Chinese copper consumption in this most recent cycle and that China may be one of the places where Nexans alleged surplus has been hoovered up. We have done some tentative, albeit so far weaker, analyses along the same lines for several other Asian countries. Again these analyses point to imports above and beyond domestic fabrication, implying builds of hidden stocks in these locations. That is one avenue of analysis that supports Nexans thesis of hedge fund and investment bank hoovering up of a recent large copper surplus into hidden locations. There are others. If there has been a build of hidden stocks in recent years it should have inflated ICSGs consumption data. But could that be? Since, for the last two years combined, 2005 and 2006, ICSG shows a rise in global consumption of about 2%. Could that feeble a rise still be inflated? The answer is yes. As the first table in this section makes clear, on trend global copper consumption has been a mere 2.5%. But, with the price of copper now far higher relative to the price of substitutes like aluminum than has ever prevailed before, one might expect aggressive substitution and a growth rate well below trend. As I will illustrate later, this has happened in prior decades with copper as well as many other commodities in spades.
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From Nexans we get a window on this potential. February 8, 2007
Nexans tells us that its copper consumption has been flat over the past two years. In the wire sector substitution is more difficult, at least initially, than in the brass mill sector where plastic tubing, thinner tube walls, etc. are easy options. So if Nexans has been flat, overall industry consumption may have been down. Why has Nexans consumption been flat? Because much cheaper aluminum is making inroads in wire, as their explosive aluminum consumption testifies. For last year ICSG reported a surplus in the copper market of 350,000 tonnes. If consumption of copper over the last two years was a little negative rather than a little positive, one gets a surplus of perhaps three quarters of a million tonnes. ICSG can account for most, but not all, of its estimated surplus for 2006, implying a possible hidden stock build on the order of 100,000 tonnes. If the real surplus was higher, so was the implied hidden stock build. Let us try another avenue. ICSG has estimates on refined production and mine production. Commodity statisticians time and again make errors at turning points. And one of those errors is a systematic tweaking of the supply and the demand data to generate a balance that is consistent with prevailing prices. ICSGs significant 350,000 tonne surplus in 2006 is already wildly inconsistent with todays prices which are unlike anything ever seen before. Could it be that they have been edging down their production data estimate because otherwise they would show an even larger surplus, which would be even more out of whack with todays sky high prices. There are many compilations of global mine and refined production from statistical agencies, metal consultants, etc. We have looked at many of these. In particular, we have looked at one where, given the business situation of the analyst, there would be a bias, if anything, towards a lower, not a higher, number. We have looked at this analysts strengths and weaknesses to make a judgment on any likely error. We have found that this compilation stands up to detailed scrutiny. It generates a production number that is many hundreds of thousands of tonnes higher than that of ICSG. If we plugged this number into the ICSG framework, their 350,000 tonne surplus again becomes a three quarter of a million tonne surplus or higher. If we make both the above adjustments to ICSGs refined production estimate and their apparent demand estimate, all of a sudden we have a surplus of perhaps a million tonnes. Of course, the larger the actual surplus relative to the now standing ICSG estimated surplus, the larger the possible
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implied hidden stock build. So you can see that there may have been a hidden stock build in 2006 well in excess of a half a million tonnes. Such possible errors in the official data have further implications for the possible accumulation of hidden copper stocks in this cycle. Whatever the underestimate by the official statisticians of the surplus last year, it most likely carries back into the prior year. If ICSG has the 2006 percentage changes in demand and supply more or less right but the level of both are wrong, a much larger surplus in 2006 implies a smaller but still significant surplus in 2005 rather than their now prevailing estimate of a deficit. The difference between such a surplus and the official estimate of a deficit corresponds to a possible further hidden stock build that occurred in 2005 and possibly earlier. Therefore several avenues of analysis can provide support to Nexans claim that the market has been in surplus, that the surpluses have become quite large, and that someone has hoovered away a million tonnes of surpluses into hidden stock locations. What can we say going forward? U.S. housing still absorbs 10% or more of copper embodied in final products produced both in the United States and elsewhere in the world. The trend in copper consumption is being affected adversely for the first time in this cycle by cyclical factors with the bust in U.S. housing. If substitution was significant in 2004 and 2005, with a much, much higher price signal in 2006 substitution should now intensify. There is a general agreement that global mine capacity will rise healthily this year, and so far this year the outlook is for a higher capacity utilization rate. It is not hard to make the case that the copper surplus will increase by several percent of demand this year. If all of the above happens, the copper surplus could increase by 3% or 4% or 5% of global supply/demand of roughly 17 million tonnes plus. If so, we may be looking at a surplus of perhaps 1.5 million tonnes this year. That approaches 8% of supply and demand. The copper market has seldom experienced such a large relative surplus. When it has been approached it has always been at deep price troughs. But the copper price is not low. It remains monstrously high. So projects are now underway that cannot be stopped, and that ensures yet further net gains in supply going forward. And production processes that result in economization and substitution are also underway that cannot be stopped. For example, wire makers have found a way to clad much cheaper aluminum with copper and achieve the same functionality with a small fraction of copper consumption and massively lower overall costs. Initially, manufacturing aluminum wire with a thin copper clad proved to be difficult, but this production process has finally been perfected in China. Production lines to do this started to expand last year. The practice is now disseminating globally. We are still in a very early stage of diffusion of this practice. This is typical of the demand rationing process. Such lagged demand responses to the crazy copper price increase over the last year and a half, coupled with unstoppable increases in supply, ensure yet higher surpluses beyond 2007. Should we be surprised? No! Speculation in copper in this cycle may have resulted in a build of hidden stocks that dwarfs anything that merchant squeezers did in the past. The
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result has been a price distortion that has no historical comparison a six fold rise in the dollar copper price in this cycle versus rises of 246% or much less in all prior cycles since 1860. Microeconomic logic tells us that such an unprecedented price distortion should lead to an unprecedented surplus. What happens if the market goes into a surplus of perhaps 8% of supply/demand and this grows and grows because new projects with sunk costs cannot be stopped and investments that destroy demand are just beginning to take hold? In the end, the cumulative surpluses will become unmanageable for any speculators, no matter how well heeled they are. It is not clear what will happen to the hidden stocks that have been hoovered away in this cycle. I know that in prior cycles, when squeezes failed or when prolonged bear markets with full contangos took hold, merchants accumulated and then held on to large hidden stocks of copper and other base metals which they could finance almost costlessly in a full contango market. Something like this might happen, at least initially, to the hidden stockpiles that have been built in this cycle. But, in the end, even if the speculators somehow hold on to their hidden stocks, a mega surplus must be dealt with. At some point it will not be possible for the speculators to simply keep on buying up such a surplus. There will have to be an eventual closing of mines to the point where the market is, at a minimum, in balance. Aside from depressions, I do not know that we have ever seen an episode where so much production capacity had to be shut down to achieve that end. And to do that will require a copper price below the cash costs of many copper producers, not just the most marginal ones. Look at the current copper cost curve; that will be a very low copper price, indeed.
Of course, as prices tumble along the way, speculators may have to disgorge their hidden stocks. I do not believe it is possible to sell over a short period hidden stocks of a magnitude that may now exist and will surely exist in the near future. In prior cycles stock liquidation on a much lesser scale created powerful undershooting of the mean. This time such stock liquidation dynamics might dwarf those of the past and an unusually
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prolonged period of very low prices may be required. This means a deeper undershooting of marginal cost than in the past. This means greater pressure to reduce production well below the level of consumption in order to not just bring the market into balance but to go further and absorb the stock overhang. I think we cannot imagine how severe the industry strains will be when this comes about. Aluminum The nickel price relative to the cost of production and past trends is a crazy, crazy price. The copper price, the same. But the aluminum price is not a crazy price. Almost two decades ago in 1988 it soared to a brief peak above $1.80. So todays price of $1.30 looks high, but not necessarily artificially so. Nonetheless, there is a lot of evidence that the same is happening in aluminum as has happened in copper and nickel. In the case of nickel I cited the Chinese nickel producer Jinchuan calling the LME a paradise of speculations. In the case of copper I cited Nexans. In the case of aluminum, I find it useful to return to Chinese spokesmen. Formerly Chinas planning commission, the National Development and Research Commission (NDRC) may be Chinas most important body responsible for economic matters. In recent years it has been very focused on reducing the exposure of Chinas manufacturers to high commodity costs. It has also been very concerned about over investment by China in certain economic sectors, including steel and aluminum. So it has thought a lot about metals prices and their prospect. Given that perspective, I find the following statement by the NDRC pertinent: The NDRC said: "Possibilities of a steep fall in aluminum prices could not be ruled out if international hedge funds pull out of the aluminum futures market next year." It stressed that hedge funds' massive buying into aluminum futures was another cause of the bullish prices this year." China Daily, December 28, 2006 So, for the NDRC, the aluminum price is high today because of massive hedge fund buying. Has this hedge fund buying been the passive actions of many investors, or has it been the result of a concerted effort by a few that mimics the merchant squeezes of the past, but on a larger scale. In recent months the press Financial Times, Reuters, Bloomberg, and elsewhere have provided so much commentary that the latter clearly seems to be the case. Below are two notes from the Financial Times.
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A battle raged in the aluminium market on Monday between one investor holding a $1.7bn long position betting that prices will rise against a number of shorts who are equally determined that prices will fall. Market talk suggests the holders of the short positions have substantial amounts of aluminium available for delivery to market. This could wreck the strategy of the investor, thought to be a hedge fund, holding the long position, which is understood to have maintained its position since mid-December. Analysts say the position is equivalent to nearly 645,000 tonnes, almost equal to the size of the LMEs aluminium stockpiles of 695,000 tonnes. At current market prices, it would cost $1.7bn to buy 645,000 tonnes of aluminium. Copyright The Financial Times Limited 2007 One party has maneuvered itself in a position where it could take delivery of almost 650,000 tonnes of the metal, or about 93 per cent of total LME aluminium stockpiles. At current prices, it would cost $1.7bn to buy 650,000 tonnes. If the demand for aluminium was booming, there would be a clear-cut reason for the confidence to hold such a position. But demand from aluminium users is not robust, with US orders falling and forecasts that production is set to outstrip supply in China this year. Still, cash aluminium prices were priced at more than a $80 premium to the benchmark three month forward contract yesterday. The premium has narrowed from more than $100 a tonne on Monday. The aluminium cash price tends to trade at a premium to the forward price, when demand is strong and inventories are low. The last time aluminium cash prices were trading at such a high premium to the three-month price, the London Metal Exchange launched a probe into the aluminium market about possible collusion between market participants. The investigation was launched in August 2003 but was abandoned the following year after regulators failed to find any evidence of collusion. However, this time the LME said it could see nothing untoward in the aluminium market. The LME has the power to inspect the trading books of all its members, which are mainly financial institutions, and their clients. But Robin Bhar, base metals strategist at UBS, said: Aluminium cannot be described as a tight market and based on current supply and demand trends there is no need for cash prices to be trading at a premium. This suggests that the current premium has been financially engineered by a large fund player, who maybe is acting alone or with other players. All eyes focus on aluminium (FT) By Kevin Morrison
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If you check our appendix, you will see that this kind of commentary goes on and on in the press and in the statements of traders and analysts. I described above the typical dynamics of a merchant squeeze play. I suggested that todays hedge funds in commodities may not be just investors, like pensions and endowments, but players engaging in squeeze tactics on a more massive scale than in the past. In the above quotes and others in our appendix we see a clear cut indication that hedge funds are financially engineering and may be acting with others. Commentary regarding the latter suggests another possible collusion between market participants that was investigated years ago. Such massive squeeze tactics would typically involve accumulations of physical metal held off the market in order to make the squeeze in the futures market work. If such hidden stock builds in aluminum are occurring, how big might they be? Just look at the comments above of the visible positions of one or a few hedge funds. There is roughly 800,000 tonnes of aluminum in the LME. That is no small amount. For one or a few hedge funds to own almost all of the aluminum in the LME is to hold one visible physical position worth billions of dollars. There are similar holdings in nearby futures. Why not then assume that there are comparable holdings of invisible off warrant metal to make the squeeze work? Let us now look at aluminums fundamentals. Among base metals, aluminum has had a higher secular growth rate over the last decade and a half closer to 4% for aluminum as opposed to 2.5% for copper. In addition, recently the price of aluminum has been one third of copper. In the past it has been almost equal to the copper price. There has been a two and a half fold rise in the price of copper versus aluminum. Changes in relative prices induce substitution. As demonstrated above in the Nexans case, aluminum production over the last two years may be higher than the past trend because of substitution out of copper wire into aluminum wire. Nonetheless, if hedge funds and merchants have built hidden stocks in aluminum, along with other base metals, our apparent demand data for aluminum should also be inflated. The statisticians tell us that aluminum demand rose perhaps 7% to 8% last year. Maybe in reality it was 6%. The statisticians tell us that, based on apparent demand data, the aluminum market was roughly in balance or in a small deficit in 2006. But adjusted for a hidden stock build maybe it was in a small surplus. What about this year? Minmetals is a Chinese state entity with responsibilities in the metals sector. Star Futures is an affiliate. Star Futures produced a report in which it projected an 11% increase this year in global aluminum production. Minmetals Star Futures is not without some knowledge in the sector, as half of the increment of production this year was estimated to come from Chinas own smelters.
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Western agencies and most market participants have a somewhat more conservative view of the outlook for aluminum production growth this year. Many are looking for a production gain of 7% or 8%, with the market in a balance or a slight surplus. According to the official statisticians, global aluminum production was up 10.5% year over year in the first months of this year, with Chinese production up by more than 35%. According to most recent Chinese data, Chinese aluminum production rose by 40% in February and 37% in March. So far the data is saying Minmetals Star Futures may be more right than the Western consensus. Whatever, the case of aluminum makes it clear that in some metals industries there are no serious restraints on supply. This is not a market where supply is growing a little more or a little less than its past trend, as it is in oil. It is an industry where, already, supply may be growing at almost three times its past trend. Some new era of supply restraint! The outlook for rapid aluminum production goes beyond this year. The reason lies in the ease of increasing the material that ultimately gets processed into aluminum. First there is the primary ore bauxite. Like nickel laterites this is just another abundant tropical dirt that contains a smidge of metal. No supply impediments here whatsoever. Bauxite gets processed into alumina. Alumina is the primary cost component of aluminum. Last year, heavy investment in alumina resulted in Chinese production growth of alumina of 50% or more year on year starting at the middle of last year. This alone added an eight-percentage point increment in global alumina production in 2006. Not surprisingly, the alumina price fell in 2006 from a peak of $640 a tonne to a low of $225 with only a partial recovery to $400 so far. I have seen a compilation of alumina projects in China that are slated to go ahead. It takes about two years to build an alumina plant and bring it on stream in China. If all these projects were to go ahead, China would add 40% to global alumina supplies a tenyear increment at past global trend rates of growth, all in just a few years. I should add that China is investing in very large alumina facilities outside China as well, such as Vietnam. And there are many new plants and expansions coming on stream elsewhere in the world. The outlook is for a renewed large decline in the alumina price. But at such an alumina price the spread between todays high price of aluminum and the total cost of its production, which features alumina and energy, is very wide. This makes investments in aluminum production very profitable. So there is a price signal for Chinese provincial governments to build aluminum plants. According to the NDRC investment in aluminum smelting was up 124% in China in the first few months of 2007 versus a year ago. Todays leaps and bounds in Chinese aluminum production reflect a combination of restarts and an investment in smelters a year or two or three ago when such fixed investment was only a fraction of its early 2007 level. Given the signal of todays aluminum price that has been inflated by hedge fund speculation and manipulation, it would seem that Chinese aluminum production will keep
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racing ahead at recent past rates, creating ever wider surpluses in the years to come. The NDRC is alarmed. It sees the hedge fund basis for the current inflated price and the inevitability of rapidly growing gluts based on Chinas own investment actions. Zinc and Lead I will not go into great detail anymore. Let me be brief. The zinc market in this cycle, with a six-fold increase in the zinc price, comparable to that of copper, is a bona fide bubble by Jeremy Granthams criteria. Are super cycle demands from China or New Era supply scarcities pushing the zinc price to an unprecedented new high plateau? From what I can tell zinc, lead and silver all of which come from the same ores are also about as scarce as dirt. Production of lead and zinc globally is now exploding. The great irony is that China is the biggest source of the great supply surge. China produces roughly 30% of the worlds lead and zinc. It has very favorable geology for lead and zinc production. However, the industry has been very backward. Much of the mine production has been done by small miners in inaccessible areas using quite primitive procedures. In many cases, there has been no infrastructure, hence no vehicles. Ore has been carried in baskets on the backs of mules. Processing plants have been rudimentary; therefore, recoveries of metals from ores have been low. Exploration has been minimal. One specialist who tours the lead and zinc mining regions of China extensively has reported that, for the first time ever, one has encountered drilling rigs on a Chinese lead and zinc mining site this past January. For someone from the mining culture of the West this is incredible: to mine without advanced drilling is to walk blind. All of a sudden, this is all changing. Small operations are being merged and rationalized. Funds for investment are available. Improved recovery techniques are being employed. Infrastructure is penetrating the far hinterlands, replacing mules with vehicles. I have been told of one instance where the introduction of roads alone is resulting in a small mine going from a negligible 1,000 tonnes a year to 45,000 tonnes a year which is a medium sized mine in the world of zinc all in a mere year. Therefore, it should not be a surprise that growth in Chinas production of lead and zinc are now far outpacing growth in their consumption. Last year, according to Chinese statistical sources, zinc mine production rose by 16% year over year versus an average 10% growth rate in years past. And the data for early 2007 suggests a yet higher growth rate this year. Therefore, it should not be surprising that China is suddenly becoming a major exporter of zinc. The recent numbers on Chinese gross zinc exports are dramatic, as displayed in the bar chart below.
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CHR Metals, March 23, 2006 Something similar is happening to Chinese lead production, though it has yet to surface in booming exports. It looks like there is nothing to stop such rapid progress in this aspect of the Chinese domestic mining industry. The Chinese authorities, burned by the explosion in the prices of natural resources, are committed to investing huge amounts of money both at home and abroad to develop and secure sources of supply of all commodities. The odds are that Chinese production of lead and zinc will continue to outpace domestic consumption, adding continuingly to global supplies. According to the best supply work I have seen similar zinc/lead mine expansions are occurring all around the globe. Serious analysts intent on creating accurate supply schedules cannot keep up with the many smaller expansions and new mines in many other places in the world. Zinc mine production may be on course for more than 10% growth this year. If demand grows on trend, which is around 3%, a small deficit (apparent demand and hidden stocks again?) last year would become a large surplus this year. Based on the work of the analyst I believe is the worlds best on zinc, one cannot square Chinese domestic zinc production growth as well as measures of Chinese apparent demand growth with many other indications of much lower domestic Chinese zinc consumption growth. There is an implied build of hidden stocks. According to recent press reports there has been a rapid build of hidden stocks in Shanghai. Hedge fund and merchant shenanigans again, anyone? The same can be said to some degree about silver, because more than half of all silver production comes from lead and zinc ores. Over the decade prior to 2005 silver exhibited
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one of the poorest demand trends among metals, with virtually no growth in demand over the decade. At the same time, despite low metal prices in the late 1990s and early in this decade, primary supply rose at 3% per annum. A large market deficit in the early 1990s turned into a small surplus. Now, with the huge expansion of lead and zinc production, along with other projects globally with silver bearing ores, that small surplus has probably become a huge surplus. Worse yet, some silver uses like silverware are very price elastic. In the past, owing to huge above ground stocks of silver in various forms, silver scrap supply has been very price elastic. We will not see again the very high scrap supply elasticity that helped bury the Hunts almost three decades ago, but we should still see a considerable scrap surge in response to price. These are two more reasons why silver should be moving into a large surplus. If all these markets are going into surplus, where are those surpluses going? The odds are, to the same or similar hedge funds and merchants who are operating in the base metals we delved into in detail above. We see this also in some minor metals. A case in point is palladium. This market is apparently in surplus, as exchange stocks have risen from negligible levels to over a million ounces in a few years (which is big for little palladium). Yet the palladium price has more than doubled, reportedly because hedge funds have been willing to buy all these visible stocks and no doubt invisible stocks as well. Another case in point is uranium, whose price has gone up 20 fold in this cycle. Because it is a strategic material individuals cannot directly own uranium. It must be owned via a special facility. As a result, it is public information that a large share of all spot transactions are absorbed by hedge funds, and it has been this incessant buying that has skyed the uranium price. And on and on. When it comes to metals, we see hedge fund speculation, hoarding and squeezing everywhere. Not only have some metals markets been driven far, far higher in this cycle compared to all past cycles; we see the same phenomenon across all metals. It is the combination of both the amplitude and breadth of the metals bubble that probably makes it the biggest speculation to the point of manipulation in the history of commodities. On Costs and Long Term Prices Metals bulls often justify todays heretofore unimaginably high prices by pointing to recent higher production costs. As regards prevailing prices the thesis is absurd: though capital costs and cash costs, both average and marginal, have risen a lot in this cycle, prices are still massively above the total costs of the most marginal producer. But the question arises, how great is the current metals bubble? Is it less than the historical price experience would suggest because costs have risen by a great deal?
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The answer is, short run costs have risen, but not long run costs. In every metal cycle there are demands on capital goods and current cost items because, over the short run, the supply of capital goods and inputs lag. Capital goods in mining are not off the shelf items; for a while, during mining booms, demands for such specialized equipment simply exceed the ability of capital goods producers to deliver. The same is true of spare parts, key chemicals for processing, and the like. The same is true of skilled labor. Typically, the demise of the prior boom results in the layoff of so many geologists and engineers that people leave the business and the professional schools wither. But as profits of suppliers and wages of skilled workers rise, new supply comes on with a lag. When the metals cycle turns down, supply to the industry keeps roaring ahead. Scarcity gives way to glut. The profits of capital goods and engineering firms collapse. Equipment costs and consulting services fall in price. Skilled workers in the industry are laid off again in droves. Those that hang on accept lower wages once again. This pattern is perennial. It has happened in every cycle over the past decades. Most striking, even though the period from the early 1970s to the late 1990s saw much inflation in the general price indices, the nominal costs of the production of metals barely rose. In effect, we saw a pattern that is centuries old, whereby real metals costs and therefore prices fall in real terms on average by perhaps two percent a year. We should not be surprised. Excluding the cost of energy, which might rise secularly in real terms in this cycle, the cost of capital goods and the current inputs in mining are the result of nominal wages plus productivity gains in mining. The latter have, on average, been significant perhaps somewhat higher than in most manufacturing industries. This combination of nominal labor costs and strong sector productivity has, through each cycle, resulted in almost flat nominal and declining real costs. The rate of decline has not been very high like in tech goods where productivity gains are very large on average, but such productivity gains have been higher than in some manufacturing industries where productivity gains have been fairly hard to come by. Todays metal bulls present another argument for a higher cost base for metals in this cycle declining ore grades. There is no doubt that in many of todays mature mines ore grades are declining, and new deposits do not tend to have the high ore grades of the past. But the latter is precisely the point. Ore grades have been declining since the days of the Romans. Over the period from the early 1970s to the end of the 1990s, when base metals prices barely rose in nominal terms and fell hugely in real terms, average ore grades fell fairly dramatically. Yet, typical incremental productivity gains obviously more than offset such ore grade declines. One can argue that, in this cycle, we are seeing a secular rise in energy costs, which are major for mining, and that will not be reversed this time. One can argue that productivity gains will be less. On the other hand, there is less inflation in general prices indices in the U.S. and elsewhere versus prior cycles. The above considerations argue that, as in
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past cycles, the current rise in costs all up and down the cost curve presented below will be reversed to some degree.
But that is not the real reason why costs in metals will fall far more than anyone now expects. The real reason does not have to do with the level of the cost curve; it has to do with the degree to which the cost curve shifts outward. And the degree to which the demand curve fails to shift outward. Throughout the history of the industrial world at any point in time there is a cost curve for metals. That cost curve is rather flat in its inframarginal portion and then rises very steeply as in the above chart. In other words, most mines have quite low cash operating costs. But there are a few standby mines with very high cash costs which can be brought into production when demand is strong and supplies are strained. But even though marginal cost under conditions of strong demand is always way above average cost owing to the steep nature of the far out or marginal end of the cost curve, the real price of base metals has always fallen over time. The answer to why that happens, despite the steeply rising far end of the cost curve, is simple: new deposits with low cash costs are continually being found and developed. Their inclusion in the cost curve is in the low inframarginal part of the curve. This pushes the entire cost curve outward. In effect, over history such additional capacity has been pushing the cost curve out more rapidly than the demand curve shifts out. The intersection of the two is therefore never in the steep marginal part of the curve except for brief periods but is rather further into the inframarginal portion where new mines keep cash costs low. As for the highest cost marginal mines, when the cost curve shifts outward, they are simply dropped from the cost curve, forgotten, consigned to the dust bin of history. Some of todays inframarginal mines then become the new marginal mines that constitute the steep high marginal end of the ever shifting cost curve. So the relevant cost of production that determines where metals prices will gravitate is determined by the speed to which the global cost curve shifts outward.
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What determines that rate of outward shift? Two things. First, the success of new exploration, which finds hitherto unknown deposits with low cash operating costs. Second, output prices and the availability of finance, which bring high capital cost/low cash cost projects which are on the shelf into production, thereby pushing out the cost curve. When people consider technological change and its role in reducing mining costs, they focus on the impact of such change on production processes. But it is important as well to focus on technological change in the exploration process. Modern exploration techniques are able to see beneath the earths surface in a way miners could not do in the past. Technology has resulted in a high pace of new exploration success whenever money has been spent. This has added to the availability of low cash cost projects, even though the globe has been girdled and the easy to see surface deposits have been picked over. When metals prices are low little is spent on exploration. Little new is found. This is what happened when metals prices collapsed late in the 1990s. When metals prices are sky-high exploration budgets tend to explode. Which is what is happening now. Exploration finds new low cash cost projects. This eventually shifts outward the supply schedule over long periods of time. This happened repeatedly over the period from the early 1970s to late 1990s. Exploration success had a lot to do with the containment of nominal average cash operating costs and nominal marginal cost despite significant inflation in general price indices over those decades. But there is my second point which is more relevant right now. There is always a large inventory of base metals projects that have been discovered and delineated. Their implementation is simply a matter of economics. Typically in metals, projects have very high capital costs and very low cash operating costs. The hurdle to their development is coming up with the capital needed to get them into production. Once the capital costs are sunk you do not close down such mines until they lose money on a cash operating cost basis. Therefore, very high metals prices, high profits and available finance can rapidly add to the low inframarginal portion of the cost curve and thereby shift outward the curve and marginal cost. I have said earlier, we have never seen such a huge increase in base metals prices relative to past historical trends and such a persistence of super high prices. Under these conditions projects which have been on the shelf because capital costs were too high suddenly become super economic. Many projects which heretofore could never yield an adequate return to the initial capital outlay now have paybacks of one year or less. The totally anomalous high amplitude of this cycles rise in metals prices is giving the go ahead to many high capital cost/low cash operating cost projects. This is why most compilations of future increments to mine production show a growth rate in capacity that is far higher than the growth rates in the past. As these projects come on stream the cost curve exclusive of capital costs and comprised solely of cash operating costs gets shifted
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outward faster than in the past. If the demand curve shifts at a lesser pace that is more consistent with history, the intersection of the two curves or marginal cost can actually fall even if there is inflation in overall in cash operating costs. On Demand Destruction And Marginal Cost Worse yet if sustained super high prices also lead to demand destruction. Then the demand curve shifts out more slowly relative to the past, while the supply schedule is shifting out more rapidly. The implication then is a yet lower intersection of the two curves; that is, yet lower marginal costs. A key question then is, will todays super high metals prices lead to demand destruction, and will that demand destruction persist even if prices fall. Because it is significant and lasting demand destruction that will cause the demand curve to shift out more slowly relative to the past and contribute to lower marginal costs in the future. In my discussion of nickel and copper above I provided examples of substitution and economization that are now occurring. Strangely, most analysts and metals producers today are literally ignoring the potential for demand destruction. If you look at the supply and demand forecasts of consultants and analysts which the marketplace and the mining companies now embrace, you see time and time again forecasts for above trend growth in demand for these metals despite three, six and even tenfold increases in these metals prices. All of microeconomic theory and economic history says that this is outright foolishness. Changes in relative prices ration demand, and massive changes in relative prices literally destroy demand. If one looks at economic theory, for a price inelastic commodity, a doubling in the relative price of a commodity might shave 10% from demand. Yet, our consensus of analysts and consultants implies that this cycles much larger relative price increases will have virtually no impact on demand. What does the historical record say? It says unequivocally that increases in real metals prices comparable to or even less than the increases in this cycle destroy demand to such a degree that it takes many years of positive global economic growth to simply bring demand back to the peak levels experienced before demand destruction set in. Let me provide examples. From the late 1960s to 1973 there was a large increase in real base metals prices. The increase was not as large as has transpired in this cycle, but it was greater than the historical average for all metals cycles encompassing roughly a halfdecade or so throughout the last two centuries. Prices peaked in late 1973 or early 1974, as did global demand for these metals. In late 1974 into early 1975 there was a severe global recession. But this recession was followed by a powerful multi year business cycle upswing into the next cycle peak which was reached in late 1979 or early 1980. From 1973 to 1979 there was an overall increase in global economic activity of more than 20%.
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Despite this very positive backdrop for global aggregate demand, western world copper production peaked at just under 7 million tonnes in 1973 and it did not get back to that level until 1978. Overall world lead production peaked in 1973 at 5.2 million tonnes and did not exceed that level (at 5.4 million tonnes) until 1977. Aluminum and zinc departed in separate ways from this trend. Aluminum demand recovered more rapidly. Western world aluminum demand peaked at 13.9 million tonnes in 1974 and surpassed it at 13.97 million tonnes in 1976. The time for re-attainment of the prior peak was a mere two years, but even over that two year time period there was a significant increase in global aggregate demand. At the other extreme was the zinc market. Western world zinc production peaked at 4.8 million tonnes in 1973 and did not surpass that level until 1986 when it came in at 4.9 million tonnes. The experience worldwide (encompassing the East Bloc) was somewhat different: world zinc demand was 6.2 million tonnes in 1973 and, after a cyclical fall, rose to a new high of 6.4 million tonnes in 1979. The dramatic demand destruction for zinc in the western world at the time was a response to the oil price shock which led to a need to reduce the weight of vehicles. Zinc die-castings were replaced by lighter castings. This dynamic of demand destruction did not really occur in East Bloc countries; hence, the bounce back in demand in world terms was quicker. The extent and relative permanence of demand destruction differed from metal to metal after the great price surge from the late 1960s into 1973/1974. But in all of these cases demand destruction was very great and it cast a very long shadow, even though the real (inflation adjusted) price of these metals fell very sharply after 1973 1974 and remained very depressed for decades. Such severe demand destruction with such a long shadow is not confined to metals. It occurs in all commodities. Most notable is the example of oil from the 1970s to the 1990s. In the 1970s, when the oil price soared and soared, it was widely believed that oil was so vital to global demand patterns and production processes that the demand for oil would prove to be almost totally price inelastic. And, for a long period in the 1970s, it appeared that was the case. But, beginning in the 1980s, oil demand fell by 15% over a several year period when the global economy grew more less at trend. The price elastic response of oil demand occurred with a long lag, but, in the end, it was very great with an overall very, very large decline in global intensity of oil use. It was this demand destruction at high oil prices that broke OPEC. Saudi Arabia, the swing producer, had to keep cutting production to defend the high oil price. In the end Saudi cut its production to an unsustainably low level, and OPECs price support operations had to be abandoned. The oil price collapsed to a low of $10 a barrel (from a peak of $40) and then averaged in the low teens for a decade with the exception of a brief spike in price at the time of the Gulf War.
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What impact did this very large decline in the real oil price have on global oil demand? Was the demand destruction of the early 1980s reversed by low prices, or did it cast a very long shadow? The answer is clear: it was not reversed and the shadow cast was very, very long. Despite the very large collapse in the real oil price all the way into the early 1990s, oil demand on average grew at roughly half the rate of global GDP growth. In other words, intensity of use of oil continued to fall and fall despite the very low oil price. Worse than the base metals, it took more than a decade amidst trend global economic growth for global oil demand to simply re-attain the peak global demand level reached at the end of the prior cycle despite a huge and persistent real oil price decline. Again, the historical pattern, this time for all commodities, suggests that, rather than seeing well above trend metals demand growth in the years to come as the consensus now projects, we are more likely to see outright declines in global demand for these metals as demand destruction takes hold. Investor Revulsion From Metals I: Strategic Diversification Into Commodities Overall Is Self Destructing Part of the investment and speculation in commodities in this cycle comes from strategic investments in commodity derivatives by pensions, endowments, etc. and part comes from speculation and more by hedge funds. Will the former, which have helped inflate metals prices, persist? There are several tenets to the recent strategic allocations to commodities in long term institutional portfolios. 1.) You cannot time markets, so you should make a strategic allocation independently of whether an asset class looks cheap or dear. 2.) Your objective is to maximize the risk adjusted return where risk is measured in terms of volatility. 3.) You can reduce your volatility and raise your risk adjusted returns by investing in commodities future baskets because commodity futures baskets yield almost as much as bonds and stocks but are inversely correlated, thereby reducing overall volatility. There is an important point that must be stressed. Strategic allocations to commodities only increase risk-adjusted returns if the return to commodities is reasonably high. One can accept the lower return to commodities relative to the returns to stocks and bonds, but it cannot be that much lower, since the reduction in volatility from inclusion of this inversely correlated asset is limited. In effect, the foregoing of return must be less than the gain from reduced volatility. Why, traditionally, have pension and endowments not included commodities in portfolios as diversifiers? Because traditionally they thought about diversifying with the physical stuff itself. And if you diversify with stuff you give up too much return to make the diversification work.
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What is the return to stuff? Historically commodity prices have fallen in real terms. In other words they have lagged inflation in the general price indices. Exactly how much they have fallen in real terms and exactly what their nominal return has been depends upon the time period and the commodity basket you choose. Over the last several decades, but prior to the last two years of this super boom in some commodity prices, a good set of assumptions is that the general price level has inflated by about 3% per annum and commodity prices have risen by about 1.5% per annum. In fact, for large portfolio investors the return to stuff has been a little less. Unlike stocks and bonds, holding commodities involves certain non-negligible storage and insurance costs. More importantly, physical commodity markets are surprisingly small. The total value of all inventories of commodities globally has typically been only a few percent of the value of the total outstandings of bonds or stocks. And most of these physical commodity stocks have been working stocks that cannot be readily purchased. This means that buying and selling large amounts of commodities (appropriate to the needs of global pension and endowment portfolios) will disturb prices and involve significant transaction costs. Given the above considerations it is likely that the net nominal return to portfolios from investing in physical stuff has not been more than 1% per annum. By contrast, in a 3% inflation environment, bonds have yielded somewhere between 5% and 9% and equities have yielded somewhere between 8% and 11%. In effect, you gave up an immense amount of yield if you diversified out of bonds and stocks into commodities. You did gain by reducing overall portfolio volatility, but that gain was not large enough to offset the loss in yield. Diversifying with stuff did not enhance risk-adjusted returns. Enter the innovation of the commodity futures basket. In the early 1990s Frank Russell Associates and Goldman Sachs pioneered the idea of using commodities futures baskets rather than stuff as a strategic diversifier. Commodity futures baskets exhibited the same inverse correlation as the physical commodities themselves. But the yield or nominal return to commodity futures baskets was perhaps 6 percentage points higher in a 3% inflation environment. Here is how it works. Instead of investing a certain amount say 100 in stuff you purchase commodity futures with a nominal or face value of 100. To do this you only need put up a margin of 10 in a non-interest bearing account. The remainder of the funds you hold on deposit and earn the prevailing rate of interest, which, in a 3% inflation environment, might be 5%. In doing so, this interest income adds 450 basis points to your overall nominal return. In addition, from the perspective of the early 1990s looking backward, you earned an additional return from rolling your commodity futures forward. The annualized backwardation on a commodity basket like the GSCI was perhaps 1% or 2%. Rolling
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your commodity futures forward to the next liquid contract as first notice day approached provided an additional nominal roll yield of perhaps 1.5%. The combination of the interest on your cash balance and the roll yield increased the total nominal return to holding a commodity futures basket by 600 basis points above the return to mere stuff. If stuff yielded 1% your commodity futures basket might yield 7%. That total yield is almost as much as the return to bonds and not far below the return to stocks. With this new commodity futures strategy the strategic investor was giving up very little in the way of yield to achieve reduced volatility. The diversification with commodities worked: the risk adjusted return to the overall portfolio would be higher. The problem with this strategy is simple. The commodity markets are too small relative to pension and endowment and other portfolios to accommodate it. As commodity futures baskets became popular as a strategic diversifier, the purchase of these baskets and similar purchases of commodity derivatives by hedge funds pushed up futures prices relative to spot prices. First, these commodities futures baskets went from their historical backwardation to a small contango. Then the contango became very large. In energy, we went into supercontangos, which became far greater than the cost of carry. Very large contangos began to emerge in grains and other soft commodities. Large backwardations, which prevailed in industrial metals at high prices, began to disappear. Depending on your basket, these contangos in some cases are 15% annually or more. With such high contangos the roll yield is now disastrously negative. Let us go back to the above example. We must now replace a positive roll yield of 150 basis points with perhaps a negative roll yield of 1500 basis points. Our previously calculated positive nominal return to a commodity basket of 7% now becomes a negative return of 9.5%. If diversification using stuff with a positive nominal return of 1% did not work, diversification with a commodity futures basket with a deeply negative return will surely not work. Investment bankers have tried to change the weights in their commodity baskets away from supercontango markets to backwardation markets in order to reduce this negative roll yield. But most of the few commodities that remain that do not have large contangos are small markets. Therefore, not much can be done in this regard, since any significant such reallocation will throw these few remaining commodity futures into full contangos or supercontangos. But it is actually worse than this. The tsunami of buying by the pinstripe investor in commodities has raised commodity prices above their marginal costs (which is their long run equilibrium). Over time, it is inevitable that demand will be rationed and supply will be encouraged. Surpluses in commodity markets tend to increase contangos in their futures markets. That means that, over time, the presence of the pinstripe investor will ensure full contangos or supercontangos everywhere. There is no getting around this: the buying pressure of the pinstripe investor has destroyed and will continue to destroy the return assumptions that led him to commodity futures baskets in the first place.
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Pinstripe investors of all kinds and their consultants who recommend to them commodity futures baskets are backward looking. The pinstripe investors are backward looking because that is their orientation. The investment bankers and fund companies who sell pinstripe investors such commodity futures baskets may not be backward looking; they may recognize that the current contangos and supercontangos and the implied negative roll yield is here to stay. But they are salespeople. However, in time, it will be realized by everyone involved that the buying pressure of the pinstripe investor in commodities has changed dramatically the returns to commodity futures baskets. And, in doing so, has destroyed the diversification case for such strategic allocations. Some commodity baskets now have deeply negative returns. At todays high commodity prices this can only get worse. No strategic investors with a basic menu of high yielding stocks and bonds can continue to hold commodity baskets with negative returns. Therefore, over time, much of the strategic investments that Pinstripe Investors have made in commodity baskets will be liquidated. I am hearing that some strategic investors are now liquidating, though new commitments are still offsetting. Such flows may now be close to zero on a net basis. Eventually they will be negative on a net basis. Only when this liquidation is largely over will the prohibitive contangos go away and the diversification rationale for investing in commodities become valid again. Once this process is well under way pinstripe investors in commodities may feel foolish. They may feel they have been persuaded by investment bankers and others who sold them deeply negative return instruments even though the sellers realized the inherent return to such baskets had turned very negative. This could create a climate of revulsion which could accelerate such liquidation. Such revulsion will apply to all the commodities included in these baskets. That will include all the metals. This is the one of two revulsions that the metals sector will experience in time. The Risk of Revulsion II: Revulsion From A Hamanaka on a Massive Scale. This cycles metals bubble is far worse than its commodity bubble. What I have described so far is a base metal sector that is out of all touch with reality. We see price distortions relative to underlying fundamentals the likes of which have never happened before. The reason is investment and speculative demands. Strategic investment demands have been a contributor, but a lesser one. Speculative hedge fund demands have been overwhelming, and across the entire metals complex. And in this cycle such speculation has gone to the point of manipulation.
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This is an old story. It should be a familiar one. It happened a decade ago with the Hamanaka incident in only one metal copper. As illustrated in the preface to this metals section, just recently a new class action lawsuit is scheduled to go to trial against J.P. Morgan for financing Sumitomo (Hamanaka) and the fraud and manipulation involved. You would think the world would have remembered. Yet, despite the very considerable published commentary we have found about these metals being out of touch with reality because the LME is a paradise of speculation and manipulation there is little such commentary among mainstream analysts and consultants. After the Hamanaka incident unfolded Paul Krugman discussed this age old process of speculation to the point of manipulation, which I have described above. So far so good. But a long time ago somebody--I wouldn't be surprised if it were a Phoenician tin merchant in the first millennium B.C.--realized that a clever man with sufficiently deep pockets could basically hold such a market up for ransom. The details are often mind-numbingly complex, but the principle is simple. Buy up a large part of the supply of whatever commodity you are trying to corner--it doesn't really matter whether you actually take claim to the stuff itself or buy up "futures," which are nothing but promises to deliver the stuff on a specified date--then deliberately keep some--not all--of what you have bought off the market, to sell later. What you have now done, if you have pulled it off, is created an artificial shortage that sends prices soaring, allowing you to make big profits on the stuff you do sell. You may be obliged to take some loss on the supplies you have withheld from the market, selling them later at lower prices, but if you do it right, this loss will be far smaller than your gain from higher current prices. It's nice work if you can get it; there are only three important hitches. First, you must be able to operate on a sufficiently large scale. Second, the strategy only works if not too many people realize what is going on--otherwise nobody will sell to you in the first place unless you offer a price so high that the game no longer pays. Third, this kind of thing is, for obvious reasons, quite illegal. (The first Phoenician who tried it probably got very rich; the second got sacrificed to Moloch.) Why is this incident not in the forefront of everyones minds? Why, after the Hamanaka incident, which sent some to jail, some fleeing outside the reach of the law, many lawsuits and a new court case now at hand, have the supposedly self-policing exchanges and their regulators not been active? Without going into details, I can assure you the exchanges know what is going on. They know who the dominant longs are that everyone talks about. They know of exchange metal movements that involve non-commercials. They probably know all that Jinchuan or Nexans or the NDRC know. They probably know what the traders and analysts cited above know and what is behind their comments about the markets speculations and squeezes. And so do their regulators. The exchanges pass information to the regulators. Others have complained to the regulators and with evidence.
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Paul Krugman says that such activities are quite illegal. I am not sure. I have been told by the U.S. regulators that squeezes are illegal in the U.S., but hard to prove. I am told collusion is illegal, but hard to prove. I am not sure in London, under the rules of the FSA and the LME, such operations are illegal. But I believe that the FSA recognizes there can be undesirable market abuses. I am not sure if the LME, which some describe as nothing more than a cabal of brokers overseeing what has historically been something of a cesspool, would recognize any abuses unless forced to. So, we may ask, as the exchanges and the regulators know what is going on, why is nothing done? The answer is the Anglo-Saxon approach to regulation. The principal metals markets are in the U.K. and U.S. In one conversation I have had with U.S. regulators we both agreed that the current policy of regulation in Anglo-Saxon commodity markets is to let the fox guard the hen house. Paul Krugman made this point with respect to the Hamanaka incident a decade ago. The funny thing about the Sumitomo affair is that if you ignore the exotic trimmings--the Japanese names, the Chinese connection--it's a story right out of the robber-baron era, the days of Jay Gould and Jim Fisk. There has been a worldwide rush to deregulate financial markets, to bring back the good old days of the 19th century when investors were free to make money however they saw fit. Maybe the Sumitomo affair will remind us that not all the profitable things unfettered investors can do with their money are socially productive; maybe it will even remind us why we regulated financial markets in the first place. It is possible that the regulators in the United States may finally be concerned about what the fox guarding the hen house is doing to the hens. In a recent FT article entitled, Futures enforcer issues warning, we are told Regulators need more funds to guard against fraud and manipulation. April 20, 2007. This article suggests that such concerns of the CFTC have to do with energy and perhaps not with metals. This is understandable. Prior to the Amaranth incident consumer groups got wind of a possible hedge fund manipulation of the price of natural gas. They took their complaints to the attorney general offices of several states, as well as to the U.S. Congress. They got a sympathetic hearing, at least at the state level, but the states realized they had neither the financial resources nor the expertise to follow through. And they also found they got no support from the CFTC. But after the Amaranth debacle these allegations about hedge fund manipulation of natural gas, which is politically sensitive because it is the home heating fuel of American consumers, came before the Congress again. Hearings are now being held to see if there was manipulation and why was the CFTC asleep at the switch. Hence, the emergence of concern by the CFTCs chief enforcer? But it is not clear whether his concerns about fraud and manipulation extend to the metals markets. Prior to the Amaranth debacle, there was very little comment in the public domain about manipulation in natural gas. From my perspective, there was little smoke
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that might have indicated a fire. By contrast, in the public domain there is now huge talk about possible manipulation in metals. So it would be surprising to see so much publicity over the CFTC enforcements concerns about fraud and manipulation but no attention to metals at all. As for Britains FSA and the LME, the assessment of Jinchuan and Nexans of the behavior of these UK agencies suggests we may never see the modicum of concern than may now be surfacing in the U.S. at least until the inevitable unwind of the current shenanigans in LME metals occurs and brings with it its consequences and revelations. Perhaps there is now so much smoke the U.S. and U.K. regulators are now scared of looking for fire. Look at it this way. In the Hamanaka incident, only one metal copper was involved. There were only two colluding parties, Sumitomo and another. And the price of copper was only pushed to $1.46, close to, but not even, at the top of its prior 3 decade trading range. In this case, there may be no manipulation and collusion. Or maybe there is but it cannot be proven. But if the many commentaries in the public domain have merit, the scope of the manipulation and collusion could be vastly greater than in the Hamanaka incident. Many metals are involved. Many more than two players may be working together. And the price distortions are hugely greater. Metals like copper, nickel and zinc are not at multi decade highs they are several times multi decade highs. If there is manipulation and collusion on such a scale, what would be the eventual consequences in terms of legal actions. They could vastly surpass in aggregate claims those that followed the Hamanaka incident. Would the U.S. or U.K. regulators, having let things get to such a point, have the resolve to investigate and act? What would be the impact on metals prices if they uncovered what the many public commentaries suggest? What would be the impact on the exchanges if there were such revelations? It is not hard to conclude that, if the many publicly voiced claims and suspicions have merit, that the regulators are now afraid to act because of the consequences they might provoke. Does this mean that, if the regulators leave things alone, all will be well? Absolutely not. Such absence of regulation allows excesses that lead to outcomes that become socially intolerable. In the U.S., cheered on by the likes of Alan Greenspan, mortgage lenders lent to people who could not pay on terms that ensured massive future defaults. Two years ago the regulators began to see what would happen and called for stricter standards. But, typical of the laissez faire Anglo-Saxon New Financial Architecture, private lobby groups in finance and real estate objected and the regulators did nothing. The result is a housing bubble that is now bursting and a mortgage finance crisis which has become the focus of the ire of the public and the congress. And the mess may be only in its early stages.
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We should expect a similar public post mortem of the metals market when the speculation and manipulation come to a bad end. And it is this spectacle that will lead to that second more intense and more focused revulsion of investors to the metals markets. Conclusion On Metals Revulsion In the end, no matter what are the games of speculators in base metals, the fundamentals will prevail. Surpluses will become too great to hoard and hide. Prices will fall to and below a marginal cost that will prove to be little different than in past cycles. Institutional investors that have been caught up in the bubble in various ways will suffer huge losses. As with the tech bubble, all the Wall Street cheerleaders of the bubble, with their crazy New Era fundamentals, will be discredited. There may be Amaranth type crises which disgust institutional investors with the speculating hedge fund sector. And, as has happened again and again in the past, the regulators who sat idly by will be accused and attacked. When bubbles burst the asset class always becomes profoundly discredited. There is always revulsion. But when it turns out that there is the skullduggery typical of so many of the big bubbles in the past, when the regulators in charge of maintaining the rules of fair play have been seen to fail in their role, the revulsion is far more profound. In my judgment the odds are very, very high that this will all transpire. Investment funds will eventually be taken out of the metals sector with savagery. The reversal of the fund flows responsible for the commodity bubble described in the prior section will be more complete in the metals sector. This reversal of the tsunami of fund flows will deepen further any price declines to marginal cost or below that will be made inevitable by the fundamentals. So todays record price distortions will generate a fundamental response: record surpluses that will cause mean reversion, overshooting the mean to the downside, and a very long period of low prices to force mine closure and absorb the inventory overhang of record surpluses. And this nuclear winter will be deepened by revulsion that causes reversal of the speculative fund flows that have fed, in myriad ways, the metals bubble.
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APPENDIX
Copper
David Threlkeld, the first trader to publicly allege in 1991 that former Sumitomo Corp trader Yasuo Hamanaka was cornering the market for copper, says record prices are being `àrtificially'' supported again by speculators, threatening a slump before the end of the year. Copper hit a record high in early morning London trade Monday as Grupo Mexico, the world's fourth-largest producer of the metal, failed to end a strike at its Asarco unit in Arizona. The metal rose US$20 (HK$156), or 0.6 percent, to US$3,607 a tonne. Inventory tracked by the London Metal Exchange, or LME, the world's biggest metals bourse, has plunged in the past 12 months to a 31-year low. The slump has pushed the gap between the cost of copper for immediate and three-month delivery to its widest in more than seven years, according to data compiled by Bloomberg. The supply squeeze has caused a 27 percent jump in prices in the past year, fueling profit at producers such as Chile's Codelco while hurting users including Paris-based Nexans. The possible existence of undisclosed stockpiles may trigger a price drop, just as in the 1990s, after Hamanaka's market manipulation was detected. Copper reached a record in London today. ``The guys who made their money on Hamanaka made a fortune on the way up, but made 10 times the fortune on the way down,'' said Threlkeld. ``To go long in this market today is a mug's game.'' Threlkeld was speaking from his home in Scottsdale, Arizona, where he runs his metals trading and consulting company Resolved Inc. The LME, which can invoke powers including the suspension of trading if it suspects there is an attempt to corner the market, said the market still ``reflects the fundamentals.'' ``There is nothing going on that is causing us concern,'' said LME chief executive Simon Heale.
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Copper dropped 21 percent on the London Metal Exchange in June 1996 after Hamanaka, Sumitomo's chief trader of the metal, admitted to the unauthorized trades. Threlkeld had told the LME in 1991 that Hamanaka asked him to confirm bogus trades made on the exchange. Hamanaka, who lost Sumitomo US$2.6 billion, was sentenced to an eight-year prison term in 1998 at the age of 48. Sumitomo said it was unaware of the trades. European wire and pipe makers, lobbying through a London- based industry group, in June asked the LME if it was monitoring copper trading. Members of the International Wrought Copper Council, or IWCC, were concerned that the higher premiums charged on the LME don't reflect the demand. ``There was an increase of underlying concern from a number of people about what was going on,'' said Simon Payton, secretary general of the IWCC, in July. ``We want to know whether everything is in order,'' Thomas Goede, an executive at Germany's KM Europa Metal, which makes about 700,000 tons a year of copper products and was one of the signatories to the letter, said last month. ``We're wondering why we don't see more copper come into warehouses.'' Though he doesn't have first-hand evidence this time, Threlkeld said traders may be accumulating the commodities to boost prices. In 1980, silver jumped to US$50 from US$6 an ounce after US billionaires Nelson Bunker Hunt and William Herbert Hunt hoarded the metal. Eight years later, the brothers were convicted of conspiring to manipulate the market. `Ìt's stocks, together with the action of speculators, that has lifted the price'' of copper, said Chilean Mining Minister Alfonso Dulanto. `Ì don't see how it can last. It's something out of all proportion.'' Copper in the past two months has surged to a succession of records on the LME, with metal for three-month delivery hit an all-time high of US$3,615 per ton in early trade Monday. By mid-morning it had slipped to US$3,595 per ton. ``There seems to be a play going on,'' said Stephen Briggs, a metals analyst in London at Societe Generale, one of the 11 companies that trade on the floor of the LME. ``Trading action suggests that there is an attempt to make the market seem tighter than it really is.'' To buy copper for immediate delivery, consumers this year have paid as much as US$265 a ton more than for three-month delivery. The last time it so much more costly - an anomaly known as ``backwardation'' because in a conventional market it should be cheaper - was in June 1996, about a year before the LME began monitoring the market for signs of manipulation. The three-month contract is the most heavily traded on the bourse.
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Data on the exchange's Web site show one unnamed party holds between 30 percent and 40 percent of the copper stored in LME-approved warehouses. ``There might be some parties involved in taking positions in the market and therefore to some degree, and putting it very carefully in quotes, manipulating the market,'' said Harald Kroener, speaker for the management board at German pipemaker Wieland-Werke, a copper consumer. ``We have a slowing of the fundamentals and an acceleration of the price, Threlkeld said. `Ì see a divergence, and I've been a major bull on copper.'' Inventory in LME-registered warehouses has fallen 35 percent this year to 31,550 tons. The total dropped to 25,525 tons on July 22, the lowest since June 1974. Threlkeld said there is 40,000 tons of metal in LME warehouses in Singapore but not declared to the exchange, citing an unnamed associate he said has had access to paperwork documenting the stocks. Nexans, a producer of electrical cables and wiring that is the world's biggest copper user, said locating metal has become easier even as prices have risen, suggesting copper is artificially expensive. `Ìt is certainly easier than it was last year,'' said Christian Velten-Jameson, corporate vice-president finance at Nexans in Paris. LME inventory is ``probably the visible part of the iceberg.'' ``The copper price is being willfully propped up,'' said Robin Bhar, an analyst at Standard Bank in London who has followed the LME for 21 years, speaking in a July 13 telephone interview. The current market `ìs very reminiscent of the Sumitomo era.'' Source: Copper Price-Fixing Claim, Simon Casey, Bloomberg, August 16, 2005. Reprinted in The Standard (Hong Kong). Demand for copper fell by 2 per cent in the first half of 2005, according to Nick Moore, commodities analyst at ABN Amro. Fingers are thus being pointed at the hedge fund community. This is window -dressing ahead of the end of the quarter. The funds are going to try to hold the price up, said Mr Moore. This is all fund buying; that is all it has been, said an analyst at Natexis Metals. The hedge funds are self-fulfilling; they create the momentum and then they run along with it, and they were pushing the market to test the previous high.
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Source: Copper peak due to hedge funds, Steve Johnson, Financial Times, September 27, 2005. "The high copper price doesn't match the feeling in the physical market," Roberto Souper, vice-president of sales at government-owned Codelco, said in an interview. "It's very influenced by investors and speculators." Source: Codelco Says Copper at 16-Year High on Speculation (Update1) Bloomberg 2005-06-16. Copper may not lose its recently found luster (record high of $1.56 per pound) any time soon if certain macro funds holding the metal have anything to do w/ it. Speculation mounts that some macro funds are simply "hoarding" copper stockpiles and keeping it away from warehouses assoc w/ futures exchanges knowing full well that Chinese demand (up approx 13.5% last year alone) although dropping slightly remains robust while supplies are falling quickly. In fact, the LME fell 375 metric tons or 0.9% to 41,200 tons (a level not seen since 1974). As some economists refer to China's economy w/ words like "overheating" and "inflationary," a growing number of analysts have taken down their estimates "slightly" for copper usage in China especially w/ reports pointing toward lighter imports of the metal in the region. However, despite the fact there has been lighter imports of the metal in the region, the level still remains quite elevated and that could continue to drive copper stocks higher. While demand may be slowing, supplies are likely to remain quite constrained until new supply hits the markets in 2006. Until the "hoarded" copper gets dumped back into the marketplace, shares of Phelps Dodge (PD 92.23 +1.03) will likely remain attractive, along with other copper producers like BHP Billiton (BHP 26.55+0.10) and Southern Peru Copper (PCU 47.67 +0.02). Source: Logic Advisors' O'Neill Comments on Copper Prices, Inventories, Bloomberg, 2005-06-08 15:58 (New York) By: Jennifer Itzenson and Monica Bertran June 8 (Bloomberg) - William O'Neill, a partner at Logic Advisors LLC in Upper Saddle River, New Jersey, comments on the rise in copper prices. Copper prices in New York today rose for the 12th time in 13 sessions as inventories monitored by the London Metal Exchange fell to a 30year low. O'Neill was interviewed today in New York. On supplies: "We have tight stocks in London, Shanghai and New York. It's a little bit of what I would describe as an artificial tightness. When you look at the overall supply-demand equation, it is not really that tight." "In this case it is more, 'not at the right place at the right time.' If you look at the global economy, copper is pretty fully priced." On price outlook:
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"We have a speculative bubble. The funds have become long. The tightness in London is there, the tightness in Shanghai is there." "I think that the global demand level will not keep these prices up at this level for an extended period of time." "This is sort of an accident waiting to happen." Source: Logic Advisors' O'Neill Comments on Copper Prices, Inventories, 2005-06-08 15:58 (New York). Bloomberg. COPPER users have threatened to turn their backs on the London Metal Exchange, alleging hedge funds are driving copper prices to speculative extremes that no longer reflect supply and demand. In a letter to the LME and the Financial Services Authority, the International Wrought Copper Council said that its members faced severe difficulties financing deliveries. "This market, where speculators can buy what does not exist, is doing serious damage to our industry and will bring into question whether the LME copper price should continue to be the recognised reference price," it said. An LME spokesman insisted that the market was running in an "orderly" fashion. The exchange last intervened in the copper market in 1996 after a rogue trader from the Japanese bank Sumitomo lost $US2.6 billion. David Threlkeld, a veteran copper trader who exposed the scandal, said he feared the speculative fever was even worse this time, blaming it on a group of New York and London funds. "This is a perfect storm. If oil takes a dive, there are going to be a chain of margin calls going through the copper market, and then we'll find there are no buyers," he said. "Copper will implode overnight. This is like flipping condos in Miami, the last one holds the bag." Mr Payton said he was rebuffed by both the LME and the FSA, receiving a letter from the FSA insisting that it was not the role of the two bodies to "limit legitimate speculative activity". Source: Copper users attack funds' feeding frenzy, London Telegraph, May 3, 2006. "There are signs of softness in housing and motor manufacturing, but in other areas the situation is harder to read for the moment," said John Kemp, analyst at Sempra Metals.
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"Copper seems expensive at 7500. But the major hedge funds ... have demonstrated their ability to keep the market tight by buying up all the stock in recent days." Source: John Kemp, Sempra Metals, September 27, 2006 These funds have enough capital to keep the market short for the next six to 12 months and that is why upcoming wage talks, the possibility of strikes disrupting supplies are a major worry for consumers, analysts said. Source: Bloomberg News, September 2006 "The present level of cancelled warrants allows to anticipate a moderation in stocks withdrawal in the following quarter variations of cancelled warrants are reflected in the following three months if no unexpected entrance of material attracted by a high backwardation- takes place in the warehouses of the metal exchanges. This entrance could be justified because in 2004 stocks decrease has been greater than the forecasted shortage, and certain quantity of material has become to be in non reported invisible inventories." Source: Cochilco's Q4 2004 market commentary Demand destruction and substitution is still the mostly talked about theme, supported by continuously sliding cathode imports. Slower copper imports are in sharp contrast to the 10.8% GDP growth and 28% growth in fixed asset investment. One trader estimated that as much as 350,000t of copper demand had been permanently lost due to substitution from aluminum: low-end home appliances, low voltage power cable and joints used in aircon units are most typical examples. That figure may be an overestimation but the Chinese are clearly not buying copper in same proportion to the size/growth of the economy as was the case a few years ago. On supply side, we heard about 30% growth in domestic concentrate, contributed by both the large mines (22-25% typical metal content) and small wildcat mines who produce low grade ores (15-18%). Rising inventories in Shanghai, along with higher stocks reported by Comex and the LME are casting doubt within the Chinese metal community as to whether the previous tightness was an artificial illusion created by funds and merchants hoarding metal. A perception of reduced industrial relations risk from Latin America and soaring output from African countries where China has substantial investment are also affecting sentiment. Source: November 2006 UBS commentary Conclusion: market in increasing surplus since autumn 2004 For 2004 => Surplus estimated at 600 kt by Nexans (supply and effective consumption). Where did that materials go?
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And the surpluses seen in 2005 and 2006 ? => Nexans estimation: 1 Mt, hoovered away Hedge funds and investment banks => Now only driving forces in the market LME => No more the institution allowing the consumers to have a physical access to the copper at a price managed by the economics fundamentals Game facilitated by several types of manipulations: Statistics Media: very good use of strike in Chile, land slide in Indonesia, ships in difficulties due to bad weather Long list of catastrophes, well handled to justify the rally of the copper price, without any relation anymore with the fundamentals Will market regulators take a tougher look at the copper market? Will Central Banks confidentially follow the exposure of the commercial banking world towards hedge funds (the big players!) ? If we want to protect the Industry from the excess of the financial world: Nexans is convinced that what happened in the commodity markets must be on the agenda of the Governments Source: Nexans Presentation, Desjardins Commodities Conference Looking into the mind of the potential short seller the hesitancy with regard to the real physical market is coming from a lack [of] visible inventory build and the US Dollar. On the inventory front we should now be seeing exchange stocks rising. Our supply and demand figures suggest that there could be a 100,000t surplus this year but so far none of this has turned up at the LME, Comex or Shanghai. Furthermore, reading into the data for last year we suspect that a fair amount of inventory was built up at the consumer level and this logically should also be off-loaded into the exchange given current and recent backwardations. Given my tendency towards conspiracy theories, I suspect that the metal is being hoarded. Holding back up to 300,000t of copper (current value a little under $1bn) is small fry for some of the bigger merchants and macro hedge funds. Source: Maqsood Ahmed, Base Metals Outlook, Caylon Financial, June 2, 2005. Still, the first trader played down the impact from the backwardation. "Theoretically it should put pressure on the premiums, but it probably won't this time as I would imagine that those people who need to finance
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material now run a long position so they don't mind [financing costs] as long as they control [the market]," he suggested. Source: Copper Premiums Rise in Europe as Buyers Compete for Material, Metal Bulletin, March 20, 2007: It is becoming clearer that some powerful bulls have structured themselves long of the nearby months in the LME copper market. The move has been timed to coincide with what should be a strong period for Western World demand and the target is the large bear short position that built up on both sides of the Atlantic from the end of last year. Last weeks LME compliance reports showed two consistent dominant long position holders on the cash and tom/next dates. The positions have fluctuated almost daily within the LMEs reporting bands but have tended to account for at least 100% of LME open warrants on a rolling basis. The bulls presence was last week evidenced by a dangerously unpredictable backwardation across the nearby dates. At one stage Thursday morning the tom/next spread briefly flared out to $10 backwardation. But backwardation was also the order of the day all through the cash-to-3-months period. The period hit $81 backwardation at Tuesdays close, the widest backwardation since July 2006, and eased only slightly to $67 at Fridays close.
Source: March 26 Metal Insider

European copper premiums were indicated higher, but still broad-ranging last week, while actual spot trade remained thin -- despite the apparent pick-up in interest. Producers, consumers and traders said many market players were pricing material and inquiries were flowing in, but there was very little actual business being done. Comments from sources on the state of the European physical market this week mostly centered around the hefty backwardation, around $75-80/mt on Friday afternoon, and the rumors that a physical fund was holding warrants in Rotterdam with the assumed intention of being able to play with LME prices and spreads. "Physically speaking a backwardation is not justified, it's artificial. There's plenty of metal around," said a consumer. A copper products maker said the backwardation might trigger a sell-off by merchants who had been sitting on material waiting for better premiums: "Financing is difficult for merchants so we could see some selling around in an attempt to get rid of stock." A producer agreed saying: "We might see a few distress sales -- selling for financial not market reasons," he said, adding that to result in the large backwardation "someone is holding stock and paying for it. Source: European physical copper: Premiums higher, spot trade still thin, Platts. Reprinted in Metal Insider, March 26, 2007. European copper cathode premiums were unchanged this week as the market was still seen extremely quiet on the back of sufficient cathode supply, slow demand and a
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widening backwardation, producers, consumers and traders told Platts. The cash-to-threes backwardation was $100/mt at the time of cash settlement on the London Metal Exchange on Friday, flaring out from around $60/mt at the beginning of the week. Some sources said it was the large warrant positions held by a physical fund in Rotterdam and Livorno which had pushed the spreads out further, implying that metal was tight, when in fact it was not. Warrants for these two locations were heard offered at $80-100/mt. But, market sources agreed that these numbers were not reflective of the physical market and had not filtered through in to deals, because consumers were well-covered. "There is still enough cathode around so no one has to buy," said a producer source, adding that the widening backwardation had also kept players out of the market -- "it has been a very quiet week." A consumer said premiums were under downward pressure as the summer slowdown was approaching and some companies with June financial year ends were book squaring. "Just owning copper at this point is a financial burden, so people are offloading," he added. A European trader said he had not done any business in Europe. "Someone asked me to quote, but its so quiet I don't know where the market is," he said, adding that usually July was quite an active month. A second trader said warrants in Livorno were being offered at $80-100/mt and in Rotterdam at similar numbers. "The Italy warrants are strongly held by one player," he said, adding that every company did what suited their book -- so while it did not make sense to others in the market, it must make sense to whoever was holding the position. "If the funds look at copper stocks going down, there is a tendency to buy and the price rises," he noted. The trader said Chinese activity still had the biggest impact on the market: "If the Chinese are buying, the metal will go there." A third trader said the last two months had been very quiet in Europe. "People bought on contract last year, so they are well-covered," he said, adding that he had last heard Rotterdam premiums at $50-60/mt. "Italy is also very quiet, it is the same as in Rotterdam," he noted. Source: European physical copper: Premiums unchanged, trade still thin, London, Platts. Reprinted in Metal Insider, June 4, 2007. "On the surface exchange stocks patterns in Europe seem to be conforming to normal seasonal patterns with big rises over the Dec 06-Jan 07 period giving way to an accelerating downtrend over Feb-May. Local LME stocks fell by 17,850t last month, compared with declines of 9,150t in April and of 8,250t in March. Were aware, however, that many players are viewing this usual seasonal pattern with an unusual degree of scepticism, since the local market appears to be well supplied and premiums, although off their early-year lows, are not exactly signalling any real tightness. Are European stocks levels being massaged? By the very nature of the questionan answer would imply we could see invisible off-market inventoryits impossible to say. However, there may be some strategic game afoot with one eye on developments in
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the US, where if current patterns continue, exchange stocks could be whittled away to limited quantities in the least sought-after locations." Source: Metal Insider, June 1, 2007 "The re-surge in prices does have fundamental backingas well look at belowbut this has in many ways been an engineered move by aggressive bull hedge funds. Two dominant position holders have been consistently gracing the LMEs daily compliance reportsmost recently they were both in the 30-40% band. Leverage has come from the options market and fun and games on the forward curve have meant less producer selling than might otherwise have been expected on such a sharp move." Source: Metal Insider, April 23, 2007
Nickel
Prices of some base metals are surging at London Metal Exchange(LME), with current 3month copper recorded all-time high of $7,300/ton, while nickel scores beyond $20,000/ton, which has detached from the fundamental prices and largely caused JNMCs concerns over it. According to our market investigations, the shooting-up prices of copper and nickel astonished not only the traders but panicked consumers, including some big businesses as well. Our latest survey shows that most of the copper fabrication plants have no prospects to make profit, comprehensively operating under capacity, some of the medium-small ones had been shut down or even out of business. Consumers of these metals have turned to alternatives as widely as possible. The consumption in China has not met peoples expectation as usual in this peak season. Statistics indicate that in China, nickel apparent consumption during January-February fell by 15.6% compared to the same period last year, while copper apparent consumption fell 10% in January and January-February import volume of copper sharply dropped 58.8 percent. Lots of doubts were aroused in the survey about LMEs fairness, justice and openness, and also about its role in pricing discovery. International Wrought Copper Council (IWCC) had expressed their complaints in letters to LME and Financial Services Authority (FSA) that its members would no longer regard the LME copper price as their pricing benchmark. JNMC does not favor the market of primary nonferrous metal products which is now full of excessive speculations. Such a volatile situation, if continued, must be detrimental to interest of consumers. Moreover it will hamper the long-term development of the whole industrial chain of mining, smelting and metal processing, and that of other relevant industries including futures exchanges. Hence, we hope wide-viewed companies in the industry to have discussion and consultation and share views with each other, take steps to maintain the industry in a sound and sustainable way by converted effort to protect both producers and consumers interests. Source: April 17, 2006 statement by Jinchuan Group
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Recently, price of LME three-month nickel fluctuates above $20,000/ton, JNMC shows its concerns about it. On 17 May, 2006, nickel price was pushed up $1,000/ton just a few minutes before LME closed, which further confirms that LME nickel market is excessive of speculations and with a suspicion of manipulations. So we hope the producers and consumers make concerted efforts to calm down the price of nickel on a reasonable level. Source: May 19, 2006 statement by Jinchuan "To the irrational surging of current nickel price, Mr. Li Yongjun, JNMCs president and Chairman of the board, delivered his personal opinion on the disorderly nickel market. He said the LME is no longer a place for fair dealing of metals but a paradise of speculations and that the rocketing and slump of nickel price would do harm to interests of all industries concerned. Mr. Li showed his great concern about the irrational situation of the current nickel market. He said that it is necessary for the LME to improve the trade regulations and strengthen management of the market. Following such a roiled market can only result in sowing the wind and reaping the whirlwind. It will not only impair development of the downstream industrial sectors and the nickel industry but bring ill effects to the LME and speculators. He deemed that no one can have the last laugh in a market with crazy speculations. " Source: August 2006 statement by Jinchuan Since the April 2006, the LME nickel market has entered into a climbing way, rising successfully, the price has jumped to USD$48,000/mt from USD15,000/mt. The range reaches 200% in such 11 months. Especially since the February this year, the trend went into madness, from USD35000 then to USD48000 currently, whatever the changes range or its speed all break the history record. Such crazy price that has stimulated the irrational investment in nickel field., In recent years, all the nickel mining projects are going well like a raging fire. No matter the sulfide or laterite, both aroused the interest of investor. The exploitation progress has accelerated. In the coming years, items coming into production intensively, serving abundantly , we are afraid of maybe that will intrigue the price slump in future and burying hidden trouble for the health development of nickel industry. Source: March 19, 2006 Jinchuan Statement Under the current situation of nickel market, Jinchuan Group Ltd, as an accountable and reliable global company, has the obligation to remind customers and consumers that do not to be puzzled by deceptive information of nickel stock, conditions of supply and demand, as well as price released irresponsibly by a few foreign agencies. JNMCs high-positioned manager reiterates that the group insists providing its products to consumers who simply use nickel for their production, reminds customers on the alert that a little few of traders and agencies may bid up nickel price.
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At the same time, Jinchuan asks its customers, trading agencies and foreign services do not take part in bidding up nickel price and stocking up its nickel products. Source: Statement by Jinchuan, March 28, 2007 The price of nickel has surged to a record $50,000 a tonne (25,320) as world warehouse stocks fall to half a day's supply on booming demand for stainless steel and shadowy moves by "pinstripe" funds. China's top nickel producer, Jinchuan Group, warned that the price had lost touch with industrial reality, setting off a wave of "irrational investment" in new mines that would send prices crashing once the bubble burst. "The trend has gone like a raging fire into madness. We are in deep anxiety about at the potential ill consequences," it said. David Humphries, chief economist for Norilsk Nickel, said hedge funds had moved in for the kill, triggering a violent "short squeeze" on the futures markets. Those caught with open bets on lower prices are being forced to cover by purchasing the metal, fuelling a blow-off price spike. "For many of those contributing to current prices, it's just a financial play," he said. Source: Ambrose Evans-Pritchard, Nickel price 'loses touch with industrial reality', London Telegraph, April 6, 2007. Nickel fell to a 10-week low, erasing its leading position this year on the London Metal Exchange, as stockpiles rose and the bourse imposed new rules to curb what one analyst described as "collusive" trading. Two or more companies, each holding 25 per cent or more of LME-monitored nickel stockpiles, now need to make more metal available to other buyers. Inventories tracked by the LME increased 2.4 per cent to 8,604 tonnes, the highest since July 10. "It's a clear signal that the LME plans to act against this type of collusive market behaviour," said John Kemp, a London-based analyst at Sempra Metals Ltd., one of 11 companies trading on the floor of the LME. "Stockpiles have been rising and there doesn't appear to be a shortage of physical metal." Source: Nickel drops to 10-week low amid 'collusive' trading, Bloomberg, June 8, 2007. People are frightened of shorting in this market. Those who have tried to go short have burned time and time again. It's just not worth the risk." "...trading remained thin with only 500 lots trading by 3pm London time."
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"Nickel is very volatile because of the thin market," said the first trader. "It's not rare to see the price moving $2000 on only 200 lots traded." Rumours are circulating that a strong long position, either a trader, a hedge fund or a producer, is holding the price artificially high. The suggestion is that the party owns large stockpiles off the market, and controls the stock inflows and outflows from LME-warranted warehouses to keep prices at the $50,000 level. Source: Expensive Nickel Becoming More Illiquid, Metal Bulletin, May 18, 2007 Nickel stocks in LME-registered warehouses were down 480 tonnes at 3,450, of which only 1,872 or just over half a day of world consumption were available to the market. But traders said funds were keeping material out of sight to fuel price gains. "The market is tight but it is not that tight," the trader said. Source: Copper soars six percent, February 22, 2007, Reuters. "Funds speculating in nickel are ``the major cause'' of the price surge, Eero Mustala, a spokesman for Outokumpu Oyj, the world's third-largest stainless-steel producer, said today by telephone from Espoo, Finland. " Source: Chanyaporn Chanjaroen and Brett Foley, Nickel Heads for Biggest Weekly Gain in More Than Two Years, Bloomberg, March 16, 2007 A factor that we underestimated was the hedge funds' aggressiveness in pushing prices ahead of the fundamentals: leading to higher prices coming earlier; a quicker scrap response; and more rapid destocking than we anticipated. The combination of the hedge funds' aggressiveness and a relatively illiquid LME market resulted in substantial price volatility. The market does work: a shortage of supply leads to higher prices, which generates the necessary demand substitution, which returns the market to balance. Unfortunately, the pricing mechanism is a very blunt way of allocating the final few thousand tonnes of supply in a million-plus tonne market. As long as prices remain high, while LME stocks and liquidity remain low, price volatility will be an unfortunate part of the nickel market. Source: Presentation by Peter Goudie Executive-Vice President, Marketing, Inco Limited, December 13, 2004 - Mining Resources Analyst Group, Toronto
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Nickel is amazing. People are becoming very nervous about what's going on. It's difficult to trade," an LME trader said. Talk in the market is that a U.S.-based hedge fund is sitting on a large amount of nickel in an attempt to force prices higher. Source: LME Nickel hits new record on tight supply, Reuters, 13 Mar 2007 The task of the nickel longs is to keep inventories at these critical levels. They will then be rewarded with acute pricing tension." "We expect the trigger for lower prices to be speculators taking fright at either effectively killing the contract when it will have risen to such a level that it ceases to trade in the ring with no bid and offers or a sudden ingress of metal. The latter seems unlikely but perhaps the Arctic shipping season in June will increase metal availability as the Yenisey river floods and the Dudinka port thaw allows the release of Norilsk metal." Source: ABN Amro, Keeping the Faith March 2007 The LME nickel market remains the preserve of a handful of hedge funds with the occasional skirmish from the CTA types and prop traders at the Ring Dealing Member level. Industrial users for whom the contract was initially designed for are far and few between. Consequently, with a limited number of serious players involved the term "liquid" is not one that can be easily applied to the LME nickel market. Source: Maqsood Ahmed, Base Metals Outlook, Calyon Financial, 2 June 2005 "In addition to the factor of demand, adding to nickel price support is fund speculative buying. Hot money worldwide swarming into metal market for profit as well as the information of dropping nickel stocks of LME and worker strikes of nickel producer add fuel to the nickel price surging. But many reports say, further capacity of nickel production will be utilized in 2007. This will ease the tension of supply and demand." Source: Jinchuan Group Limited, January 25, 2007 Despite continuing concerns over low stock levels and generally tight fundamentals, according to traders contacted by Platts nickel's steady rise is almost wholly the result of speculation. "There is no fundamental tightness in the market any more," said one European trader. "If you make a few calls you can find what you need. The market at the moment is purely speculation-led, although I am surprised that the price has gone this high. I thought it would have corrected by now. Three-months London Metal Exchange nickel ended the third ring Friday at $46,800/mt, after closing Thursday at $47,100/mt. Nickel stocks in LME registered warehouses stood at 3,564 mt on Friday, a slight fall from Thursday.
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"This current price surge is not being caused by the fundamentals of supply and demand -- they remain good," said a second European trader. "There is demand there, but it's no more apparent than it was a couple of weeks ago, yet the price continues to rise." He went on to argue that people were waiting to see if we reach the $50,000/mt level for three-months then pull back. One UK-based trader said: "There are still funds manipulating the market, tending to block out other players, so at the moment lots of people are just standing and watching, waiting to see how things pan out." He continued: "The long-term forecast for nickel is about $7,000/mt, yet at the moment it's almost $50,000/mt. I suppose there has to be a correction at some point, but maybe not in the immediate future." However, a third European trader said a correction might already have happened in relation to premiums. "I don't know anybody who'll pay a $2,000 premium for briquettes," he said. "It's not so much what's happening with nickel as a commodity in itself, more the knockon effects for stainless steel, and other markets nickel feeds into," said the UK-based trader. "Finding alternatives when the price of nickel becomes this high is tricky and time consuming, and I'm just hoping none of my clients are pushed into Chapter 11 bankruptcy." He went on to argue that "nickel has been going bananas over the last couple of days." The third European trader argued that people are "still living hand-tomouth, and in general there's not much trade going on." The problem will come, he said, "when we hit the buyers' resistance level." "At the moment," he said, "people are paying the price being asked, but how long can this carry on? Markets have collapsed in the past, so why not nickel? If the price of nickel keeps rising the way it has recently we're in danger of destroying it as a commodity." Source: PLATTS: European physical nickel: Nickel not tight any more-trader, London. Reprinted in Metal Insider, March 19, 2007. "The market is not as tight as people are making out," said the first UK-based trader. "In fact, it's being manipulated a little by funds." He argued that there is stock out there, "although briquettes remain very tight", but if we "look at uncut there is certainly spare material around. I've heard traders offering large amount this week." The trader continued that producers are trying to sell, and the consumers are out there, but they're not happy about the current price. Source: European physical nickel: Price can't be sustained: trader, Platts. Reprinted in Metal Insider, March 12, 2007. The average LME cash nickel price for the third quarter 2004 was $6.35 per pound, the fourth highest quarterly average LME cash nickel price since nickel became one of the metals traded on that exchange, as nickel markets remained tight. Nickel prices were volatile due, we believe, in large measure to trading activities by hedge and other funds in nickel. Reflecting this volatility, the difference between the high and low LME cash nickel price for the quarter was approximately $1.80 per pound. We believe that
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underlying nickel demand remains strong as we continue to see stainless steel demand growth in many markets and a better than expected recovery in nickel demand in a number of non-stainless applications. However, market volatility and high prices continue to cause substantial quantities of nickel-containing stainless steel scrap, a substitute for our primary nickel in certain applications, to enter the market. There has also been a high level of stocking and de-stocking activity in both nickel and stainless steel as consumers of these materials reacted to price volatility. Source: Press Release: INCO Reports Results For Third Quarter of 2004. The London Metal Exchange on Thursday defended its decision to introduce extraordinary measures to calm the nickel market which has seen prices soar this week amid speculation about unusual trading patterns. Simon Heale, chief executive of the London Metal Exchange, rejected criticisms that the market had become disorderly because of the extreme shortage of available nickel. What you have by any standards now is a remarkable shortage of nickel . . . it is a challenging market, he said. But has anyone defaulted? Is anyone likely to default? Absolutely not. Global nickel stocks have fallen to about one third of a days worth of world consumption, with just 1,248 tonnes available. Mr Heale accepted that the market had come under pressure, but denied there was evidence that any investors were manipulating prices. He said the backwardation limit which limits the spread between the cash and futures price to $300 a tonne was introduced to ensure that there were no problems with the settlement of contracts. Well have to wait and see if the LME measures are effective in defusing the situation, said Robin Bahr of UBS. He added that the market appeared to be calmer on Thursday but noted that the spread between the cash and futures position remained at about $4,000 as the tight market continued. Three-month nickel futures fell $1,100 or 3.8 per cent to $28,000 a tonne on Thursday after reaching a record $29,200 a tonne on Wednesday. Traders say there does not appear to be a shortage of physical metal although consumers are having to pay record prices. However, growing speculation about manipulation has circulated in the market. Rumours suggest that hedge funds may have deliberately bought up metal to store in warehouses to drive up prices as part of the takeover battle for control of Inco, the worlds largest nickel producer. Its a curious constellation that nickel prices soared at the same time as the takeover for Inco, said one trader.
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Trading in London on Wednesday saw frantic covering of short-positions. The TOM/next spread which allows short positions to be rolled over for a day surged to $1,000 from about $100 just a few weeks ago. Source: Chris Flood, LME defends move to calm nickel market, Financial Times, August 17, 2006. Nickel consumers are importing directly from producers and aren't facing the tight supply side conditions that some hedge funds would like the market to think exist, according to a senior executive at Indian metals importer Kothari Metals Ltd. "It's true that there is a very low level of inventories in LME warehouses, but there is no huge shortage of nickel as being projected," Ranjit Singh Kothari, company managing director, told. "Most of the big consumers are importing directly." LME nickel stocks are currently 5,064 tons, with just 3,768 available to the market because the rest are held on canceled warrant, meaning the metal is accounted for and about to be drawn down. This is just over one days' global consumption of the metal. Right now, the nickel market "is reacting on panic and out of haste," Kothari noted. "Speculative funds are taking control," he said, adding Indian and other Asian consumers are able to easily source materials and none of their shipments are delayed or canceled. "No one is gaining out of this situation except for a few hedge funds," Kothari added. Source: Hedge Funds Overstate Nickel Tightness: Metals Importer. Metals Place, January 23, 2007 A raw materials buyer at a second large European stainless mill also admitted that it will be producing less austenitic material in the second quarter because orders for the nickelbearing grades are falling as a result of high prices. "End-users are rebelling against these prices", said the buyer. "We have even had people from our customers' purchasing departments questioning whether the LME is the right way to set the price for nickel, but what other option do we have?" He continued: "But people are really angry because the wide opinion is that these quotes are influenced by hedge funds that have no physical demand. Is it right that people who do not need nickel have such an impact on the price just by gambling the market? My customers don't understand the price development." [Later in the article]
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The London trader agreed that the nickel market is being driven by speculative interests and that physical metal users are suffering as a result. ..."Maybe we have to see a $50,000 cash price before it will correct, but this is not so much fundamentally driven as it is manipulated." Source: Metal Bulletin: Stainless Steel Mills look to cut Q2 Nickel Buying as Nickel Soars, March 13, 2007. The global nickel market has already moved into a surplus, despite the low London Metal Exchange inventory level, said David Humphreys, chief economist at Russia's Norilsk Nickel. "The only stocks data that are available is the LME stocks, but it's not wholly representative...there are stocks with the producers, and there may be stocks with the hedge funds," Humphreys told reporters on the sidelines of the China Nickel 2007 conference Wednesday However, substitution isn't a big issue, Humphreys said, citing China as an example. "There aren't lots of opportunities to use substitution. You have to rely on nickel, with Chinese consumption mainly focused on the construction sector," said Humphreys, who was previously Rio Tinto's chief economist. Instead, "the hedge fund demand is something that should be taken into account" when analyzing prices. Source: Norilsk Chief Economist: World Nickel Market In Small Surplus, Dow Jones Commodities Service, May 30, 2007
Lead
In the absence of meaningful producer or macro hedge fund selling lead prices (particularly cash) have been at the mercy of merchants and their pricing games. Secondly, with respect to the statistical surplus this is still very modest at best. 30-50,000t excesses are small fry relative to the amount of funds available for engineering exercises. Reading between the lines, supply is stronger than the figures suggest but the question remains, where is the lead? As seasoned players know all too well, hoarding in nothing new to this market and engineering has become more elaborate than ever before. Source: Maqsood Ahmed, Base Metals Outlook Calyon Financial, 2 June 2005 Lead hit a fresh record high, its third in a week, but analysts said the fundamentals were easing and buying was mainly triggered by fund activity.
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"Lead reached another new high...In the absence of a clear fundamental reason, the increase in price was attributed to fund buying," Standard Bank said in a research note. Lead for delivery in three months hit $2,550 a tonne in early European trade and was last at $2,510/2,530 against $2,510 on Wednesday, when it rallied 4.6 percent. "There is an enormous amount of speculative interest behind the price at the moment," economist John Kemp at Sempra Metals said. "It's a classic story of a small, illiquid contract that is very susceptible to high volumes of money being pushed behind it," he said. Source: Copper slips on hefty stock rise, lead at new high Reuters, June 21, 2007
Zinc
"We were disappointed" with the increase in inventories, Lindsay said. "It is not as if we didn't know that there was potential for more 'hidden stocks' showing up. We did. The extent of the sheer volume of the increase was disappointing. We hope that's the bulk of it, but by definition, hidden stocks are hidden, so you don't really know." Source: Teck Cominco's Lindsay Comments Rise in Zinc Inventories, Bloomberg, June 16, 2005. The LME zinc price of late is the one of the best examples of a market engineering its own moves. As seen earlier this year persistent speculative interest drove prices through the key chart level of $1260/t. Thereafter, a feverish splurge was seen with the CTAs and the macro hedge funds all turning into buyers. There was some producer selling into the strength, as evidenced by Umicores announcement to shareholders, however, this was in reality swamped by funds on the buy side and cash settlement prices hit a high th of $1430/t on the 16 of March. Once the rampant speculation ended and the market ran out of buying ammunition the zinc market give up its gains almost as quickly. Once again punters have effectively been found playing with themselves. The intended game is to panic consumers and off-load your long onto them. However, weakness in the steel market was already emerging by March and thus the industry saw through the shenanigans at the LME and held its nerve. Consequently, prices have now retreated back to the starting point with a low of $1216/t seen in mid May-05. This represents a 15% retreat from the high and the main question now posed is if prices will continue to head south with sentiment driven by the easing in the steel market or whether supply concerns (which have real substance to them) will become the overriding factor and result in a retest of the of the recent high. Source: Maqsood Ahmed, Base Metals Outlook Calyon Financial, 2 June 2005
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Aluminum
We view investor/hedge fund manipulation at the highest levels for some time (one investor has >50% LME aluminum inventory) and coupled with fears of a slower 2007, this will likely result in a substantial correction in metals prices from spot. Source: Merrill Lynch, Time To Take Select Profits Ahead Of Q1 2007 Volatility, December 2006 The NDRC said: "Possibilities of a steep fall in aluminum prices could not be ruled out if international hedge funds pull out of the aluminum futures market next year." It stressed that hedge funds' massive buying into aluminum futures was another cause of the bullish prices this year. Source: China Daily, December 28, 2006 When metals get too expensive, consumers cast around for alternatives. In contrast, some speculators shift their preferences when prices fall. Aluminium is their new target. One investor is currently sitting on a long position reputedly equivalent to just under 650,000 tonnes of the metal not far off the 700,000 or so of inventories sitting in the warehouses of the London Metal Exchange. Fear of shortages is moving the futures market. In the past month, "cash" aluminium for immediate delivery has gone from trading at a $30 per tonne discount to the three months forward contract to now commanding a premium of more than $80. The critical question is how much aluminium is really out there, since official inventories offer only a partial picture. How much metal flows into LME warehouses over the next couple of days will provide a clue. A few tens of thousands of tonnes would signal genuine shortages. However, big swings can occur: 117,000 tonnes appeared in one 48-hour period back in November 2005. Squeezes in the metals market are nothing new but it is odd that the latest one should emerge in aluminium. At 32m tonnes of annual consumption, the market is big about the same size as copper's in value terms. Fundamentals are also uninspiring. Demand for aluminium products in the US slumped by 20 per cent year-on-year in December. China has warned that efforts to rein in excess supply are making little progress. In Reuters' latest poll, analysts forecast an average price of $2,455 a tonne this year 6 per cent below that for 2006. Source: Aluminium Squeeze, Financial Times, January 16, 2007 Aluminium and copper are over-supplied in 2007 in our view on even conservative production outlooks: the hedge funds appear to be controlling both these markets despite increasing production surpluses. Source: Merrill Lynch, Commodity Price Review: March 14, 2007
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All eyes will be on the aluminium market today. Commodity traders are bracing for volatility as they wait to see to how one party that has built a massive position in the market will act. It is settlement day for contracts to buy and sell aluminium that were struck more than three months ago. The large market position that has been built up could potentially see the withdrawal of almost all of the aluminium inventories in warehouses registered with the London Metal Exchange if the party chooses to take delivery of the metal. Analysts believe this could see aluminium prices soar. It is unlikely that such a dramatic event will unfold but the market is still guessing what will transpire in the coming days. One party has manoeuvred itself in a position where it could take delivery of almost 650,000 tonnes of the metal, or about 93 per cent of total LME aluminium stockpiles. At current prices, it would cost $1.7bn to buy 650,000 tonnes. If the demand for aluminium was booming, there would be a clear-cut reason for the confidence to hold such a position. But demand from aluminium users is not robust, with US orders falling and forecasts that production is set to outstrip supply in China this year. Still, cash aluminium prices were priced at more than a $80 premium to the benchmark three month forward contract yesterday. The premium has narrowed from more than $100 a tonne on Monday. The aluminium cash price tends to trade at a premium to the forward price, when demand is strong and inventories are low. The last time aluminium cash prices were trading at such a high premium to the three-month price, the London Metal Exchange launched a probe into the aluminium market about possible collusion between market participants. The investigation was launched in August 2003 but was abandoned the following year after regulators failed to find any evidence of collusion. However, this time the LME said it could see nothing untoward in the aluminium market. The LME has the power to inspect the trading books of all its members, which are mainly financial institutions, and their clients. But Robin Bhar, base metals strategist at UBS, said: Aluminium cannot be described as a tight market and based on current supply and demand trends there is no need for cash prices to be trading at a premium. This suggests that the current premium has been financially engineered by a large fund player, who maybe is acting alone or with other players. Traders and brokers said that it was thought the market participant started accumulating its long position more than four months ago, at prices below current levels. The benchmark three-month aluminium prices have on average steadily risen since midSeptember from about $2,400 a tonne to about $2,700 yesterday. Source: Kevin Morrison, All eyes focus on aluminium, Financial Times, January 16, 2007. By Pratima Desai - Analysis
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LONDON (Reuters) - Aluminum players are bracing for another attempted squeeze, but the market may prove robust enough to thwart any such ploy. Disquiet has grown as outstanding call options to buy aluminum for three-month delivery (MAL3: Quote, Profile, Research) at between $2,900 and $3,400 a tonne in June on the London Metal Exchange have risen to 51,000 contracts, about three times previous levels. Exercising the contracts would mean the holders acquiring more than 1.2 million tonnes of aluminum -- used in construction, transport and packaging -- at a potential cost of more than $3.9 billion. Stories abound of producers who have tried in the past to maneuver prices higher and succeeded to an extent. But more spectacular have been the failures. "A lot of people who have tried to corner the market don't exist anymore," said Klaus Rehaag, executive vice-president at hedge fund firm Gardner Finance. "Markets tend to be more efficient than people think." Examples include an attempt to corner the silver market more than 25 years ago, when Texas-based Nelson Bunker Hunt and W. Herbert Hunt were forced to sell their silver holdings and sustain heavy losses as prices collapsed. Sumitomo Corp's revelation in 1996 that its star trader Yasuo Hamanaka had lost $2.6 billion on unauthorized trades devastated the copper market and prices tumbled. THEORY Market talk is that most of the aluminum contracts this time round are held by two U.S.based hedge funds and that the run-up to the expiry of these options on June 6 could see volatile price moves as aluminum attempts to break higher. The cost is thought partly to have been met by running down a large holding -- from more than 90 percent to less than 50 percent -- of available or on warrant stocks at LME warehouses. "I don't think this is part of a play to push prices about. The trade is principally hedging and the funds are value investors, theoretically," said Mike Frawley, Calyon Financial's global head of metals. "The entities, in whatever sector of the market, run the risk of the market running into them." The position is bigger than in December, when nearly 10,000 options to buy aluminum at $3,000 a tonne spooked the market.
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"There have been numerous attempts to try to get aluminum above $3,000," said John Kemp, analyst at Sempra Metals "Physically aluminum is not even remotely tight." LME stocks since November 2005 have jumped more than 60 percent to above 820,000 tonnes, around 10 days of global consumption, with a gain of around 130,000 tonnes since January. PROFITS Aluminum has mostly traded between $2,600 and $2,900 since last October. "The holding isn't going to change the outlook of the market, which is looking at fundamentals," Frawley said. Many analysts think aluminum prices should be lower and estimate supply will exceed demand on average by around 250,000 tonnes this year -- some go as high as 600,000 tonnes -- from a deficit of about 600,000 tonnes last year. However, some speculators think aluminum has lagged other metals over the past year and see it rising, possibly exceeding the record highs above $3,310 seen in May 2006. Such a price rise would mean that the options sellers would have to cover their exposure by buying futures in case they have to deliver and that could boost upward momentum. It would also mean that the premiums on call options would rise, potentially reaping a profit for the holders if they decided to sell their contracts before expiry. Source: Pratima Desai, Market may thwart any aluminum squeeze, Reuters, May 1, 2007.
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