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Wednesday, 9 May 2012

Ending a super-cycle

Metals update
Following the last post there were some more signs of China-related noise in the copper and commodities markets.  The ever vigilant FT Alphaville team reported on a note out from Standard Chartered detailing their visit to a warehouse in Shanghai which was stuffed to sinking with copper and aluminium (with some revealing photos).  Meanwhile there were reports today of new research from Nomura's China metals and mining analysts which found that after adjusting for GDP (rather than usual per capita bases) they predicted flat or low growth in China for metals.

As always, the picture for commodities is not unanimous, with teams at RBS and Barclays Capital positive to bullish on prospects for the materials sectors.  But as reported previously there do seem to be growing distortions in the commodities markets.  For the copper market, this was discussed in detail by BBC Radio back in 2011 (who spoke to industry users, staff at bursting warehouses and analysts at both bullish and bearish institutions) while FTAlphaville recently had some helpful background on unusual moves in the copper and oil markets.

Looking across different reports there seem to be four factors which could have been driving the stockpiling of metals in China (until recently):

i) domestic loan collateral and financing schemes: As set out in the last post, Chinese financial authorities have tightened the limited availability of bank credit making alternative financing schemes through informal lending popular.  Many schemes use warehoused copper or other metals as collateral for loans.

ii) schemes to arbitrage price differentials in commodities markets:  There has been specific comment on the price differential between the London and Shanghai prices for copper, and that arbitrage trades can impact on the price.  As explored in the last post, market based schemes can involve "re-export" of surplus copper from domestic warehouses in Shanghai, but in fact the copper only travels to other bonded and private warehouses which hold non-domestic (bonded) stocks.

iii) schemes to manipulate market prices of commodities: As explained in this piece by Reuters, it is a "time-honoured technique" amongst commodity traders to use private and non-disclosed inventories to restrict the apparent (and official) supply of a commodity, gain control of a substantial portion of the remaining "official" supply and then squeeze prices higher.  The article mentions current suspicions that certain traders are engaging in the practice and shifting large volumes into private warehouses, "off-warrant", creating the appearance of tight supply.

iv) schemes to arbitrage differentials between domestic ("onshore") and foreign ("offshore") exchange rates: Although China is undergoing financial liberalisation, with the movement to a more flexible yuan/renminbi rate, there still exist discrepancies between deposit rates and currency prices which can be exploited with stored metals used as collateral.  The previous Reuters investigation gave some detail on this.

End of the commodities super-cycle
With such distortions as excess inventories and incomplete price discovery it is not surprising that headlines have referred to an end of the commodities "super-cycle" - the continuation of high commodity pricing trends beyond levels suggest by fundamental indicators and drivers (which included sustained high Chinese demand).  An article in the Australian mentioned the example of one mining company topping up its own production with market purchases to meet demand, while the Financial Times considered outcomes for mining sector investments following a downturn.

Aside from the immediate hit to shareholders, there could be a couple of other impacts.  First it could be argued that in addition to the commodity traders, a number of large banks, including JP Morgan, Barclays and BlackRock could be exposed to kickback from inventory shielding schemes as they have significant warehousing and commodity investment operations.  Some have argued that certain banks which have large commodity ETF funds predicated on rising commodity demand are keen to maintain high prices to encourage subscriptions to their ETFs, regardless of fundamentals.  Hence some of the derisory comments on social media as to the slightly concerning tone of a Blackrock client blog this week which argued that it is "critical for the global economy that China lands softly".  The related growth of commodity backed structured financing does carry some risks as discussed here.

Also, it seems possible that speculation and arbitrage in the Chinese currency between offshore and onshore markets may complicate the liberalisation of Chinese exchange rates and the economy.  Martin Wolf explored the risks and complexities of liberalisation back in February, and it will be looked at in more detail in posts to come.  Meanwhile Fraser and Howie in their book Red Capitalism noted that non-convertibility of the Chinese currency is one of the pillars maintaining financial stability, with uncertain consequences if removed.

Thanks to the reader who identified the BBC Radio link!

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