(The opinions expressed here are those of the author, a columnist for Reuters.)
By Andy Home
LONDON May 28 Copper spreads on the London Metal Exchange (LME) tightened sharply last week as the market finally started reacting to the continued steady erosion of available stocks.
The previous disconnect between dwindling stocks availability and a relatively loose market structure had caused much collective head-scratching in the market.
The conundrum looks as if it is now being resolved as front-month backwardation returns to levels historically associated with the current low level of stocks.
A research note by Goldman Sachs, advising short position-holders to roll out of the front part of the curve, seems to have acted as a collective wake-up call.
Analysts at the bank warned that the benchmark cash-to-three-months time spread CMCU0-3, valued at $83.50 per tonne backwardation at Tuesday's close, could flex out to $100-$150 imminently. ("Copper, expecting very near-term LME spread tightening", May 22)
Stock trends now hold the key to how tight this market could get. The LME system needs fresh supply, and to get it, the backwardation must move to a level that incentivises deliveries into LME sheds.
In practice, this means a tug of war with Chinese buyers for the metal sitting in Shanghai's bonded warehouse zone.
A CROWDED SPACE
Wednesday morning's daily LME stocks report <0#MCUSTX-LOC> showed registered inventory sliding another 6,725 tonnes to 169,825 tonnes. That's the lowest level since August 2008.
Even more significant is the continued erosion of on-warrant tonnage, since this is the market's ultimate liquidity pool.
At 94,325 tonnes, it has fallen to the lowest level since April 2008, thanks in large part to a 19,750 tonne burst of cancellations at New Orleans last Thursday.
New Orleans is where most of the exchange-registered stocks are located. The U.S. port currently holds 83,825 tonnes of the non-cancelled total.
The next two largest concentrations are at Rotterdam and Singapore, both of which hold just 2,500 tonnes.
As stocks liquidity shrinks, the front part of the LME copper curve is becoming a crowded place.
The LME's daily market reports are now showing three large holders of cash and "tom-next", the shortest-dated spread in the market's prompt date system. <0#LME-WHC><0#LME-WHT> Between them the positions are equivalent to at least all of the non-cancelled stocks, quite possibly more.
Unsurprisingly, "tom-next" is itself backwardated, flaring out to $8 backwardation on Tuesday and trading on Wednesday morning at $1-2 backwardation. And equally unsurprisingly, the cash-June spread has also tightened, currently trading at just over $30 backwardation.
Spread volatility seems assured as shorts try and escape the cash-date squeeze by moving down the forward curve.
WHERE'S THE COPPER?
There is nothing particularly sinister about this. None of the major long positions on the cash date are outrageous in outright terms, but collectively they are huge relative to what's available in the LME system.
The key issue here remains that of low tonnage.
Backwardation is needed to attract more metal into LME sheds - particularly that metal sitting in the liquidity pool that is the Shanghai bonded warehouse zone.
Estimates inevitably vary as to the size of this unreported stockpile, but there are thought to be around 600,000 to 700,000 tonnes in Shanghai, much of it pledged as collateral against lending in the shadow credit market. That's more than the total amount of copper sitting in the world's three big copper exchanges combined - LME, COMEX and the Shanghai Futures Exchange.
Goldman's assessment of the likely tightness over the coming month or so is based on a calculation of how wide the backwardation will have to be to unlock this material and entice it back towards the LME system.
There are, as the bank points out, several moving parts to this calculation, including LME spreads, Shanghai physical premiums and the profitability of the copper collateral financing trade, the latter a multi-dimensional phenomenon itself.
What is clear is that the LME backwardation is not yet wide enough to draw metal out of China.
Its April trade figures showed refined copper exports of 21,499 tonnes, very much within the range of the last six months. Cumulative exports so far this year of 77,000 tonnes are down by 50 percent on the equivalent period last year.
Import flows, by contrast, remained strong at 341,000 tonnes. China's net draw on refined copper from the rest of the world has increased by 560,000 tonnes so far this year.
So, it's not too hard to work out why exchange stocks everywhere else are so low.
The problem for LME short-position holders, however, is that there is no sign this flow of metal into China could be abating.
Deliveries into the LME warehouse network so far this month have totalled a paltry 2,325 tonnes and only 25 tonnes of that at any Asian location.
Higher Chinese imports this year are thought in part to reflect higher term bookings by fabricators. If so, such material will not be available for LME delivery, least of all during a seasonal high spot for end-user demand.
That leaves the "known unknown" that is metal being imported for financiers, but here too things have been complicated by reports that the government stockpiler, the State Reserves Bureau, has been buying up bonded stocks. And that material won't be available any time soon either.
Goldman expects the Chinese market to loosen up in around three months as the seasonal demand peak passes and domestic producers ramp up after maintenance closures.
Three months is a long time for holders of LME short-dated positions, though, and there is too much uncertainty about the multiple moving parts in the Chinese import equation to draw any hard and fast conclusions as to what may happen in the interim.
The best indicator remains the LME's daily stocks reports. No fresh inflow at all in today's update. Will tomorrow be different? (editing by Jane Baird)