(The opinions expressed here are those of the author, a columnist for Reuters.)
By Andy Home
LONDON, June 24 It's been three weeks since the first reports of something amiss at the Chinese port of Qingdao started hitting the headlines.
Missing, in fact, was some of the metal pledged as collateral by a local trading outfit called Decheng Mining, which was itself collateral damage in an investigation into potential corruption, or "serious discipline violations" as the Chinese authorities call it, by Mao Xiaobing, party secretary of the Silk Road city of Xining.
At the heart of the fake collateral scandal appears to be around 100,000 tonnes of aluminium, 200,000 tonnes of alumina and 20,000 tonnes of copper.
Yet despite the relatively small tonnage involved, it has been the copper market that has been most shaken by the unfolding investigation at Qingdao.
On the London Metal Exchange (LME) the nearby spread structure collapsed as the first reports started hitting the news wires. The benchmark cash-to-three-months period CMCU0-3 imploded from $101 per tonne backwardation at the end of May to $3 backwardation on June 6. Outright prices followed suit, three-month metal falling from $6,970 to $6,640 over the same week.
The market's reaction was understandable. Although the impacted tonnages were higher for aluminium, collateral financing in this particular market is the exception rather than the norm, not least because China is largely self-sufficient in the light metal.
Copper, however, is an altogether different story. Everyone in the market knows that there are hundreds of thousands of tonnes of copper sitting in China's bonded warehouse zone, some of it in transit to Chinese manufacturers but more of it doubling up as collateral for the country's shadow lending sector.
Behind the LME price and spreads reaction lay the fear that at least part of that copper mountain would surge back into the safer haven of LME-approved storage.
Yet, three weeks on and there's still no sign of any copper and the front part of the LME curve has started tightening again. So was it all a false alarm?
NO DISORDERLY UNWIND
Certainly, in terms of visible exchange inventories, the immediate Qingdao effect appears to have been minimal.
The LME system has received just 1,050 tonnes of fresh inflow since the start of June and of that only a minimal 150 tonnes has been warranted at an Asian location, Busan in South Korea on June 19.
Nor has there been any obvious impact on stocks registered with the Shanghai Futures Exchange (SHFE), where duty-paid stocks have fallen by 11,100 tonnes and bonded stocks by 5,318 tonnes over the course of June.
Yet behind the scenes there does seem to have been some movement of copper holdings as financing banks run the ruler over their counterparties and tighten up their storage requirements.
Metal appears to have been shuffled within China, with big-name warehouse operators the main beneficiaries. It is possible, but so far unproven, that some has also left the country, heading to LME warehouse locations in South Korea.
But quite evidently, if the latter is true, the copper has not been warranted, in which case it would have shown up on the LME stocks reports.
Which makes sense.
As time passes without fresh revelations, it does look as if Qingdao was a one-off. There has, critically, been no disorderly unwind of financing deals, even if the terms have been significantly tightened. The collateral finance business, in other words, is rolling on, albeit with increased scrutiny of where the metal is being stored.
And while LME-approved warehouses sit at the top of the quality chain, you don't actually have to warrant the metal to achieve the credibility and credit premium that goes with LME storage.
LOSS OF FINANCING APPETITE?
While the immediate panic has passed, there are legitimate concerns as to whether lending capacity for collateralised copper deals will contract as banks, both Chinese and international, get more picky about who they are willing to lend to.
Analysts at Macquarie Bank, for example, suggest that some 290,000 tonnes will flow out of bonded zones over the course of June through September, reducing the amount of copper sitting in bonded limbo to around 600,000 tonnes. ("Qingdao scandal: copper off, bonded stocks drop - where will it stop?"; June 14, 2014).
But they are not expecting any significant further contraction beyond that point, explaining:
"Besides the copper metal that is imported for the domestic market, which must first spend time in the bonded areas, the metal-financing transit trade, where metal sits in the zones for a few months held in a consecutive series of sale and repurchase agreements, is a very established and popular method of playing the interest rate arbitrage between China and ex-China".
In reference to the Chinese authorities' long-running game of cat-and-mouse with collateral financiers, Macquarie goes on to conclude that "large and well-established importers have been seen to survive previous credit crackdowns, and we expect they will again."
Moreover, the most obvious place for that bonded copper to go, if it does go, is the domestic market in China, particularly given the tightness of supply evident from falling SHFE stocks and the SHFE's backwardated structure <0#SCF:>.
Remember that one of the appeals of copper as collateral rather than, say aluminium, is that China is structurally short of the stuff, meaning there is always going to be an import buyer if the metal needs to find a home. That hasn't changed one iota after the Qingdao scandal.
BACK TO BACKWARDATION?
Back in London there is still evident caution that displaced metal may yet appear in the LME system. The cash-to-threes spread, currently trading at just over $30 backwardation, is still a long way short of those late-May levels.
But with exchange stocks still steadily eroding, there is no shortage of structural tension in the spreads. The LME's daily dominant position reports currently show one holder of cash and warrant positions equivalent to between 50 and 80 percent of open tonnage <0#LME-WHC> and tom-next CMCUT-0, the shortest-dated spread in the LME system, has been flipping in and out of backwardation for several days now.
In essence, we're back to where we started before Qingdao first hit the news. Depleting stocks and spreads tension have been the two running themes of the London copper market for many months now.
It's why the backwardation flared out over the course of May and why it's starting to widen again. Until such time as metal can be incentivised onto LME warrant, both trends will remain in place.
The Qingdao scandal looked as if it was going to do the market's work for it, but given the lack of arrivals over the interim three weeks, the chances of a rebuild in LME stocks from displaced bonded warehouse units, are fading.
It's business as usual, it seems, both for the collateral financing trade and for the LME copper contract. The market of last resort is still battling to attract units from the market of first resort that is China's bonded warehouse zone. (Editing by William Hardy)