Thursday, April 23, 2009

Is there a bubble forming in copper?

Well, this just gets deeper and deeper. Before we proceed with the rest of the article, it's important to note that there currently isn't really a significant amount of room for copper to fall. However, as we dig through the details an inconsistent picture emerges.


As we mentioned in our first article on the subject, we discussed an uneasy feeling that demand was sure to fall in aggregate and copper prices did not seem to have that priced in. Supporting that view, BarCap reports that the mood at CESCO 2009 was relatively skeptical on the direction of the market and many were questioning if the market was reflecting the fundamentals. The consensus expectations were predicting a roughly 10% drop in demand with some going as high as 13.5%. As we would expect, most of this is coming from developed/industrialized countries. Put another way - in 2006, the ratio of OECD:China:ROW Cu demand was in roughly a 2:1:1 ratio. By 2009, this ratio is closer to 1.2:1.1:1.0, with overall demand numbers largely unchanged.

Of course, no surprise here. However, with OECD plummeting and no real respite in sight for their economies and ROW being relatively stable - the question on demand becomes how much can we rely on China to keep importing huge amounts of copper.

Through our research, four major reasons have emerged to sell the story on why China is importing so much copper in the context of a global economic contagion. None of them are convincing.

1) The government is stockpiling vast amounts to store value in commodities and/or taking advantage of historic lows to build up reserves while the getting is good

First, I have yet to figure out a convincing reason why a hyper-conservative investing entity would move from Treasury bills to copper as a store of value - the same copper that has fallen almost 3x peak to trough. There is a valid argument that China has a long-term investment horizon but it has repeatedly shown that it likes to act like a drawdown-shy pension fund. Diversifying for China would be buying other government bonds, not buying pseudo-strategic resources for its industrial complex. As for the second reason attributed to this cause, if true, it seems an unsustainable demand driver. Once China has filled up the tank and goes away satisfied, what then? There is also a minor quibble that if it were true, one would think China would be a little more subtle about it's buying and play the market structure a bit better - though the sheer volume hinders that to some degree.

2. China is an economic powerhouse (unlike us capitalist dogs), and despite being a largely export-driven economy, is putting up great production numbers in the face of the worst international collapse in 70 years and needs the copper to fuel the machine

As we have discussed in our last post why we severely doubt the veracity of China's numbers, we won't rehash. However, I don't think we are the only ones to doubt the methodology, political agenda, and reliability of their numbers - a quick Google search will show a number of other luminaries who are highly skeptical. Additionally, we have gotten anecdotal reports that the mood on the ground in China is much less sunny than what we are hearing from the official releases. When the Chinese middle class expands and the currency finally floats, it may be a more sellable story - but until then, it's tough to swallow.

3. Chinese scrap is getting harder to find/salvage/produce/refine, etc.

This is the most puzzling one of them all as we have yet to see any concrete proof that this is true. Instead, most research analysts seem to take this as a given assumption and proceed from there. This is a dangerous precedent as it has the potential for some big shocks if it eventually turns out to not be true. To simply say that Chinese scrap is not as abundant as it once was without data to back it up is a head scratcher, to say the least. If readers can shed some light on this, would be interested to hear more:

4. The SHFE and LME spread copper arb trade

Simply put, if this is true, we can't think of a situation where this doesn't end in tears. The spread admittedly is ridiculously high but given the market barriers, it's unlikely to be the primary driver of aggregate Chinese demand, especially since the Chinese government isn't naturally a market arb player.

In summary, we have to seriously question the fundamentals of the rally in copper. Many of the reasons being tossed around seem unsubstantive and/or unsustainable. However, there may be market forces going around that aren't being discussed and it would be really interesting to get more color on those.

Thanks to BarCap for some of the numbers
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