Still waiting for that China copper unwind

Still waiting for that China copper unwind…

David Keohane | Feb 21 09:23 | 2 comments | Share

Right, so if we’re not blaming the squid we may as well spend a bit more time on China. Whack-a-mole finance can have a long reach after all and may very well be skewing LME copper price levels which, instead of reflecting the LME stock position, are maybe reflecting all of that copper sitting somewhere in China, often tied up in tricky financing deals in the shadowy sectors of the economy.

What remains interesting is the implicit and very sensible worry that all of that supply won’t stay under wraps forever. We’ve written about that before quite a bit but recent WMP hiccups make it a tad more immediate.

Before we get to that though, the first question should really be, where is all that dark inventory? From Citi’s metals team (with our emphasis):

Not all in the bonded network if market estimates of Shanghai bonded inventory are to be believed. Indeed, estimates of Shanghai bonded volumes fell throughout 2013 from around 800- 900,000 mt at the start of the year, to around 525-550,000 mt by year end. In addition, SHFE inventory fell by 79,000 mt through the year, pointing to a bonded + SHFE fall of around 400,000 mt. Estimates of excess availability of metal in 2013, when combined with market estimates of draws from Shanghai bonded warehouses and SHFE warehouses, either suggest that even high 2013 consumption growth estimates of 11.7% were pessimistic or that inventory builds were going on elsewhere. We believe that large volumes of collateralised financed metal are being held in bonded warehouses not only in Shanghai, the focus of most bonded estimates, but also in other Eastern Seaboard port cities. We also believe that metal might be being held in ‘hidden stocks’, essentially in the form of on-shore customs cleared stocks, which we believe are being used by some Chinese corporates as a collateral tool to secure loans at reduced interest rates. However, this is not the only source of non-reported or not estimated stock holding and stock builds. The Chinese State Reserves Bureau (SRB) is a holder of large volumes of copper in China. There was strong, though unsubstantiated, market speculation that the SRB were active copper buyers during H2 last year.

Estimates for Chinese bonded inventory levels on the rise again, but still appear to be very conservative — From the 550,000 mt market estimates at the end of 2013, volumes of metal held in the Shanghai bonded network are now estimated to have risen to between 650-700,000 mt in early February. Shanghai bonded inventory is generally taken by many analysts and market commentators as representative of total Chinese bonded copper inventory. However, we believe the bonded volumes have been built up in a number of other Eastern seaboard ports such as Guangzhou, Ningbo, Lianyungang, Rizhao, Qingdao, Tianjin, and Dalian. Indeed, we believe there could be an additional 300,000 mt of copper sitting in bonded warehouses in these other ports, which would suggest there is currently up to 1 million mt of refined copper in China’s bonded warehouse network.

SHFE inventory is also on the rise — SHFE warehouses copper stocks have also risen sharply in 2014, with levels up 54,000 mt since the start of the year to 180,341 mt. The builds in China in SHFE and the bonded network alone dwarf the draws seen in LME inventory, before any estimate of additional or ‘hidden stocks’ is made. Wood Mackenzie data points to refined copper inventories in China reaching 2.136 million mt at the end of 2012, rising to 2.41 million tonnes at the end of 2013 when their production and consumption estimates are combined with Chinese official refined copper trade data. Given recent January import data, these volumes, if correct, can be expected to continue to rise.

And if much of this is indeed down to collateral financing demand or, you know, ‘cash for copper’ financing where the charmingly non-perishable metal is held as part of interest rate arbitrage and/ or to turn working inventory into a lovely, red, yieldy asset…

… you have to wonder how long that stuff will stay tied up. A final chunk from Citi:

Chinese collateralised demand for metal can be viewed akin to contango financing demand for on and off-warrant aluminium in the West, in that financing demand competes with real demand in the short-term. However, in the longer term, such stock building will act as a competing source of metal supply when market conditions allow or Government/regulatory intervention forces a change. The Chinese Government has been trying to force the latter with recent announcements on controls on the shadow banking sector, the main source of collateralised financing deals. Market concerns over the future availability of large volumes of China based inventory seem to have been weighing on LME price levels in recent months. However, it should be remembered that in May 2013, SAFE (State Administration for Foreign Exchange) introduced new regulations that initially dampened financing activity. However, workarounds were found leading to financing demand bouncing back strongly from August onwards. SAFE tried again to further crackdown on this activity in early December, but this time it had virtually no impact. We believe crackdowns on shadow financing are likely to have limited effectiveness given the significant involvement of non-Chinese banks in this trade (part of the motivation for doing more of this out of Malaysia & Singapore).

Granted that lacks a conclusion but the idea that this stuff has to come on to the market eventually seems fair if irritatingly vague. The fact is, as Credit Suisse put it, so long as it is possible to borrow against copper at lower rates than can be earned through alternative onshore investments or lending, copper financing deals are likely to persist in one form or another.

In short, it seems commodity prices don’t always converge with supposed efficient market fundamental reality particularly quickly. After all, this particular dark inventory stock has been rising for more than five years now. That’s a long time for markets to stay irrational. And a long time for potential imbalances to be accumulated, without any episodic self-correction.

Yes, things will one day probably converge with the fundamental reality. If that’s because demand has finally been revitalised to a level matching the expectations of speculators funding all this carry, all will be well. If, however, they converge because cheap carry funding is no longer available then the disruption could be immense.

Either way, those who argue futures markets are always efficient at dispersing risk, might want to reexamine those thoughts. If the above tells us anything it’s that the efficiency of futures markets can be massively disrupted whenever there’s an incentive to induce information asymmetry in the market and/or when funding carry trades discourage rational pricing.

Consequently, the real trouble, in the short term, seems likely to only arise unexpectedly.

From Credit Suisse, also vague but a little bit scarier:

Conversely, unwinding of financing positions – the most obvious switch being a short circuit in the performance of wealth management products (WMPs) – has the potential to create a major rush for the exit by players tied up in the game. In this event, liquidation of physical copper positions could be highly disruptive to prices through releasing copper to consumers and onto terminal exchanges. Harnessing stockpiles of copper (and other commodities) to provide financial yields is one thing but other forms of inventory financing have also helped to prop up unprofitable businesses through non-core returns. The eventual closure of excessive manufacturing and fabrication capacity could cause loan defaults in these sectors and similarly trigger forced inventory liquidation.

For copper, the presence of physical exchanges provides an ultimate circuit breaker, but the initial price correction could be pronounced, depending on the (indeterminate) volumes of metal launched into the market. Such scenarios sit outside of our base case but we do think they pose a material risk.

Interesting considering the travails in China’s shadow banking system, no?