Why commodity markets are in for a rude awakening

The official count for copper and soybeans is likely way off

A vendor naps on a chair in front of shelves of steel commodities at a metal products market in Hefei, China. (Stringer/Reuters)

Have you ever played Pit? You can think of it as the commodity markets version of Monopoly (only, it’s much more fast-paced). The aim of every Pit player is to be the first to corner the market in one of a number of commodities. The game is a riot, but the purpose of this post is not to shill for it.

I bring it up because there is a substantial body of evidence that many raw materials have been subjected to massive hoarding in recent years. Some of that activity, as in Pit, might be aimed at cornering the market and keeping prices high. I have written here on Econowatch about how financial players have been stockpiling metal in the aftermath of the financial crisis to take advantage of the difference between spot or current prices today and prices in futures markets. There is more to the hoarding story, though. The practice might have started earlier, and for different reasons.

Hedge funds and large commodity traders have reportedly been stockpiling copper in China since 2004-2005. The purpose, according to a Dow Jones exposé published in mid-2008, was to create the appearance of a shortage of said metal by hiding it outside of London Metal Exchange warehouses (markets use LME inventory data to get a sense of supply and demand trends). This stockpiling helped keep prices high, to the benefit of those allegedly involved in the scheme.

In some cases, copper was “hidden” right under the LME’s nose. The BBC visited a warehouse in Rotterdam a couple years ago and found that only 40 per cent of the copper was declared to the exchange. In other words, suppose there are 100,000 tonnes of metal sitting in a warehouse, but only 40,000 tonnes are “visible” to the market. What you see is not always what you get.

The issue of how much metal was being stockpiled in China surfaced again in early 2010. The International Copper Study Group, which produces widely-quoted data on the metal’s supply and demand picture, detected that something was amiss. Those concerns emerged in a seemingly accidental email to the group’s public distribution list recipients, including this author. One of the attachments in the email described the purpose of an upcoming meeting:

In calculating apparent consumption ICSG does not take into account unreported stocks and only considers stocks officially reported or stock changes that can be inferred from production and trade data… However, ICSG acknowledges the existence of such “unreported” stocks and their impact on market balances. This is especially true in the case of China and hence the note included in ICSG monthly press releases.

Unreported stocks were of particular concern in 2009 given the exceptional level of Chinese imports and the possible distortion it presents to obtaining an accurate picture of the global supply/demand balance. Given the current climate and ICSG’s mission of promoting greater market transparency, it is of interest to delve into the unreported stocks issue and its impact on market balance.

To understand why this is so important, it’s crucial to understand something called “apparent consumption.”

When analysts look to gauge demand for many commodities, the assumption is made that any material either produced domestically or imported is consumed, unless it shows up in reported inventories. Think of it as a short-hand proxy for demand.

Hence the term “apparent” consumption. If inventories at an exchange go down, it is believed the metal is being used in industry and the market is drawing on stockpiles because supply is tight. Similarly, if metal is being shipped into China but not showing up in exchange warehouses, the metal is counted as consumed.

This is why the copper statisticians were concerned in 2010: recent Chinese imports looked huge on paper, but anecdotal evidence suggested stockpiling was inflating the numbers.

Hoarding metals in China does not appear to be the exclusive domain of foreign hedge funds and trading companies. Chinese firms have been playing the game, too, sometimes for speculative purposes and sometimes in order to circumvent tight credit problems.

UBS relayed in March 2009 “anecdotal evidence of Chinese companies with no need or use for copper buying and stockpiling the metal ‘because it is cheap’.” Around the same time, Bloomberg noted reports that private speculators, including pig farmers, were buying physical copper and nickel as investments.

As I pointed out a while ago, some local firms that cannot get conventional loans have also taken to piling up copper, which they use as collateral in order to borrow. Australia’s central bank explained the basic mechanics last August:

Under these inventory financing schemes, firms purchase copper on deferred payment terms (and on an unsecured basis) to use as collateral for obtaining renminbi-denominated loans from Chinese banks, with the proceeds of these loans either invested directly or on-lent in the unsupervised lending market.

The practice doesn’t seem to be confined to copper: Bloomberg reported in 2011 that Chinese firms were also using piles of soybeans for the same purpose.

All this hoarding does not necessarily mean that a commodity price crash is imminent. In theory, the hoarding could go on for some time.

What it does suggest, however, is that in some commodity markets “real world” demand has long stopped driving prices. Rather, prices are high because of stockpiling, which is happening for a multitude of reasons. The problem, of course, is that this can’t continue forever. At some point, surpluses get too big and reality comes back to bite. When that happens, the accumulation of commodities will cease and much of the stockpiles are likely to get liquidated, with obvious implications for future prices.

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