COLUMN-Copper market script gets turned on its head: Andy Home

(The opinions expressed here are those of the author, a columnist for Reuters.)

By Andy Home

LONDON, March 17 (Reuters) - So much for the expected copper market script this year.

The broad consensus among analysts was that 2014 was going to be all about supply.

Global production of mined copper jumped by eight percent in the first 11 months of last year, according to the latest estimate from the International Copper Study Group (ICSG), a dramatic turnaround after years of systemic under-performance.

That supply surge was expected to translate into increased availability of refined metal during 2014, pressuring prices steadily lower.

The accepted wisdom, though, was that this was going to be a slow, accumulative process, culminating in a price trough some time in the fourth quarter.

That consensus was ripped apart in a matter of hours early last week, as London Metal Exchange (LME) three-month copper imploded to a 44-month low of $6,376.25 per tonne.

And the blood-bath had nothing to do with building supply pressures but everything to do with demand, first and foremost Chinese demand.

ALL ABOUT DEMAND

The kink in the story is that it's not even the state of industrial demand in China, the world's largest copper user, that really spooked copper.

That China has started the year off in muted form is not in doubt. Just about every indicator, from purchasing managers indices to export figures, has painted the same picture of slowing growth.

That casts a shadow over every industrial commodity from aluminium to zinc.

What differentiates copper, and to some extent iron ore, from the rest, though, is the sensitivity to another sort of demand.

Investor (Other OTC: IVSBF - news) demand for copper as collateral for use in China's shadow credit market has seen imports boom far beyond levels that could be explained by manufacturing usage or stocking cycle alone.

The result, as everyone now knows, is the rapid build of inventory in the Shanghai bonded zone, currently estimated at 700,000 tonnes plus.

This copper mountain, three times the size of LME stocks, is underpinned by a complex and opaque credit structure.

Which explains why the market took such fright when a previously little known company called Chaori Solar Energy made history by becoming the first Chinese company to default on a bond.

The news sent tremors rippling through the entire Chinese credit system and, in the case of copper, ignited fears of a disorderly unwind of financing trades.

THE GREAT UNWIND...?

So far at least, there is very little evidence of an impending collapse in this copper credit mountain.

The most sensitive gauge should be the level of physical premium for metal in Shanghai's bonded warehouse zone.

Although the premium has weakened over the last couple of months to around $120-140 per tonne, that's still a very high level by any historical benchmark.

If collateral trades were being forcibly unwound and copper dumped into the local market, the premium would be falling much faster and harder.

As analysts at Barclays Capital argue, "the mainstream mechanics of copper financing mean that the parties involved do not face immediate pressure to sell physical stocks." ("China copper: No fire sale", Mar. 14, 2014).

In what BarCap terms a "regular trade financing" deal, the copper has already been physically sold, or, in what it calls an "inventory financing" deal, both sides to the transaction should be fully hedged. There exists the potential for financial losses but "the spectre of a massive fire-sale of physical stocks appears to be unwarranted".

There is, of course, a risk here of focusing too much on the "known unknown" that is copper collateral financing whilst missing something far bigger lurking even deeper in the shadows.

It is precisely the opacity both of the financing trade and of the true Chinese inventory picture that has contributed to the panic.

...OR THE GREAT REBALANCE?

With that important caveat, the most likely scenario is not a Great Unwind but a Great Rebalance as global inventory build shifts from China to the rest of the world.

It is Chinese demand for copper as collateral that has sucked surplus metal into the Shanghai bonded zone while simultaneously draining availability everywhere else in the world.

The combination of credit stress, in the form of reduced new lending for copper financing, and weak physical market conditions, particularly an import-negative London-Shanghai arbitrage, should see less copper flowing into China and more going to replenish depleted stocks elsewhere.

That process could be accelerated by increased Chinese exports from those producers qualifying for preferential tax treatment on tolling of imported raw materials into refined metal.

There are indeed signs that this is about to happen.

Six large Chinese smelters have agreed to export around 150,000 tonnes per month, according to Wu Yuneng, vice president of one of them, Jiangxi Copper.

Rather confusingly, though, when Chinese copper smelters talk about "exports", they can mean "exporting" metal only as far as the Shanghai bonded warehouse zone.

Whether copper "exports" make it as far as LME warehouses in Asia will depend on the pull being exerted by the LME market in the form of a cash premium generated by backwardation.

Although the front part of the LME curve is indeed in backwardation, at around $21 per tonne basis the benchmark cash-to-three-months period , it is not extreme and a lot smaller than it was just a couple of weeks ago.

DEMAND DRIVERS

While we wait to see how the promised "export" flow pans out, other drivers are kicking in to slow the downside momentum.

Firstly, copper's break out of a long-established $6,900-7,500 per tonne trading range has stimulated forward buying by industrial users.

European consumers, in particular, have been capitalising on the combination of a lower copper price and a favourable euro-dollar exchange rate to lock in prices as far forward as 2018.

Another direct result of the recent price shake-out will be the impact on the scrap component of the copper market. The scrap trade is notoriously price sensitive, not least because much of it tends to be unhedged.

Sharp price movements such as those just seen, therefore, tend to cause scrap traders to withhold supply, affecting both the availability of raw material for secondary producers and for those manufacturers who blend scrap into their intake.

The effect either way is to increase manufacturing demand for refined metal.

Lastly, there is the potential for the world's ultimate buyer to step into the fray.

China's State Reserves Bureau (SRB) is thought to have been mulling stepping up copper purchases even before last week.

A copper price starting with a "6" will be just as enticing to SRB buyers as it is to European manufacturers, although they will try and move with stealth if they do pull the trigger.

None of which is to argue that the copper price couldn't yet drop further. Bears, not least the Chinese bears who helped trigger this rout, are still in the driving seat and still feeding off the technical momentum signals.

But there are now powerful price stabilisers starting to kick in on the demand side of the market.

That, of course, turns the expected script, which was all about supply, completely on its head. (Editing by William Hardy)