COLUMN-ICSG rewrites the copper market narrative: Andy Home

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

By Andy Home

LONDON, Jan 29 (Reuters) - Things are not turning out as expected in the copper market. Again.

This was supposed to be a time of feast. But it feels more like famine. At least as far as the London Metal Exchange (LME) copper contract is concerned.

The LME copper market has been gripped by front-month tightness since the start of December. As of Tuesday's close the benchmark cash-to-three-months period was valued at $39 per tonne backwardation.

The immediate cause of that tightness is not hard to find. LME stocks of copper (MCUSTX-TOTAL (NYSE: TOT - news) ) have been trending steadily lower since the middle of last year.

Moreover, much of what is in the LME system is cancelled, meaning it is earmarked for load-out. Open tonnage, the true liquidity base of the contract, is hovering just above multi-year lows at a current 128,400 tonnes.

^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ Graphic on LME copper stocks: http://link.reuters.com/rat46v ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^

So where has the expected surplus gone? And, more critically, is there a surplus at all?

And if you're experiencing a certain sense of deja vu reading that, it's because those two questions have been a running theme of this market for many, many months.

A FUNDAMENTAL(S) PROBLEM

The copper market has had a fundamental problem understanding its own fundamentals for several years now.

The root cause of the confusion has been the missing component in the calculation used to determine market balance.

Comparing global production with global usage only gets you so far. The key third part of the equation for any commodity market is change in inventory, which loops back into any usage calculation.

And that's where the copper market has been consistently blind-sided.

In times past inventory could be largely defined as the amount of metal sitting in the warehouses of the three major exchanges - the London Metal Exchange, COMEX and the Shanghai Futures Exchange.

But in recent years all three have been eclipsed by a fourth stockpile, the metal sitting in Shanghai's bonded warehouse zone.

It is privately held. There are no daily reports on how much is there or how much it has changed. It exists in a statistical twilight zone, beyond the calculations of bodies such as the International Copper Study Group (ICSG), which can only count what can be verifiably counted.

It wouldn't matter so much were this stockpile not so large. At times it has been estimated at up to a million tonnes, dwarfing the tonnage in the visible exchange sphere.

Changes in the Shanghai copper mountain, therefore, have often been the single most important determinant of market balance, just sadly one that has been missing from official calculations.

ALL CHANGE

No more.

The ICSG has effective its January monthly bulletin started including an assessment of the Shanghai mountain.

It will use "an average of stock estimates provided by three consultants based on their ongoing research and analysis of the Chinese copper market to estimate the unreported inventory changes".

To the ICSG's previous monthly snapshots of market balance and seasonally-adjusted market balance will be added a third assessment of market balance after changes in Shanghai bonded stocks.

And what a difference it makes.

^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ Graphic showing ICSG copper market balances with and without factoring in Shanghai bonded stocks: http://link.reuters.com/syn46v ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^

The recent history of the copper market looks very different, as shown in the graphic above.

The popular copper market narrative, underpinned by the ICSG's previous methodology, was of structural production-usage deficit gradually diminishing before turning to surplus, most likely some time last year.

That narrative is transformed once changes in Shanghai bonded stocks are included.

For example, the ICSG previously assessed the market as being in 421,000-tonne deficit in 2012.

That was the year that the market first really woke up to the size of the stocks lurking in Shanghai. And although there was plenty of anecdotal evidence that those stocks were growing exponentially, their statistical invisibility meant they didn't challenge the orthodoxy of market deficit.

Now, however, the ICSG assesses 2012 as a year of 147,000-tonne surplus. It's just the surplus built far away from the statistical light in the form of a Shanghai stocks build-up now estimated by the Group at 471,000 tonnes in the first 10 months of that year.

DEEPER DEFICIT

What was built in 2012 was drawn down in the first half of 2013.

The massive destock was visible only through refraction in the form of lower Chinese imports and rising inventory everywhere else. LME warehouse stocks, for example, surged from 320,000 tonnes at the start of 2013 to a June high of 678,225 tonnes.

Both trends seemed to confirm the accepted narrative.

Everyone, after all, knew that mine supply was on a roll after years of collective underperformance. And dwindling Chinese imports of refined copper seemed to confirm the view that the country's extraordinary copper growth story was coming to an end.

In the event Chinese demand was still running as strong as ever but being met by what at the time were poorly visible drawdowns from the Shanghai bonded zone. The ICSG now estimates that such stocks fell by 326,000 tonnes in the first 10 months of last year.

Factoring that stock change into the equation explodes the ICSG's estimate of market deficit from 169,000 tonnes in the January-October period to 556,000 tonnes, the largest supply-usage shortfall yet in the past few years.

Which explains why exchange inventory, both on the LME and COMEX, has shrunk so drastically since the middle of last year.

And why short position holders are now paying the price on the front-month LME spreads.

PERCEPTION AND REALITY

This is the age-old markets story of perception and reality.

The reality is that the global refined market has been roughly balanced over the last few years.

Surpluses and deficits of less than 300,000 tonnes have been statistically marginal in the context of a 20-million tonne market-place.

Perceived shifts in the balance, however, have dominated the market's internal dialogue, a phenomenon amplified by a collective fixation on binary outcomes, deficit or surplus, and on an easy linear narrative of famine turning to feast.

The latest ICSG figures show how wrong some of those perceptions have been, distorted as they were by the statistical black hole that was the Shanghai bonded warehouse zone.

It turns out the truth, or at least the latest version of it, was never as linear as the copper narrative suggested.

None of which is to deny that this market should finally be moving to a period surplus as booming mine supply is converted into improved metal availability.

Emphasis, though, on that word "should".

Time will yet tell but at least we'll have a better statistical understanding of where we are on the journey.

(Editing by Tom Heneghan)