COLUMN-LME copper spreads; the new normal or ticking bomb?: Andy Home

(Andy Home is a Reuters columnist. The opinions expressed are his own)

By Andy Home

LONDON, May 14 (Reuters) - This morning's stocks report from the London Metal Exchange (LME) showed another 5,500 tonnes of copper departing the system and another 1,150 tonnes of net cancellations .

Both trends have been running for many weeks now. Headline registered stocks have just fallen below the 200,000 tonne mark for the first time since October 2008.

Open tonnage, meaning the amount of metal that has not been cancelled in preparation for physical load-out, stands at 108,100 tonnes, the lowest level since May 2008.

Low and falling physical stocks have pulled the front part of the LME curve into sustained backwardation. The benchmark cash-to-three-months period was valued at $42 per tonne backwardation on Tuesday.

What's surprising, though, is that the backwardation isn't as pronounced as it was the last time that LME open tonnage dropped to these low levels.

Does this signal a new bearish "normal" in the copper market, or is the growing disconnect between stocks and spreads a ticking bomb? ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ Graphic on LME copper stocks and spreads: http://link.reuters.com/wuq39v ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^

HISTORY IS NOT REPEATING ITSELF

The relationship between LME stocks and outright price has long broken down for most metals for varying reasons.

In the case of aluminium and zinc, both of which bear the burden of high legacy stocks, any linear relationship has been fractured by the stocks financing trade and the resulting mass movement of metal between visible and dark inventory.

While copper has been tinged by similar gaming of the LME warehousing system, the real issue has been the emergence of the Shanghai bonded warehouse zone as a physical liquidity pool, thanks to China's appetite for collateralised credit.

LME stocks still have a direct bearing on the structure of the forward curve, however, because open tonnage remains the core physical determinant of availability.

And right now something looks amiss in the LME copper market.

When open tonnage was last this low in May 2008, that cash-to-threes period was consistently valued at over $100 per tonne backwardation. Go back a bit further to 2007, when open tonnage was also below 100,000 tonnes, and the same sort of triple-digit backwardation was the norm.

Leon Westgate, an analyst at Standard Bank London, argues that the three-to-15-month part of the curve is even more misaligned with the level of registered inventory.

That spread "has started to tighten in recent days, however it remains very benign at around $60 backwardation and well out of line with historical levels, which have been from $250 to $850 backwardation at similar on-warrant stock levels". ("Commodities Daily", May 7, 2014)

Westgate goes on to note that "the spread is instead behaving as if there is at least another 100,000 to 200,000 tonnes of available copper in LME sheds".

SURPLUS NOW, SURPLUS TOMORROW?

There is, of course, a lot more than that sitting in the Shanghai bonded warehouse zone - around 600,000-700,000 tonnes according to the latest local estimates.

It is the single largest concentration of refined copper inventory anywhere in the world, eclipsing the total amount of visible metal held by the LME, the Shanghai Futures Exchange and the COMEX exchange combined.

If the world market for refined copper is in surplus, always a questionable proposition given this market's perennial problems in pinpointing supply-demand balance, then that surplus is surely in China.

Are the LME's "benign" spreads in effect pricing in this Shanghai metal as being readily available?

Or are they subdued because everyone is expecting more surplus to come as last year's surge in mine output makes its way down the production chain to the point that it is simply a matter of time before LME stocks are replenished?

After all, the copper market was a much more bullish place in 2007-2008, with LME three-month metal trading consistently above $8,000 per tonne as production struggled to match booming demand.

Surplus today, albeit in the wrong place, and expectations for a bigger surplus tomorrow would help explain the lack of impact of falling LME stocks on the spread structure.

A QUESTION OF AVAILABILITY

Both propositions, however, assume that current and future surplus will be available to the LME market.

It's a big assumption.

So far, for example, there has been no sign of metal moving from Shanghai to the LME system, even with the latter in backwardation and the former in palpable surplus, or at least until a couple of weeks ago.

Chinese copper smelters have indeed capitalised on the negative arbitrage between the two markets but only in the form of what they call "exports" to the bonded warehouse zone.

And that's where the redistribution of stocks has stopped. The LME system has experienced only minimal arrival rates over recent weeks, just 2,975 tonnes over the course of April and just 325 tonnes so far in May.

It is evident that if LME tonnage dropped further to critical levels, it would need a bigger incentive in the form of a wider backwardation to trigger a reverse flow of metal from Shanghai.

But maybe the scale of surplus-building along the production chain means such an adjustment is unnecessary?

There is a broad consensus that even China can continue absorbing surplus units only for so long and that it is therefore simply a matter of time before LME stocks start rebuilding.

A QUESTION OF TIMING

But how much time?

Chinese copper demand is entering one of its seasonal high points; the government in the form of the State Reserves Bureau is hoovering up metal; and the copper collateral trade continues to defy expectations of its imminent demise.

The country, in short, is still sucking in refined copper from the rest of the world.

Net (Dusseldorf: NETK.DU - news) imports in the first three months of this year totalled 946,000 tonnes, a first-quarter tally beaten only once, in 2012. The preliminary trade figures for April suggest the import boom is continuing.

It certainly doesn't feel as if Chinese demand, whether manufacturing, government or financial, is fully sated, which implies that surplus units will continue bypassing the LME system en route to Shanghai.

Until that changes, there is unlikely to be any major replenishment of LME copper stocks.

Which means that the tension in the historical relationship with spreads is going to remain a feature of the London market for the time being.

There is no easy answer to the questions posed by this tension, but on current stock trends, we may not have to wait too long to find out.

(editing by Jane Baird)