Copper Inventories versus Supply/Demand Forecasts

Fundamental analysis of commodity markets is based on statistics for supply and consumption. Estimates of the balance between supply and demand are then used for price forecasts. The International Copper Study Group (ICSG) as well as many analysts and investment banks and independent research institutions forecast that the copper market will be in a supply surplus this year and that this surplus would increase next year. Thus, it is not surprising that copper traded down from almost $8,300 per ton to less than $6,700 per ton. The increasing Chinese GDP growth rate prevented a further slide of the copper price and led to a sideways trading range.

However, this approach has some major drawbacks. The first one is that statistics of historical and actual global supply and demand differ among the institutions providing official statistics. This makes forecasts difficult to compare. Furthermore, historical data is revised frequently for several years in the past. However, commodity markets react on data when it is released first. Therefore, a quantitative analysis of the relationship between commodity prices and the balance of supply and consumption could lead to false estimations. The frequent revisions are also a problem if supply and demand have to be estimated by methods of univariate time series analysis.

The second problem is the data compilation. Surveys among copper mining companies and official production statistics could be used for the supply side. However, the difficulty is to obtain reliable data for copper consumption. Thus, a proxy is used, which is called apparent consumption. The ISCG writes in its recent forecast for copper that “…, ICSG uses an apparent demand calculation for China, the leading global consumer of copper, accounting for about 40% of world demand. Apparent copper demand for China is based only on reported data (production + net trade +/- SHFE stock changes) and does not take into account changes in unreported stocks [State Reserve Bureau (SRB), producer, consumer and merchant/trader], which may be significant during periods of stocking or de-stocking and which could significantly alter supply-demand balances.”

The third disadvantage is that the data is not easily available for the broader public. The ICSG publishes monthly data by press releases, but time series of supply and consumption are only available for subscribers.  

Based on the expectation of higher production from new and existing mines, the ICSG predicts that the copper market will be in a surplus of 387,000 tons this year after a supply deficit of 421,000 tons last year. For 2014, the supply surplus is predicted to increase to 632,000 tons.

In our quantitative fair value model for the copper price, we have not included data for supply and consumption for two reasons. The first is already mentioned above, the frequent revisions make the regression coefficients less reliable. The second reason is that even monthly data is published with a delay.

But fortunately, there is other data available, which is a good proxy for the supply and demand situation and this data is published on a daily basis. The three major exchanges trading copper futures and forwards provide data on inventories held in licensed warehouses. Our analysis showed that there is a high correlation between the supply/demand balance and the development of the warehouse inventories.

Thus, the conclusion is that if there is an increasing oversupply of copper, then also the warehouse inventories as reported by the exchanges should show a rising trend. A supply deficit should be accompanied by falling inventories.

As the first chart shows, total inventories held in licensed warehouses of the three exchanges reached a high in the early second quarter, which was slightly exceeded at the end of June this year with 928,093 tons. However, since the start of the third quarter the warehouse inventories declined steadily and are down by around one third at 611,335 tons. At all three exchanges, the reported warehouse inventories declined. It is thus a broad based trend. This development does not indicate that the trend of increasing supply surplus continued.

More important for the price development of commodities are the free available inventories. Unfortunately, our data sources provide only figures for the LME. Here, the free inventories (on warrant) already peaked in the first quarter and then declined as the second chart shows.

The inventory data should send at least an alert that consumption of copper might be stronger than the ICSG and some analysts currently predict. Of course, copper prices do not only depend on inventor levels or changes. Other fundamental factors also play a role, especially the development of leading indicators for the Chinese economy. Nevertheless, the drop of warehouse inventories should provide some support for copper. If inventories decline further, copper might even rebound.      

If it does not go up on good news…

After the release of the US labor market data the week before, there was no major data release scheduled for the week just ending. Thus, it were only speeches and statements by FOMC members, which had an impact on the markets. However, despite a slightly weaker US dollar, a firmer US stock market and yields on 10yr US Treasury notes edging down, the precious markets showed a disappointing performance. Only gold ended slightly in the plus, while silver and palladium posted stronger losses.

At the beginning of the week, it was the president of the Federal Reserve Bank of Atlanta, David Lockhart, who confused the markets somewhat. While pointing out that the FOMC could decide as early as at the forthcoming meeting in December to taper the bond purchases, he also argued for postponing the decision. However, Mr. Lockhart is currently not a voting member of the FOMC. He only pointed out that there is a possibility for a tapering decision next month. But the likelihood for this decision being made is rather small. As he provided arguments for delaying tapering further into next year, which were supported by another regional Fed president, there appears to be currently no majority for tapering within the FOMC. The negative reaction to mentioning just the possibility of deciding to taper in December demonstrates how irrational financial and commodity markets sometimes react.

Various empirical studies point to a high drug abuse in financial centers. And many traders and investors must have been on drugs to fear that Janet Yellen might suddenly change her mind during the Senate hearing for her appointment as first Fed chairwoman following Ben Bernanke in February next year. Mrs. Yellen is one of the architects of the current quantitative easing and the forward guidance provided by the FOMC. She always voted in line with Mr. Bernanke. Thus, it was irrational to fear that she would indicate that under her presidency the Fed would make an abrupt shift in monetary policy. She stands for continuity in the Fed policy. But only after the release of her written statement to the Senate, the markets got more relaxed and stock markets reached new record highs for the Dow and S&P 500 index. However, the precious metals could not benefit from this development.

This week, the World Gold Council released its quarterly report on Gold Demand Trends for Q3. The demand for bars and coins declined from 531.3 tons in Q2 to 304.2 tons. The dis-investment in ETFs continued albeit at a slower pace by -118.7 tons after -402.2 tons in the preceding quarter. Thus, it was not only “paper gold” but also physical gold demand, which disappointed. Nevertheless, total net demand of this two major groups increased by 43.7% from 129.1 to 185.5 tons in the third quarter. But this was not enough to push the price of gold above technical resistance.

That dis-investment in gold ETFs continued was already quite obvious by following the gold holdings of the SPDR Gold Trust ETF. However, one could only speculate who was the driving force behind the selling. As John Paulson’s hedge funds are a major stake holder and have suffered huge losses, they appeared as a potential candidate liquidating holdings to fund redemptions to disappointed investors. However, the recent SEC data surprised by showing that Mr. Paulson kept his stake nearly unchanged. It were other big investors who reduced their stake considerably. Especially PIMCO was mentioned in reports. The so-called king of bonds Bill Gross got some trends in fixed income markets wrong this year. Thus, PIMCO and in particular its flagship total return bond funds suffered massive outflows for several months in a row. Therefore, our speculation that liquidation of positions to meet fund withdrawals from investors was right, but it was just another whale. Nevertheless, big funds could drive a market rapidly higher but if they liquidate positions, the drop might be far steeper.

 For several weeks, the CFTC report on the “Commitment of Traders” was not available. Not only had the delayed releases showed some surprises. Also the recent CoT report brought a surprise for gold. After the dismal performance of gold, it had to be expected that large speculators reduced their net long position in the Comex gold futures. However, in the week ending November 12, the non-commercials reduced the long positions by 4,969 to 144,062 contracts and increased the short position by 24,815 to 82,710 contracts, an increase of 42.9% within one week. Thus, the net long position dropped from 91,136 to 61,352 contracts, the lowest level since mid-September this year. As hedge funds and CTAs are rather flexible in changing their positions, it would be rather dangerous to regard this development as a new trend. Nevertheless, it sends the message that large speculators got more pessimistic on the outlook for gold.

Precious metals performed dismal despite more indications that the Fed will not taper this year and the affirmation by Mrs. Janet Yellen that she would pursue an unchanged course of monetary policy. Holdings of the SPDR Gold Trust ETF falling further and large speculators cut the net-long positions in gold and silver. This all is a clear warning that the risk for precious metals is currently more biased to the down- than to the up-side.

On Central Banks and German Economic Doctrines

It was another negative week for most of the precious metals. Only palladium managed to close higher compared to the week before.  Platinum recorded the smallest percentage loss with a decline of 0.6%. Usually, silver is more volatile than gold. However, this week, gold lost 2% while silver was fell only 1.6%. Looking at intra-day charts, it is easy to detect what drove the precious metals lower: central bank policy actions – actual and expected future ones.

Already last week, we wrote that the markets would speculate on a further ECB rate cut after the preliminary consumer price inflation fell to only 0.7% in October. However, at the beginning of this week, the consensus moved towards expecting a rate cut at a later date. But the ECB taught the markets again the lesson that one should not fight against the central banks. It also humiliated the Royal Swedish Academy, which rewarded this year’s Noble laureate to Eugene F. Fama for his theory that financial markets were dominated by rational expectations and information efficiency. The ECB did not hesitate and reacted quickly by cutting the key refinancing rate by another 25 basis points to a mere 0.25%. After the release of the ECB rate cut, the euro dropped against the US dollar by almost 2 cents to 1.33 within 45 minutes. This dragged also the precious metals lower. If Fama’s theory would be correct than the markets should have already priced in the rate cut and should not have reacted so strongly.

The ECB council decision was not unanimous. It has been reported that opposition came mainly from the Northern members, led by the German Bundesbank president Weidmann. The ECB has also been criticized for the rate cut by German economists and institutions. The head of the savings bank association, an economist, stated that the ECB would expropriate the Germans. Representatives of life insurance companies or pension fund managers blamed the ECB for punishing savers. These statements are pure nonsense. First, expropriation means that some property is taken away by the government. However, after the ECB rate cut, savers possess the same amount of bank deposits, which they would hold in the case rates remained unchanged. It is not the duty of the ECB to keep interest rates at such a level that the thrifty Germans earn a positive return on their short-term time deposits.

The ECB can only set short-term interest rates and the duty of the ECB is to maintain price stability, which implies to prevent both, inflation as well as deflation. Thus, the ECB acted according to its mandate. German savers still have the opportunity to switch into other assets, which yield a positive return. That the ECB had to cut rates to prevent a deflation in the Eurozone is a consequence of the German economic policy, which impost austerity measures in the eurozone. And it is also related to another development Germany had been criticized for by the US Treasury, the IMF and the EU, the huge surplus of the German current account, which reached a new record high in September.

Fiscal austerity in many Eurozone countries led to a decline of domestic demand and corresponding pressure on consumer prices. The German export surplus reflects also that Germany’s domestic demand is too small as Germans save more than the companies invest. This is a simple economic accounting relationship, which is not understood by the German politicians and business leaders. Defending or even extending the export surplus implies also that other Eurozone countries will struggle further to increase economic activity by exporting more to Europe’s biggest economy. But as long as total demand in many countries remains sluggish and pressure on consumer prices persist, the ECB policy will have to remain expansionary. This should have a dampening impact on the exchange rate of the euro against other major currencies.

The second push lower for the precious metals was not triggered by actual central bank policy action, but by expectations about future measures. The US labor market report came in stronger than the consensus among Wall Street economists predicted. The number of new jobs created at 204K exceeded the consensus by 83K. Also the preceding two months numbers have been revised higher by a total of 60K additional jobs. Now the markets fear that the FOMC might decide to taper the bond purchases already at the next meeting in December instead of in Q1 next year. Thus, the US bond market sold off and the US dollar strengthened against major currencies, both developments were negative for the precious metals.

However, the market overlooks again that the FOMC is not only focusing on the labor market report. Furthermore, one swallow does not make a summer. The previous reports were weaker than expected. Thus, the FOMC would like to see some confirmation that the labor market improves at a sustainable and sufficient pace. Other economic data was mixed. The ISM reports came in stronger than expected but activity indices from some regional Federal Reserve Banks and consumer sentiment were below consensus forecasts. Therefore, the FOMC is likely to postpone tapering beyond the December meeting.

But tapering is only a question of time. Thus, while the Fed is expected to become less expansionary, the ECB might have to take further monetary measures to prevent a deflation in the Eurozone despite consumer price inflation in some member countries might get close to the target. However, embarking on quantitative easing is more difficult for the ECB than it was for other central banks like the Fed or the Bank of England. While the EU treaties allow the ECB to buy government bonds in the secondary markets, the problem would be which bonds should be bought. Buying government bonds from all countries does not make much sense. If the ECB would buy government bonds of those countries where the risk of deflation is the highest, than complaints would come from Germany and other Northern countries. A difficult task for the council to select the proper instruments. But as the ECB demonstrated, the council is ready to act in time and it would ease monetary policy even further to fulfil its mandate. The implication for the precious metals is that they might remain under pressure by a firmer US dollar.       

Platinum defies negative factors due to labor unrests

Some analysts and commentators came to the conclusion that the labor unrest in South Africa would have no impact on the price of platinum. However, platinum was the only metal posting a gain this week. All other precious metals lost more than they gained the week before. Those analysts pretending that the labor unrest would have no impact on the price of platinum made a simple mistake. They just compared the price performance of platinum with percentage price changes at times of former labor unrests in South Africa. They made the implicit assumption that the labor conflicts were the only factor determining the price movement of platinum. But this is not correct. Many econometric models for the fair value of precious metals show that other factors also play a crucial role. These models could be either of the linear regression type or Vector Auto-Regressive type (VAR). Taking those factors into account and not treating them as constant leads to a different conclusion. Labor unrests still have a strong impact on platinum prices!

Two variables, which are included in those models and which are significant, are the development of the US dollar against the five major currencies as measured by the US dollar index and the price of crude oil.

In our fair value models, we include the price of the front-month light crude oil future traded at the Nymex division of the CME group, which is based on the WTI oil sort. This oil sort was long the benchmark. Including the front-month of the ICE Brent future would not change the results considerably. The price for both sorts declined last week. The front-month WTI future lost 3.3% compared to the previous week. One reason behind the price decline of crude oil was the build of inventories at Cushing despite the rise in refinery input and capacity utilization, which exceeded expectations of many analysts and traders. However, the drop of the oil price also reflects some weaker economic data. Thus, the decline of the oil price signals not only a lower inflation risk but also a slower pace of economic activity. Both developments are negative for the demand for precious metals including the PGMs.

The FOMC kept the volume of monthly bond purchases unchanged as widely expected. However, the market was surprised by the FOMC statement recognizing a weakening of economic activity. This reaction again demonstrates that markets are not always rational. Rewarding Eugene F. Fama with the Noble laureate is not understandable and the Swedish academy looks foolish ones again. The shut-down of the US government has an undeniable impact on economic activity. Some economists estimated a loss of Q4 GDP by $24bn, which is not a negligible quantity. That economic activity in the US decreased already in September is also not really surprising as the shut-down was looming and there were no signs that it would be averted by a last minute compromise.

Against the backdrop of a further delay of tapering and the FOMC’s assessment of a weaker US economy, one would not expect the US dollar to strengthen. However, this is exactly what happened. But currencies always involve two currencies in a pair, which indicates that developments in other countries might have been decisive for the stronger US dollar. The Japanese yen weakened against the US dollar on a smaller than expected increase of industrial production. But as other economic data came in stronger than expected, it is more likely that the weaker yen was caused by cross exchange rates, especially by the EUR/USD pair. The euro weakened against the US dollar from 1.3804 to 1.3485, a depreciation of 2.3%. But the euro came under pressure mainly during the last two trading days.

It might be a coincidence, but there were two related factors, which contributed to the weaker euro. There were complaints against the strength of the euro reported on Thursday. The rise of the euro above 1.38 against the US dollar is probably less of a problem for the German export oriented economy. However, for the Southern European countries, which had to take severe austerity measures in order to regain competitiveness, a stronger euro is a serious problem. Further wage cuts to remain competitive would only send those countries back into recession and would aggravate the social and political tensions.

Later on the same day, the Eurozone preliminary October inflation rate was released. The HICP inflation dropped further to 0.7%, far below the ECB target of close, but below 2%. And the stronger euro is one of the factors contributing to the increased deflation risk. While the Austrian central bank governor already ruled out a further rate cut, the market is speculating on such a move. But also some other ECB council members from the Northern part of the Eurozone oppose such a move. But due to the fiscal austerity imposed, aggregate demand could not be revived by fiscal policy without a change in the policy regime. Such a regime shift appears to be impossible. If the ECB takes it task seriously, it would have to take measures to prevent slipping into deflation. Otherwise, the ECB might repeat the mistakes made by the Bank of Japan which led to the still lasting deflation in Japan.

Given the constraints, the ECB has to take measures that monetary policy gets more expansionary in order to reduce the deflation risk. Thus, the markets are speculating on a further rate cut, some unconventional measures of quantitative easing or a combination of both. Those measures would have the welcome impact of weakening the euro against other currencies.

The outlook for more easing by the ECB is negative for the precious metals. That platinum increased by 0.2% in this environment, while gold and silver dropped 2.7% and 3.1% respectively in the week on week comparison is remarkable. And it underlines that the labor conflicts in South Africa have a positive impact on the price of platinum. That palladium only declined by 0.5% also underlines the relative better performance of the PGMs. The outperformance of the PGMs over gold and silver is likely to continue for the time being.