Metals Markets in 2014

Also at the start of the New Year, we participated at some polls about price forecasts for precious and base metals. Unfortunately, a sick leave prevented us from writing about these forecasts in this blog earlier. In-between, the LBMA has published their analyst polls in the 2014 LBMA Precious Metals Forecast Survey, a 29 page document containing the forecasts of various analysts as well as some short arguments for their predictions. Another poll by ThomsonReuters just published the consensus forecasts for precious and base metals.

There is an old adage at Wall Street that as the first week goes, so goes the year. A similar one is called the January effect and states that the performance of the stock indices in January indicates whether the stock market will be up or down for the whole year. The first few weeks of the year 2014 indicate that the factors having an impact on metals in 2013 will also drive the markets this year.

While the S&P 500 index is down compared with the end of last year, precious metals posted gains with the exception of silver. However, when we refer to the January effect, we don’t predict that the bear market in precious metals would be over and that gold would be in a bull market in 2014. What could have been observed already in the second half of last year was a significant, negative relationship between the returns of gold and the S&P index, while in the period from 2009 until the end of 2012, this relationship was positive. This pattern also prevailed so far this year and we expect it will also persist during the remainder of 2014. The reason of the structural break in the relationship between returns on gold and the US stock market was a change in the behavior of major institutional investors. The Abenomics in Japan as well as the announcement of QE3 by the Fed induced considerable shifts in asset allocations by large investors. Furthermore, the expansionary monetary policy has not led yet to a rise of inflation rates, which many fund managers expected. Nothing currently indicates that this behavior would reverse again this year.

After the strong performance of major stock markets in 2013, it was not surprising that the year started with a consolidation. The US economy is in a good shape, which should be supportive for the stock market. Thus, a severe correction or even a bear market are not the base scenario for the US stock market. Therefore, gold is not out of the woods and could even fall below last year’s low. On the other hand, a consolidation of the US stock market could lead to gains in the price of gold, which could slightly exceed the high reached in August 2013. All in all, we expect a broad sideways trading range around current levels. However, for the average price of gold this implies another negative year.

For the PGMs, we expect a similar trading pattern. However, already last year, they performed better than gold and silver. Based on forecasts of a stronger global GDP growth, the demand for PGMs from the automotive sector should increase. Labor unrests remain the risk factor on the supply side. Based on the statistics from Johnson-Matthey, we expect that the supply/demand balance will support the PGMs further. Thus, they are expected to outperform gold and silver also in 2014.

For the base metals, China and Indonesia will remain the key factors also this year. For tin and nickel, the export ban on unprocessed metal is a supportive factor. Also the stronger global growth should be supportive for these metals. For aluminum and copper, the key factor continues to be the state of the Chinese economy. The central bank, the People’s Bank of China, first led short-term interest rates rise but finally provided liquidity to ease the tensions in the money market. This demonstrates that the PBoC on the one hand will act if rising interest rates endanger the current pace of economic activity. But on the other hand, it would do nothing to spur GDP growth. Thus, we expect that the growth rates will remain in a narrow band around 7.5%. This will translate into fluctuations of the widely followed PMI indices slightly above the crucial 50 threshold, which does not exclude that the HSBC PMI might be in some months below this level. Therefore, we also expect a sideways movement for the base metals in our central case scenario. 

The Hidden Shadow Warehouses and Base Metals

Normally, we do not comment a specific press article. However, after the Christmas holiday, the Wall Street Journal published an article titled “Millions of Tons of Metals Stashed in Shadow Warehouses”. The tenor of this article is that more and more metal would be stored in hidden warehouses not licensed by the LME and that statistics about LME warehouse inventories would be less useful. Furthermore, the article creates the impression that holding inventories outside of LME warehouses would be intended to manipulate the market by banks and hedge funds.

This article contains some errors and inconsistencies. The LME is not the only metal exchange, which has licensed warehouses officially. As long as aluminum futures were traded on the CME, this exchange also had licensed warehouses for that metal and reported inventories daily. Copper inventories continue to be posted daily on the CME website. The Shanghai Futures Exchange has also licensed warehouses and publishes the stocks. Last Friday, these inventories were 186.7 thousand tons of aluminum. Licensing by an exchange means that these warehouses are delivery places for the traded contracts at maturity. If a delivery is due, the seller may deliver the metal by warehouse receipt of an official warehouse. The buyer has no obligation to accept metal, which is not held at one of the official licensed warehouses.

Thus, the statistics about warehouse inventories held on warrant and cancelled warrants provides information about which quantities are available for delivering into the outstanding contracts, counted by the open interest. However, this is only a daily snap-shot. These statistics do not imply that the metal available for meeting delivery obligations in the future are limited as the inventories could increase by delivering metals held outside the official warehouses into the official stocks. Nevertheless, the exchange warehouse inventories provide a good indication about the scarcities of the various base metals.

The author writes correctly that the official warehouses of the metal exchanges are also deposits for non-registered metal stocks. In the industry, the term "crossing the line" is well known and expresses that through easy transport over a certain line of separation, the metal disappears from the statistics, although it has never left the warehouse. But if the metal has left the "official, segregated storage area", then it is no longer directly available for deliveries of exchange-traded contracts. Often, the warehouses providing a financial incentive by lower storage costs to the metal from the official to the unofficial inventory areas.

Unfortunately, the author fails to recognize, why the unofficial stocks have risen so sharply. Here the LME and the warehouses have a significant fault. The LME warehouses function more like a mouse trap. It is easy to get the metal into the warehouse. But, it could sometimes take several months for the holder of a warehouse receipt to receive her metal from the warehouse. For this waiting period, she must bear the storage costs also. Therefore, for consumers of these metals, the pressure has arisen to store more metal outside the warehouses of the exchanges in order to have the necessary flexibility to use the metal for the own production of goods. The LME management would have to solve the problem of long queuing times at their warehouses. Maybe the law suits filed in the US will speed-up this process.

Furthermore, producers and consumers will always hold some inventory outside the official warehouses. Models of inventory holding like the Baumol model also can explain the rise of off-exchange warehouse stocks to some extend by rising global GDP and lower interest rates due to the zero interest rate policy followed by major central banks.

The problem with the so-called shadow storage is an essential one for analysts, who analyze statistics of production and consumption and derive forecasts for price developments from this data. The production figures can be estimated reasonably well. Sometimes this data will be published by national statistical offices. Analysts can also poll mining companies about their production estimates. Nevertheless, also production figures were revised even several years later and thus, have a degree of uncertainty, which should not be neglected. However, for consumption statistics the picture looks completely different. There are no reliable official statistics of metal consumption. Also polling companies using base metals as an input in the production of goods is a mission impossible given the sheer number of companies in the metal processing industry on a global scale.

Therefore, statisticians apply an auxiliary construct that is referred to as apparent consumption. The changes of the inventory holdings are subtracted from the production and the difference is considered as consumption. Therefore the better the actual changes in inventories are recorded, the better consumption could be estimated. If the change of inventories is underestimated, then the consumption is overestimated necessarily and vice versa. Thus, the disadvantage of this approach is a high degree of uncertainty about the effective consumption of base metals. Figures are revised still many years later. Furthermore, it is possible that revisions of data lead to changes in the supply/demand balance by the pen of the statisticians. It had been the case that the market had expected a supply deficit (surplus), but final figures showed a supply surplus (deficit).

This problem of data revisions has considerable implications for quantitative modelling of base metal price developments. Metal prices are based on the information available at the time of trade. If this information is significantly different from ex-post information used in modelling, then the estimates are distorted and could lead to erroneous conclusions. As data about inventories in exchange warehouses is available in a timely manner and is not subject to revisions, it is still preferable compared to estimates of the supply/demand balance.

For some base metals there are international organizations such as the International Aluminum Institute or the International Copper Study Group. These institutions also estimate the total inventory changes, whether held in private storage outside of exchange warehouses or in public strategic reserves. They publish this information on a monthly basis, although the statistics are published with a usual time lag. The stocks in the warehouses of the exchanges, however, are available the next morning.

The author also touches the area of inventory financing. In a number of articles and comments of analysts, the use of existing stocks as collateral for loans is discussed. In some of these articles, the impression is created that the metals are purchased solely to obtain a loan. This is only useful if there are opportunities for arbitrage, which should be exploited without the use of own funds. However for consumers the situation is different. They need to hold stocks for current production as just in-time production is not always possible. This inventory holding ties up capital. And since in many jurisdictions, equity is more expensive than debt financing due to tax treatments, it makes sense to fund the inventory holdings by a bank loan and to use the metal as collateral for the credit. But consumers will only hold higher inventories when they expect also an increase in demand for their products. However, normally consumers would not hold those inventories at exchange warehouses.

For producers, the situation is also different. If a market is in backwardation, they can sell their production of refined aluminum or copper at the spot market. However, if the market is in a contango situation, then it might be a better strategy to deliver the metal into exchange warehouses and to sell the corresponding number of futures contracts. Selling the metal in the spot market would depress prices even further and might lead to a less favorable price for the producer. However, if the producer needs funds, he could obtain a bank loan against the warehouse receipt as collateral.

For many base metals, inventories held in exchange warehouses declined from the peaks reached in 2013. If this metal all went into the “hidden shadow warehouses”, then the exchanges and the LME in particular should be worried and should take measures to reverse this development. The exchanges could also demand from the warehouses to provide figures off metal inventories outside the official zone at those warehouses. However, with respect to the development of global PMI indices, the decline of inventories at exchange warehouse might be more a reflection of a stronger global economy.