Where Is the Copper Supply Surplus Gone?

Only less than two months ago, the International Copper Study Group forecasted at its semi-annual meeting in Lisbon that after four years of supply deficit, the copper market would swing into a surplus. While the ICSG estimates that the apparent refined copper consumption exceeded supply in 2013 by 282 thousand tons. For this year, the ICSG forecasts a supply surplus of 405 thousand tons. This swing in the supply/demand-balance by 687 thousand tons is due to an increase in mine production, which leads also to a rise of refined copper output. For this year, global mine production is expected to increase by 4.7% to 18,904 thousand tons. Refined copper production is forecast to rise faster than mine production by 6.5% to 22,362 thousand tons. The global copper consumption is predicted to increase by only 3%, which is less than global GDP growth, to 21,957 thousand tons.

A swing in the supply/demand balance of the magnitude predicted by the ICSG should be reflected in the development of copper stocks. According to the recent figures published on May 22, 2014, by the ICSG in the press release for the Monthly Copper Bulletin, global copper stocks increased by a total of 102 thousand tons in the first two months of 2014. Inventories held in the warehouses of the three major exchanges (LME, Shanghai and CME) dropped by 25.2 thousand tons in the same period, which is in a clear contrast to the estimate of the ICSG for the first two month. Since March, the fall of inventories accelerated. Despite some temporary inventory builds at some exchanges, copper stocks are currently down 228 thousand tons YTD. This plunge of copper inventories at exchange warehouses since the beginning of March is in such an obvious contrast to what one would expect given the forecast of a 405 thousand tons supply surplus.

Certainly, copper inventories are not only held in exchange warehouses. Producers and consumers of copper also hold inventories, but one would expect that these holdings are more determined by economic activity and opportunity costs. If we take this into account, it appears rather unlikely that producers and consumers have increased their inventory holding by the amount to explain the difference between the change in the supply/demand-balance and exchange warehouse inventories.

Furthermore, if producers hold more inventories, then one would expect that they also want to hedge the inventories, especially when the majority of forecasters predict a change in the supply/demand balance. This should lead to a considerable increase of open interest and falling copper prices. However, when copper reached its low of the year so far in March, the LME copper futures open interest was up only 7 thousand contracts compared to the end of 2013. In addition, copper at the LME remained in a slight backwardation in mid-March. But copper prices were in contango at the Shanghai Futures Exchange. LME open interest in copper futures rose far stronger since mid-March to more than 340 thousand contracts at the start of this past week. This rise in open interest was accompanied by a recovery of the copper price. This argues that not producers are hedging against further falling prices due to a supply glut but consumers hedge future demand. However, this behavior would be only rational if consumers doubt that forecasts of a supply surplus depressing prices are correct.

The other explanation is that the copper supply surplus is held in bonded warehouses in China and had been used for financing deals. In April, we analyzed the development of the copper price in Shanghai and the inventories held at SHFE warehouses. In 2012 and 2013, a structural break took place and inventories at SHFE warehouses rose stronger as a model based on the development between 2009 and 2011 would have predicted. However, this development had not a major impact on the price of copper. Other factors explained the price development far better. It could not be ruled out, that the higher SHFE warehouse inventories were the result of stocks moved out of bonded warehouses.

Thus, doubts remain that the excess production of refined copper was absorbed by stocks held in bonded warehouses in China for serving as collateral in financing deals. Furthermore, it could not explain the decline of stock held in exchange warehouse inventories

While total exchange warehouse inventories decayed since the start of this year, stock held in LME warehouses declined by 195 thousand tons and remained almost unchanged in CME warehouses. At SHFE warehouses, inventories rose until the plunge of copper prices, and then also sunk from 213.3 to 92.7 thousand tons, which translates to a fall of 33.2 thousand tons since the end of 2013. It had been reported at the end of April that China’s State Reserve Bureau bought copper. However, according to the sources of the reports, the SRB bought from bonded warehouses. But this does not explain the fall of copper stocks at SHFE warehouses, unless the SRB also bought silently since mid-March copper in huge amounts held in bonded and exchange warehouses.

We have data for cancelled warrants only for LME warehouses. At the LME, the free available copper stocks plunged to a mere 92,650 tons at the end of this week. This is the lowest level since early April 2008. Copper is in a backwardation at the LME and the SHFE, which indicates that copper is tight and not abundantly available as estimates about a supply surplus would suggest. Our quantitative model for global total refined copper supply and consumption indicates that consumption would further exceed supply in this year. Structural changes can have a significant impact, which quantitative models do not incorporate immediately. Thus, we would not rely solely on quantitative forecasting models. However, the development of copper inventories in exchange warehouses, the backwardation and the results of the quantitative model increase our skepticism that the copper market will swing to a supply surplus in the magnitude forecasted by the ICSG. 

The End of the Silver Fixing

The announcement of London Silver Market Fixing Limited that it will terminate to administer the London silver fixing with the close of business on August 14, 2014, should not come really as a surprise. After Deutsche Bank already declared to withdraw from the fixings of gold and silver, only two bullion banks remained in the group conducting the silver fixing. When this decision was made public by Deutsche Bank, FCA board member, Mrs. Tracey McDermott, stated that the UK regulator could intervene if there were too few participants left in the London silver fixing.

In the media reports about the announcement, no reason was stated why London Silver Market Fixing made this decision. However, it is quite easy to guess what the major reason behind this move is. The risk of financial penalties by regulators or pending lawsuits – especially outside the UK - just got too high. In the USA, CFTC commissioner Bart Chilton called for investigations into the London fixings for some time already without having provided any evidence for manipulation of the London fixings or for misconduct by the bullion banks involved. Also the head of the German watchdog BaFin, Mrs. Koenig, accused Deutsche Bank of wrongdoing without presenting facts. The London fixing was discredited by foreign regulators. But now, they made a disfavor to many producers and consumers of silver.

In this blog, we have pointed out a few times, that the fixings of gold and silver are not comparable with the setting of the Libor benchmark rates. The London fixings are a price discovery procedure, which is based on real trading activities and not on estimates of what the market price might be. Furthermore, the bullion banks do not know how their clients might change the quantities they commit to buy or sell if a new price will be called in the fixing process. In addition, the procedure applied in the London fixings had also been used in the past at regulated exchanges.

The LBMA issued the following statement: “As part of our role as the trade association for the London Bullion Market, the LBMA has launched a consultation in order to ensure the best way forward for a London silver daily price mechanism. The LBMA will work with market participants, regulators and potential administrators to ensure the London Silver Market continues to serve efficiently the needs of market users around the world. As part of the consultation process, the LBMA will be actively approaching market participants requesting feedback.” Furthermore, the LBMA conducts a survey in the process of market consultations. Thus, the current system of price fixing in the silver market is coming to an end, but the search for an alternative system is taking place already.

What might be possible alternatives to the current London silver fixing? Silver is also quoted by many financial institutions on quote screens at Bloomberg or ThomsonReuters terminals or electronic foreign exchange trading platforms. One possibility would be to use those quotes sampled at a random time within a specified time span. Thus, traders would only know the time span, but not the exact time stamp. Then the quotes in the lower and the upper 25% percentile could be discarded and from the remaining quotes the average would be published as the new benchmark indication. However, such an approach would have the same weaknesses as the Libor benchmark procedure.

From our point of view, any substitute for the current London fixings should be based on real trades and not on quotes. Liquidity in the market is not the same at every point in time but varies during the day. Thus, a new reference price should be found when the liquidity is usually high in the market and this is the case in the afternoon London time. Furthermore, a new benchmark price should be found by trading taking place at one central location. In addition, the price should be set in an auction style procedure.

Spot trading in precious metals is usually OTC trading, but for the fixings, it is concentrated at one place where the price is discovered in an auction style procedure. If the current system has to be replaced without abandoning the advantages of high market liquidity, supply and demand concentrated at one location and auction for price setting, then moving the fixing to a regulated exchange is probably the best solution. This could be an electronic exchange but also an open outcry system. The LME is already fulfilling the requirements for a fair and transparent price setting for cash and forward transactions in base metals. There are ring sessions with settlement prices for transactions in the morning and afternoon. Moving the London fixings of precious metals to the LME ring trading might be the best alternative. Producers and consumers would be able to obtain the best price for larger quantities in trades at a regulated exchange. The procedure would be transparent and the precious metals market would still have benchmarks satisfying the requirements for reflecting the true market price.     

ECB gets ready for easing, negative for precious metals

All precious metals ended the week lower than the Friday before. Among the major fundamental factors of our fair value model, the slight increase of the US dollar index and the marginally lower S&P 500 index were negative for the precious metals, while the modest increase of the crude oil price should have been supportive. However, the major fall of the precious metals occurred last Wednesday after the speech of Mrs. Yellen at her testimony before the Joint Economic Committee of the Congress had been released.

The initial reaction in the stock market was negative, but also the precious metals headed lower. But as Mrs. Yellen stated that the US economy would need further accommodative monetary policy, the stock market recovered. Also the statement by Russian president Putin that military forces had been ordered to return back to their home bases supported the stock market and weighed on precious metals.

From our point of view, the major risk for gold and silver is biased to the downside. And the recent events and economic data in the Eurozone strengthen our assessment. The EU Commission presented the spring forecasts. The inflation rate in the Eurozone is expected to be only 0.8% this year and 1.2% in 2015, which is a slight downward revision. GDP growth is predicted to be 1.2% in the Eurozone in 2014 and should accelerate to 1.7% next year. The German economy is expected to be the locomotive for the Eurozone with a GDP growth of 1.8% this year. Slovakia and the Baltic member states are expected to post stronger growth, but these countries have only a smaller share at Eurozone GDP.

However, also the growth engine in Germany sputters. The volume of new orders in March was expected to increase by 0.3%, however, it dropped by 2.8% on the month according to the preliminary figures. Industrial production figures also disappointed with a decline of 0.5% on the month, whereas the consensus among economists predicted an increase of 0.2%. One could rightly argue that the monthly data is volatile and that a 3mth moving average would provide a better picture. However, looking at the chart below, there is a worrying development. The German manufacturing production reached the highest level since the start of the financial crisis in 2007 in July 2011. Since then, the index of manufacturing production hovered sideways. The industrial production including the construction sector exceeded the high from 2011 marginally in February, but this was mainly due to construction activity, which was up as the winter season was unusually warm. The volume of total new orders (excluding construction orders) did not even come close to the pre-crisis level when it peaked in early 2011. 

But two others points are striking analyzing the chart. First, Germany pushed through that other Eurozone member states suffering under the fall-out of the financial crisis had to impose austerity measures when the debt crisis hit the Eurozone. But the austerity measures did not only lead to a fall of economic activity in the Southern European countries, they also fired back on Germany, which is depending heavily. Second, the flow of new orders and industrial production only recovered after ECB president Draghi gave the pledge that the ECB would do whatever is needed to keep the single currency intact in July 2012. Also the decision to introduce the OMT program was helpful to restore confidence. But it was again Germany, which opposed this policy of the ECB.

However, restoring investors’ confidence that the euro would not fall apart and mitigating the financial stress of Southern Europe came at a cost. The euro recovered against the US dollar and some other major currencies. While this was initially welcome and also attracted foreign investors buying government bonds of the crisis countries again, the euro has now reached a level, which is negative for two reasons.

First, the strong euro hurts the competitiveness of many countries, especially of those countries, which compete with Chinese exporters. Many German exporters will be hurt less by the current level of the euro as their goods are not easily substituted by products of Chinese manufacturers, like luxury cars for example. But in Southern Europe, the benefit of lower wages could easily be lost by the foreign exchange rate movements. 

The second reason is the impact of a stronger euro on the inflation rate. About 10 years ago, the ECB welcomed a stronger euro as it helped to keep the inflation rate close to the target rate. However, now, the situation is completely different. In many countries, the austerity policy and a negative output gap weigh on the development of consumer prices. In some Eurozone member states, the inflation rate is already negative. A stronger euro exercises further pressure on import prices, which will feed through to consumer prices. Thus, a further strengthening of the euro would increase the risk of outright deflation in the whole Eurozone and not only in some parts of the currency area.

The finance minister of France called for measures to weaken the euro. In a typical Pavlov reflex, a spokesperson of German chancellor Merkel already rebuffed this call. However, ECB president Draghi shared the concerns of the French finance minister. While the council did not take any measures at the rate setting meeting this month, Mr. Draghi prepared the market for some policy measures at the next meeting. Another reduction of the repo rate might not be enough to weaken the euro sufficiently. We are still convinced that only some measures of quantitative easing could lead to a desired depreciation of the euro.

But it is again Germany, which voices criticism about further rate cuts or QE. The main argument against further monetary measures is that it would lead to rising real estate prices and thus causing a bubble. However, the situation in Germany is currently not comparable with the US or Eurozone member countries at the start of this millennium. For a bubble in the real estate market, two developments have to coincide: the house prices have to rise and this rise must be accompanied by a surge in construction activity. As the chart shows, the index of house prices in Germany meandered along a slightly declining trend for the first ten years of this century. But with the debt crisis, the flight of many investors into tangible assets led to a rise of house prices. However, this price increase was concentrated on a few urban regions. Nevertheless, more important is that higher house prices did not lead to a strong rise of housing permits. The rise of house prices reflects the scarcity of housing units in the favored cities, which cannot be easily increased by construction activity. Furthermore, for a bubble, house prices would have to exceed the discounted net rent income. This is not everywhere the case even in suburbs of major cities. As long as the rise of house prices is mainly driven by demand from tenants wanting to become the owner of their home, there is hardly a bubble to build.

Therefore, we come to the conclusion that the ECB will act to prevent the euro form firmer further. Just a rate cut would not be sufficient to achieve this target. Thus, even if the council decides not to embark on QE at the June meeting, the foreign exchange market will force the council to take QE measures rather sooner than later. But with the ECB easing and the Fed on hold, the economic outlook remains positive for risky assets like equities. Funds are therefore expected to prefer stocks over precious metals. This outlook would not be positive for gold and silver. However, the best friends for gold investors might be politicians taking the wrong measures endangering the still fragile economic recovery in the Eurozone.

Risk for gold and silver remains biased to the downside

Gold and silver ended the week again slightly lower. However, the PGMs rose once more as hopes for an end of the strike in South Africa were disappointed and the labor unrest continues. The two major economic events for the precious metals were the FOMC meeting and the US labor market report. But also the geo-political development in Eastern Europe played a role.

The decision of the FOMC to reduce the volume of monthly purchases of US Treasury notes and bonds as well of mortgage bonds by $5bn each should not come as a surprise. However, some market participants had feared the committee might express a less optimistic view about the US economy. This was not a rational assumption as the FOMC always stressed that the weaker economic data earlier this year was caused by the severe winter conditions in many parts of the country. According to the first estimate, the US real GDP grew at an annualized rate of 0.1% in Q1. This is still a remarkable achievement. The ISM manufacturing PMI increased further and came in at 54.9 after 53.7 the month before. Thus, the PMI rose stronger than the consensus of Wall Street economists predicted. It also indicates that the US economy expands again at a solid pace in the current quarter.

The FOMC decision and the economic data was well received in the stock market. Thus, it was not surprising that gold and silver headed lower for most of the week. But both metals pared most of the loss on Friday. One reason for the rebound was surprisingly the US labor market report. The number of new jobs created in April was far higher as expected. Instead of 215K additions to the payrolls in the non-farm sector, 288K persons found a new job. Also the figures of the two preceding months had been revised higher. Therefore, the pay-roll was about 100K higher than the consensus expected.

In addition, the unemployment rate dropped to 6.3% while the market expected only a decline by 0.1 percentage points to 6.6%. This decline was due to a lower labor force participation rate. However, we have pointed out several times that the baby boomers start to leave the work force as they retire. The negative part of the labor market report was the unchanged average hourly earnings. Some economists argued that this would limit the increase of private consumption. But the recent figures on personal spending released earlier in the week showed a strong increase of 0.9% on the month. The average hourly earnings of production workers increased by 0.2% on the month, which indicates that a broad part of the total workforce earned more and thus, could increase consumption accordingly.

Nevertheless, the labor market report was not well received in the stock market. However, it was not only the labor market report weighing on stocks and thus, helping gold and silver to recover. Also the developments in the Ukraine, especially in the City of Odessa, played a role. Safe haven government bonds pared the loss following after the release of the labor market report. German Bunds even returned back into the black. Also the precious metals profited from the flow into safe havens.

As long as economic data plays the major role, it seems that the risk for gold and silver are biased to the downside. This is also reflected by the development of gold holdings at the biggest ETF, the SPDR Gold Trust, which fell again in this past week by more than 9 tons to 782.85 tons. The release of the OSCE observers over the weekend might reduce fears of an escalating conflict in the Ukraine. This could be positive for stock markets and thus, weigh on gold and silver. However, as long as no peaceful solution is found, the geo-political developments could also lead to a (brief) rally in both precious metals.