Streetwise Professor

October 22, 2021

Back, Back, Back–And It’s Outta Here!

Filed under: China,Commodities,Economics,Energy,Manipulation,Regulation — cpirrong @ 6:06 pm

No, this is not a post about baseball, with an outfielder running to the wall only to watch a home run soar over his head. It’s about the copper market, where backwardation (a positive difference between the price for immediate delivery–“cash”–and a futures price) has soared, and inventories have gone yard.

The peak of the frenzy was Tuesday of this week, when at one point the cash-threes backwardation on the London Metal Exchange (LME) soared to $1050/tonne (them’s metric tons, y’all).

That was apparently an intraday price, because the official PM cash-threes back on that day was a mere $382.

The LME is unique in that it trades contracts for specific dates, and so there is a “tom-nex” spread too: the difference between the price for delivery tomorrow, and the price for delivery the day after that. Last Friday, this “daily back” reached $175/tonne–meaning copper delivered Monday was worth $175 more than copper delivered Tuesday. The tom-nex remained over $100 on Monday and Tuesday.

Backwardation on COMEX copper has also jumped recently. Here’s the October 21-January 22 spread(HGV1-HGF2).

Meanwhile, inventories have plummeted, declining to a mere 14,500 tonnes on Tuesday, down from around 250,000 MT in late-August:

So what’s going on? Let me first consider a fundamentals-based story.

The spreads between futures with different maturities for a storable commodity send signals on how to allocate resources over time. When demand is high/supply is low today relative to what is expected in the future, it is optimal to draw down inventories, and prices move away from “full carry” (i.e., spreads that cover the cost of carrying inventory) to incentivize this drawdown. With extreme (but expected to be fleeting) temporal imbalances, it can be optimal to consume all inventories and meet future demand out of future production (because future demand is expected to be lower or supply higher than at present). These extreme temporal imbalances lead to large backwardations to punish storage.

As an aside, that’s why this statement in a Reuters article is incorrect:

Backwardation is supposed to attract metal but this week’s deliveries into LME warehouses have so far amounted to a meagre 9,775 tonnes despite the biggest incentive in the market’s history.

No! Backwardation punishes stockholding–it’s an incentive to move stuff out to be consumed today rather than hold it into the future when it is anticipated to be more abundant.

In some respects, what is going on in copper is similar to what happened in lumber, which I wrote about some months ago. The lumber market went into a huge back due to tight fundamentals and inventories were low.

The good news here is that these price signals indicate that the extreme imbalance is expected to be temporary: copper is scarce today relative to what is expected to be the case some months from now. That’s pretty much what happened in lumber.

So why the temporary scarcity (relative to expected future scarcity)? One plausible explanation is energy prices, which are high now going into the high-demand winter season in the Northern Hemisphere. Due to supply responses that can occur in a period of months but also the seasonal decline in heating and power related energy demand, these prices are likely to fall. Metals refining is energy intensive, so such a rise in energy prices pushes up the metals supply curve today relative to what’s expected in the future: this can produce exactly what we’re seeing in copper, and is also becoming evident in zinc, nickel, and aluminum.

China is of paramount importance in metals refining, so the artificial shortage of power there (caused by price controls and high fuel prices) is exacerbating this problem. Power cutbacks to intensive energy consumers are exacerbating the short term supply disruption.

This points out how the world is hostage to Chinese policy–and Chinese policy mistakes. China has become so important in this area not because it sits atop large, cheap supplies of ores. Low labor costs made it cheaper to locate refining there, even taking into account transport costs. But also, Chinese subsidies of various sorts–financial suppression that makes capital cheap and subsidized power prices–have attracted arguably excessive amounts of capital to metals refining there. And add to that the relative indifference of China to pollution–and metals refining can pollute the air, the water, and the earth: lower environmental standards lead to lower costs and a great incentive to locate production in China.

The fallout from a concentration of metals refining capacity in China is reverberating around the world right now. Not just copper but a variety of metals are going haywire because of the energy-driven supply disruptions in China. Magnesium is just another example.

The former is a fundamentals-based story (albeit one in which central planning has distorted the fundamentals). Is this all that is going on?

Corners can also cause soaring backwardations. The LME was sufficiently concerned about the situation in the market to impose a limit on the amount of daily backwardation to .5 percent of the cash price (which is still a 180 percent annual rate boys and girls). The cash-threes backwardation has fallen by almost two-thirds (to $116/MT today) in the days since.

Fingers have been pointed at Trafigura for loading out large amounts of inventory, thereby exacerbating the tightness. Trafigura says it did so to meet obligations to customers. This would be consistent with the fundamentals story.

But . . .

It is not unknown for firms with large inventory holdings to remove them from the LME to create an “artificial” tightness, or to provide a cover story for a corner. Moreover, if a single firm owns enough inventory to be able to deplete stocks materially on its own, it doesn’t take too large a paper position for it to have a literal corner. Or even if one firm hasn’t cornered, a small number of firms with large physical and paper positions can have a nice little oligopoly that allows them to exercise market power, of which large backwardations are a symptom–and a source of profit. Think of how much money the holder of a large prompt position could make rolling that over at $100+ per day, day after day.

Put differently, fundamental tightness can create market power, and the exercise of this market power can greatly exacerbate backwardations.

The sharp drop in the cash-threes back after the LME intervened lends some plausibility to this explanation. However, a definitive diagnosis requires a deep dive into who was doing what that is not possible based on currently available public information. I am just laying out possibilities here.

Exercising market power in a tight market is sometimes referred to as a “natural corner” and has given some firms that have exercised market power a “get out of jail free” card in the United States.

I’ve just completed a paper on “natural squeezes” that critiques this flaw in US manipulation law. I’ll post it soon.

But when all is said and done, what is going on in copper now is possibly such a natural squeeze: a temporary tight supply and demand situation exploited to exercise market power. Maybe someday we’ll find out.

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  1. ‘This points out how the world is hostage to Chinese policy–and Chinese policy mistakes.’

    The Economic Consequences of Mr Xi.

    Tangential I know, but what is happening in China is quite eye-opening. All of a sudden President Xi has started ‘acting out’ all across the policy spectrum. Is he spooked by something or is it all part of a plan? Any insights as to what is going on? Conjectures welcome.

    The way production and logistics are structured Xi is going to continue being consequential well into 2023, it seems.

    Comment by Ex-Global Super-Regulator on Lunch Break — October 23, 2021 @ 3:29 am

  2. SWP:

    Some years back you linked to a Chinese market analyst, who also tinkered around the edges of CCP policy. But I forget his name. What good China sources do you cite? There is so much disinformation there that only the intrepid go there. And since the ‘fall of Hong Kong’ for all intents & purposes, there is a HUGE risk in reporting from on the ground anywhere in China, it would seem.

    Be well,
    VP Vlad

    Comment by Vlad — October 30, 2021 @ 7:09 pm

  3. @ Vlad–The people I pay closest attention to on the economics of China are Michael Pettis and Christopher Balding. Pettis in particular provides deep dives on the bizarre Chinese economic model.

    Hope all’s well.

    Comment by cpirrong — November 1, 2021 @ 1:54 pm

  4. the worst is the commercials on television to buy gold will just increase.

    Comment by Jeffrey Carter — November 2, 2021 @ 7:35 am

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