Streetwise Professor

June 15, 2024

What, Me Worry? Certainly Not About a Physical Copper ETF

Filed under: Commodities,Derivatives,Economics,Exchanges,Regulation — cpirrong @ 3:48 pm

Javier Blas is in a tizzy about a new ETF that will hold physical copper. He shouldn’t be.

He says:

Might the copper market suffer a similar squeeze [to the Hunt episode of 1980]? Until now, I would have been confident in saying no. But speculators are about to get an easy and completely legal way to dominate the market for the red metal — a development that regulators seem far too relaxed about.

Bloomberg

Why not worry, let alone panic? Many reasons.

First, I don’t know where Javier has been, but this is hardly a new development. There have been physical copper ETFs around for over a decade: I addressed a similar moral panic that erupted when that was introduced. There are also physical ETFs in other metals. The scare scenario has not transpired in all that time.

As I say every time I teach about speculation (as distinct from manipulation), what is necessary for it to distort prices is that it must somehow distort the physical market, that is, distort supply or demand. The doom scenario outlined (“As more money pours into the new fund, more copper will need to be stockpiled as backing”) seems to envision a distortion in supply. Specifically, uneconomically withholding stocks from the market.

First of all, that scenario assumes really dumb money. I mean really dumb. Buying shares in an ETF that will turn around and buy physical copper and add to inventories at a time when inventories should fall (thereby causing spot prices to be too high) means buying high and selling low. Indeed, the market is likely in backwardation under those circumstances, and in that case prices tend to trend down–and everybody can see this. Not a good investment strategy! One almost guaranteed to lose money. Yes, maybe there are lemmings, greater fools, etc., but such people would be perfect short bait. (Though maybe Roaring Kitty will make copper ETFs a meme investment!)

The Hunts (mentioned in the article) are example of how irrational stock building and holding ends in tears. As I joke in class, the Hunts are the poster children for the old joke: “Want to make a small fortune in commodities? Start with a large fortune.” All because they propped up the price of silver by accumulating ever-expanding quantities of physical silver.

Another example that may be even more on point is the International Tin Council, which tried to imitate OPEC in the worst way–and succeeded. Rather than restrict output (a la OPEC) it tried to inflate prices by offering to purchase tin at supercompetitive prices. It ended up accumulating vast amounts of tin in storage, and when the money to keep buying tin ran out the price collapsed and the ITC suffered huge losses–and almost brought the LME down with it. (This is the so-called “Tin Crisis,” not to be mistaken with the LME’s “Nickel Crisis” of 2022).

In my 2012 post on physical metal ETFs, I wrote that one mechanism that would also limit the potential distortionary effects was that if such an ETF were uneconomically maintaining excessive physical stocks, someone could buy shares of the ETF, and tender them in exchange for physical metal, and then liquidate the stocks so obtained. That is, the ETF’s management could not unilaterally withhold stocks from the market.

If you look at the Sprott prospectus, you might conclude that use of that mechanism is highly restricted: there is an option to exchange shares for metal, but it can be exercised only on a semi-annual basis.

However! Elsewhere the prospectus says:

The Trust will have the ability to optimize the value of the Trust through Copper optimization transactions, including the use of futures, warrants, CME or LME warehouse receipts, and other financial
instruments [swaps? options?] to complement the Trust’s Copper procurement strategy, so long asthese transactions provide value to the Trust.

So this isn’t a pure copper piggy bank for shiny pennies or the cathodes you can make them from. If the fund is managed to maximize value, it will trade its physical copper optimally, and reduce stocks when the price signals indicate this is optimal. For example, it could sell inventories outright and replace the copper exposure with futures with deferred expiration dates. Or it could engage in spread transactions that are common on LME, e.g., selling cash and buying three month or 15 month or whatever futures.

In this respect, the ETF is really more analogous to a hedge fund. It’s managers have a lot of trading discretion within the copper space. In this respect it is very different than other commodity ETFs (e.g., the US Oil Fund) which have virtually no discretion.

Indeed, it is my sneaking suspicion that the fund’s restriction on withdrawals of metal is due precisely to the fact that it will essentially be engaged in fractional reserve banking, as it were. That is, its potential obligations to deliver will exceed its holdings of physical metal because its “optimization transactions” will involve accumulation of large paper positions, and its notional tonnage will exceed substantially its actual physical holdings. This restriction is analogous to the restrictions on withdrawals that hedge funds impose on investors–another point of tangency between this ETF and hedge funds.

Furthermore, even if the money is dumb and the managers are too (or are like Scrooge McDuck and just enjoy frolicking in their shiny stash), it can only distort supply to the extent its physical holdings are somehow pivotal, and/or there isn’t a lot of competition among those holding copper stocks. If total stocks should fall by X, as long as enough others collectively hold more than X they can supply that copper to the market even if the Sprott fund ignores the price signal and keeps a death grip on its physical holdings.

As for “cornering,” here Javier is playing fast and loose with a loaded term. The word (and squeeze, also used in the article) connotes manipulation. Manipulation is intentional conduct. Under US law in particular, it is conduct that involves a specific intent to cause “artificial prices.” (The Frankendodd revisions of the Commodity Exchange Act and CFTC regulations issued pursuant thereto have new provisions that arguably weaken the intent requirement, but it remains in Section 9).

Yes, an ETF that can take physical ownership can corner whereas a purely futures ETF that cannot own physical cannot. (I’d also note that a fund that holds ONLY physical metal cannot engage in market power manipulation either, or at least is guaranteed to lose money if it tries). But using the “optimization transactions” in futures to manipulate a market crosses a legal line, and indeed, a line that has been in place for over a century. That is something regulators (and market participants who have private right of action under the CEA) would be very unrelaxed about.

Moreover the incremental manipulation potential posed by this ETF is likely small. Manipulations have occurred in copper, and the industrial metals, from time immemorial. Remember Sumitomo? There have been other though less severe and shorter lasting cases of likely manipulation on the LME in the decades since. The proximate cause of the Panic of 1907 was a copper squeeze. Right now with all of the hedge fund money out there, as well as the big physical players, the potential for market power manipulation is omnipresent. Sprott will be a minnow in this ocean that already has a lot of big sharks.

I also chuckle at this concern about cornering. I excoriated Javier Blas severely for his failure to see that yes, a hedge fund–Armajaro–cornered the cocoa market in 2010. Indeed Javier seemed to have a man crush on the eventually disgraced head of the fund, Anthony Ward (AKA “Chocfinger”). One of my posts suggested they get a room. (Ward’s karma came a few years later when he bet wrong in the cocoa market, and Armajaro–which had taken delivery of enough beans to make billions of Hershey Bars in 2010–was sold for less than the price of one of these).

So I reprise my 2012 Alfred E. Neuman persona: What, me worry? Well, certainly not about a physical copper ETF.

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7 Comments »

  1. Interesting.
    In the long term normal economics wins. Demand and supply.
    For the near future demand for copper is likely to rise, because connecting the grid to all those faraway windmills and solar panels requires a lot of copper.
    Then (2030? 2037?) people wake up and realise that renewables are a crock (and not even renewable) the demand for copper will collapse.
    Predicting the inflexion point, as Barbie says, is hard. But not higher math.

    Comment by philip — June 16, 2024 @ 4:13 pm

  2. “Predicting the inflexion point”: why would you want to predict the inflexion point rather than the turning point?

    Or do you mean “inflexion point” in the modern American sense of ‘something or other to do with curves but it sounds quite high-tech and who cares what it means?’

    Comment by dearieme — June 17, 2024 @ 3:32 am

  3. Touche, dearieme.

    Maybe I was thinking of up or down, not left or right.

    Comment by philip — June 17, 2024 @ 11:28 am

  4. Here is a case today where CFTC says manipulation of the physical market led to an unjust profit in a derivatives position: https://www.cftc.gov/PressRoom/PressReleases/8921-24

    Comment by David Mason — June 17, 2024 @ 11:48 am

  5. @David. But its positions were not restricted to the physical market, which was the point I was making (that a physical only player could not profitably manipulate). Trafigura allegedly made physical trades to benefit a derivatives position. Per the CFTC press release:

    The order further finds that Trafigura manipulated the benchmark price of U.S. Gulf Coast high-sulfur fuel oil throughout the month of February 2017. From approximately January to March 2017, Trafigura developed and deployed a large fuel oil export program designed to export fuel oil from the U.S. Gulf Coast to Singapore in order to profit from an observed open arbitrage for fuel oil. In connection with its arbitrage strategy, Trafigura established a long derivative position in U.S. Gulf Coast high-sulfur fuel oil, in part as an economic hedge for its anticipated purchases of physical fuel oil to export to Singapore. However, the long derivative position Trafigura entered was in excess of its short physical position that resulted from its intent to buy fuel oil in the U.S. Gulf Coast for arbitrage—the excess essentially constituting a long speculative bet on fuel oil prices in February 2017.

    Distorting the physical market to benefit a paper position is the basic market power manipulation strategy.

    Comment by cpirrong — June 17, 2024 @ 2:20 pm

  6. I’ve heard people claim the Hunt’s undoing was the result of the Comex changing the rules (liquidation only) to benefit the dealers who were long physical, short futures and getting killed on the futures margin. How much truth is there to that claim?

    Comment by Andrew Stanton — June 19, 2024 @ 9:44 am

  7. Enlighten me prof.
    Producers / consumers / transformers enter the futures market to ensure their primary commodity cost is foreseeable. (Bakeries, airlines, etc,)
    They expect to lose. It’s like an insurance premium.
    Brokers / speculators have more knowledge / smarts and expect to win, by analysing the whole market.
    At some point the consumers find the premium a bit high and invest in their own market analysis. (BP does this very successfully.)
    So the market in the end balances out.

    I don’t see how more complicated derivatives and fancy pants trading changes this basic equation.

    ???
    caveat emptor?

    Comment by philip — June 20, 2024 @ 5:29 pm

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