The real reason the copper price is being crushed

The real reason the copper price is being crushed

Kenneth Hoffman Bloomberg Intelligence: At the end of the day price is the final arbiter

The turmoil on Chinese share and currency markets, and worries about the true extent of the country's economic slowdown continue to rattle investors.

Given its widespread use in manufacturing and construction coupled with the fact that China consumes 45% of the world's supply, copper has been bearing the brunt of this bearishness.

On Wednesday in New York trade December copper contracts were trending weaker again after breaching the key $5,000 level yesterday for the first time since the global financial crisis.

Bloomberg Intelligence analyst Kenneth Hoffman spoke to MINING.com after returning from a tour of China to find out the true state of copper demand in the country.

Hoffman has been visiting China for the past twenty years and in 2015 saw a sea-change in sentiment inside the world's second largest economy:

"A few years back the analysts and companies in London started to get more and more concerned. Then it sort of spread to Canada and slowly moved to Singapore and Hong Kong.

"China up until late last year was pretty optimistic.

"When I went in April there was a decided change in the mood. On this last trip I was really surprised how negative sentiment has become. I was often asked: "What is a bullish thing you could say?" Everyone was just so bearish and concerned about what was going to happen."

The real reason the copper price is being crushed

Pile 'em high

Beijing, under Xi Jinping particularly, is determined to move away from an economy based on infrastructure investment and heavy industry to one led by consumption and services: "This strategy has been firmly in place for five years – and you've seen copper go from $10,000 to $5,000 over this time."

Hoffman says it could be a very painful transitions and may take longer than expected: "I asked many analysts and traders in China how long can the downturn last? And it ranged from three years to ten years."

While worries about the slumping economy has been around for longer, the drop in equities which has wiped trillions of the market value of stocks has come as a real shock to Chinese sentiment.

In its report Bloomberg Intelligence says the mood of Chinese metal traders is closely linked to the performance of equity markets. Expectations are that the government would be able to stabilize stock markets over the short term (although this week's fresh falls put that in doubt) and that copper has been oversold. However, "slowing growth is leaving them bearish on long term demand."

Bloomberg Intelligence expects Chinese copper demand to fall by 2% to 4% in 2015 with the main drivers sharply declining construction markets which account for an estimated 30% to 40% of copper use, flat to lower auto production at 10% to 15% of demand and slow growth in infrastructure spending.

Most investment banks and research analysts are still forecasting a positive growth rate (although those have also been steadily lowered this year), but Hoffman says with all the big drivers down a contraction "shouldn't be a big surprise to anybody."

With regard to the supply side what concerns Hoffman is that "you've had a lot of price-positive supply side events in copper. Power in Zambia, strikes, high arsenic levels in Chile, bad weather. Yet you have the copper price down by 20%."

And with 1.5 million new tonnes hitting the market this year and the same supply growth in 2016 according to Bloomberg, the good news on supply constraint may be over.

Elevated inventory levels also have something to do with the price slide.

LME inventories have risen over the past year to above 350,000 tonnes (but are down more than 40% since its 2013 peak), Shanghai Futures Exchange stocks after a big drop has now climbed back above the 100,000 tonne mark and bonded warehouse stocks inside China hold some 650,000 tonnes according to Bloomberg data.

But that's not enough to explain the depth of today's bear market following a 17% slide in 2014 and 19.5% slump so far this year.

China's unreported copper inventories are key to understanding global metals markets says Hoffman, but the extent of these undisclosed inventories of copper – tied up in financing deals or held in various forms of ore, cathode or semi-finished products – are impossible to measure.

Inventories that go unreported to the government are stored in warehouses holding hundreds or thousands of tonnes that are scattered across the country. And it could hold a magnitude of the stocks visible to the market.

Hofmann says people would literally stack copper in their garages and hold as little as 50 tonnes or 100 tonnes: "There's just no way to know what that number is. It's an impossible number. When it comes back into the market you know it's there."

One reason commodity backed financing deals – usually carried out in China's vast shadow banking system – are so popular is because it is highly lucrative.

Or was. Until the People's Bank dropped a currency bomb last week.

"The devaluation of the yuan is really going to crush the carry trade," says Hoffman.

"The carry trade goes like this: I take my metal, go to the bank, borrow dollars or yuan outside the country using the bank as a throughput and the metal as a backstop and invest it inside China for a much higher interest.

"You're borrowing at 1% and you're investing locally at 12% or 13% pretty much guaranteed. That's a great deal".

The Bank of International Settlements (the central bank of central banks) estimates the amounts tied up in the carry trade in China at $850 billion. Hoffman believes the use of metals like copper, nickel and gold as part of the carry trade and other financing deals may be greatly underestimated.

Hoffman says he's aware of a copper facility that grew inventories from 50,000 to 200,000 tonnes: "The owner told me the only reason I did that is because I make so much money off the carry trade I don't even care about making the pipes."

"We'll only find out how much metal was tied up in those deals when it hits the marketplace.  But in a declining price environment it can quickly become a death spiral."

As the commodities fall in value, banks may demand additional collateral or the sale of the metals to satisfy the loan. Borrowers then may choose to walk away, leaving lenders to decide if and when to liquidate the collateral inventory.

The unwinding of the carry trade making visible this inventory will have other far-reaching implications.

It would force a recalibration of the assumptions of mining companies and a rethink of what the underlying Chinese metal demand really has been all along says Hoffman.

And the answer to how much metal was simply being channeled into shadow banking  may not be something anyone wants to hear now that overall Chinese growth is slowing.