It’s been a very real quandary facing the physical trade and industry, which awoke on Tuesday October 19 to find copper’s cash to November spread had flared to a backwardation of more than $1,010 per tonne. The spread has since moved back to near where it started 24 hours earlier, but the potential impact of that kind of price swing on the bottom line of a hedger is immense.

It’s one reason why the LME stepped in to impose a series of temporary measures designed to cool the market, including changing its lending guidance rules, limiting the backwardation and allowing deferred delivery of some positions.

The LME’s move comes as physical commodities merchant Trafigura finds itself in the spotlight amid allegations it had been responsible for a recent spate of copper warrant cancellations. Trafigura declined to comment.

To be clear: There’s absolutely nothing illegal about cancelling metal held in LME warehouses.

What the LME will have been keen to know is where the copper is destined for, who the clients are, what the rationale for the cancellations was, and whether the member was comfortable with its own and its clients’ actions.

In other words: Was this genuine tightness, or a good old copper market squeeze?

In theory, a backwardation – when spot prices are higher than future prices – attracts metal into exchange warehouses. But that hasn’t been happening to date; quite the opposite. The latest cancellation of warrants in LME warehouses means only 15,225 tonnes are currently available to the market – the lowest level since March 1974.

This is getting precariously close to the roughly 6,000 tonnes that the LME needs to be available for its users to meet their delivery requirements and, given recent stock moves, left the exchange one cancellation away from not having enough metal.

LME data shows that one participant owns 50-79% of exchange copper warrants. Now that it has imposed measures, the exchange’s actions will likely see copper cancellations pause while stocks remain so low.

Falling stocks
The dwindling level of LME stocks has highlighted another problem: It’s not hard to own half the exchange’s on-warrant copper when inventories fall toward zero.

This has been part of the conundrum facing physical market participants: leave metal in warehouses, become a dominant long position holder and trigger the exchange’s lending guidance; or take material out and see stocks fall further. This is what the latest change to lending guidance is designed to address.

But it’s a situation that could easily cross into other metals with low inventories; eyes have been on tin stocks for some time, while nickel and aluminium are also seeing stock levels trend lower. Tuesday’s measures by the LME will act as a warning shot across the bows of other metal markets.

For sure, metal will eventually come back to LME warehouses, but there is always a time lag which allows a market squeeze to develop before it vanishes almost as quickly as it appeared.

LME trade
Another piece in the puzzle is that the LME has made a permanent switch to electronic trade for its official closing prices, a move that brokers and their clients previously warned would create excessive volatility in the spreads.

The exchange’s electronic trading platform, LMESelect, does not have the technical functionality to replicate the exchange’s complex dates structure, market users argued, and ring dealers worked hard to create markets, add liquidity and guarantee closing prices to the trade and industry that depend on them.

Meanwhile, deteriorating trading volumes are exacerbating price moves, leading to additional volatility, they added.

Case in point: It took just 300 lots to move the cash to November spread from a backwardation of around $300 to settle at $1,060 per tonne, according to ring dealer Marex.

If the LME measures fail to make a difference, there will inevitably be a casualty – for instance, a consumer forced into trouble because its hedge book is totally out of sync with copper spread moves.

What next?

The problem now for the LME is that, based on recent copper market activity, the exchange’s reputation is being called into question by market participants who argue its flagship contract isn’t functioning properly.

That’s a major issue for any exchange, which can only operate successfully if it remains orderly, credible and relevant to its users.

Despite the link between futures contracts and the physical market, the exchange doesn’t have wide-ranging, proactive physical market monitoring powers. It included proposals to introduce them in its discussion paper earlier this year, and they were broadly rejected.

The current situation in copper will inevitably reopen the debate. Until it does, the LME will be forced to be reactive, closing the proverbial stable door after the horse has bolted, as critics say it did with its measures on Tuesday.

Of course, there’s an argument to be made that the underlying fundamentals of copper point to strong demand, boosted by unprecedented fiscal stimulus globally and the metal’s increased use in electric vehicles and the renewable energies required to decarbonize the global economy.

At the same time, copper – a market that has suffered from a lack of investment for years and has a limited project pipeline – has been facing disruptions due to the Covid-19 pandemic, in addition to a well-documented logistics nightmare that has caused mass disruption to supply chains worldwide.

Add to the mix threats to production from soaring energy costs, plus power rationing in China while the country weans itself off fossil fuels, and it’s something of a perfect, bullish storm.

Fundamentals aside, the potential implications of continued wild price moves amid declining stocks are immense, not just for warrant holders but also for the LME and its trade and industry members. As one seasoned metals market participant put it, in a situation like that, innocent hedgers risk being carried out on stretchers.

This article, by Andrea Hotter, first appeared on metalbulletin.com on Tuesday October 19.

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