COMMENT: Changing settlement structure gives cause for an exchange-traded copper premium contract
China copper buyers and sellers can now speculate on or hedge out forward premiums without signing long-term contracts.
For several years market participants have been seeking different methods to reduce premium risk and compensate for the delta between fixed, year-long premium contracts and the more volatile, often lower spot market.
Now an exchange-traded contract will offer another tool for copper companies to hedge these risks.
CME Group announced during this year’s LME Week that it will launch a new copper cif Shanghai premium contract based on Metal Bulletin’s assessment, which will begin trading on November 20.
The move to an exchange-traded Shanghai copper premiums contract reflects how the market has changed since 2014.
Losses in long-term contract
Before going back to 2014, let’s review this year first.
When market players in China signed 2017 long-term supply contract at $72 per tonne, most of them believed it was a reasonable level, especially if you consider it was a 27% year-on-year cut.
But as the year developed, most buyers found the popular annual rate to be more expensive than the spot physical market.
As of October this year, Metal Bulletin’s cif basis Shanghai copper premiums have averaged at $57.89 per tonne, 24.37% lower than the 2017 benchmark of $72 per tonne.
Metal Bulletin learned that most buyers who signed long-term contracts were losing money when judged against spot, though thanks to a contango structure on the futures market, some of them just managed to break even.
And 2017 was not the worst.
According to Metal Bulletin’s historical data, the annual average spot copper premium for 2016 was $61.93 per tonne, 24.48% lower than the 2016 benchmark; while 2014 and 2015 spot average was 21.49% and 15.85% lower than benchmark levels, respectively. (Note: 2014 average is a combined average of in-warehouse and cif assessments as Metal Bulletin launched a separated cif premium in 2015.)
Call for shorter-term settlement
Due to the losses from long-term deals year after year, more companies were calling for shorter-term settlement, so that deal prices would be much closer to the spot level.
In came the floating pricing system, which can be either on a monthly or quarterly basis. Under this system, the seller and buyer will reach an agreement on tonnages first, while the settlement price will be based on third parties’ average assessments.
BHP was the first pioneer of this pricing system, and introduced floating settlement in its cathode contract in around 2010.
However, a wider-scale change has started over the past three years - after buyers faced these comparative losses for years, and companies began to enforce stricter risks control measures over their metals businesses.
In 2017, China’s largest copper cathode supplier, Codelco, joined the floating settlement club, further widening the usage of this new pricing system, and more players – including trading houses – followed suit.
Market participants believe shorter-term contract settlements will continue to be popular in 2018 and the following years as the market looks for more flexibility on premium price and risk control.
The launch of CME’s cif Shanghai copper premiums contract, which allows market players to hedge or speculate on market premiums 18 months forward, means greater transparency over premiums pricing, and allows greater hedging flexibility.
A contract structure based on calendar months also meets buyer needs for different shipment periods.
As the copper market shifts from a surplus to deficit between 2018 and 2020 due to few new mining projects, more volatile premiums are likely in the coming years. The new tool could also offer more options for market players to bet on a futures market for copper premiums.
History of Metal Bulletin’s cif Shanghai premium
Metal Bulletin’s cif Shanghai copper premium was officially launched at the beginning of 2015, and the assessment is updated on a daily basis.
Before 2015, cif basis premiums were priced in tandem with in-warehouse Shanghai copper premiums.
The decision to split the two premiums was made after we noticed the gap between warrants and ocean cargoes remained wide or were getting wider during the second half of 2014 compared with previous years.
A key milestone in this trend was the Qingdao scandal that happened in June 2014. Metal Bulletin revealed that metals, including copper and aluminium, at Qingdao port were found to have been pledged several times using receipts to secure loans from banks.
Fears from the probe quickly spread in the market and banks stopped financing business using warehouse warrants.
Copper was a perfect metal for financing due to its wide usage in different fields and easy storage. This meant banks’ preference for copper created a differential between the value of warrants and bills of lading, and premiums for the two cargoes diverged.
Due to Metal Bulletin’s quick response to market changes, the first separate cif basis Shanghai copper premium was launched in the market, the price is now widely used as a reference in transactions and floating contracts.