Commodities | Jan 15 2009
By Rudi Filapek-Vandyck
Investors might be excused for thinking they’d entered a complete new universe when the new calendar year opened with strong upward momentum for prices of base metals and other commodities, crude oil and copper in particular. Crude oil has already retreated far more than its price gained in the early days of the new year, for copper, however, so far the upward swing has lasted longer.
The question now is: will copper follow the example set by crude oil?
Let’s have a look first at why copper prices staged the robust performance they did throughout the first two weeks of January.
According to market watchers, hedge funds had entered 2009 while carrying very large short positions. This made a lot of sense given economists were predicting scheduled releases of economic data across the world would likely continue to be “horrible” and with forward looking indicators still on a deteriorating path. In other words: the global economy is in deep trouble. This cannot possibly be good news for base metals, copper in particular, as the red metal serves as a widely accepted barometer of global economic health.
Data from China have been deteriorating further through December and early January as well. Even more ammunition to justify being short!
However, a reshuffling of commodity indices, of which the S&P GSCI (Goldman Sachs Commodity Index) and Dow Jones-AIG Commodity Index (abbreviated as DJ-AIG CI) are the most important ones, injected a whole new dynamic into the market, and it was one that forced those shorts to start buying rather large amounts of copper.
Specialists at Fortis Metals have calculated these two indices represent close to 90% of all funds tracking commodity indices, with the combined assets under management (AUM) of these funds around US$100 billion (down from US$200 billion in July 2008).
One can imagine when these funds start shifting and re-allocating, spot and futures prices will move. And so they did.
Market watchers at Barclays talk about “precautionary covering” ahead of the pending index changes. They have little doubt this, and not any improvement in overall sentiment or economic circumstances, has been the main driver behind movements in copper prices thus far.
A few words about both indices.
The S&P GSCI is the largest commodity index, with an estimated US$60-65bn in assets under management (AUM). Its re-balancing has been implemented between 8 and 14 January. Index weightings are selected based on a rolling 5-year average of production (not price!) for each commodity.
DJ-AIG CI represents an estimated US$30-35bn in AUM. Its changes have been implemented between 9-15 January. Some commentators believe, however, the rebalancing of the DJ-AIG CI is likely to have had a bigger impact than changes made to the composition of the S&P GSCI because changes to the DJ-AIG CI are based on price; rolling 5-year US dollar value averages form the basis.
What this means, is that even assuming target weights remain unchanged, rebalancing still occurs based on the relative price movements of the underlying commodities. What in practice happens is that funds exposure to outperforming commodities is decreased while exposure to underperforming commodities is increased.
Of course, what the above paragraphs suggest is that funds rebalancing should come to an end tomorrow.
Time to go short copper?
Well, if anything, global economic data are still surprising to the downside and this week has seen data releases in China, Europe and the US continuing this pattern. No surprise thus, copper inventory levels have been rising sharply. Total exchange stocks are up 50kt since the start of the year, following on from a 68kt increase for the whole of December. Just as a comparison: between December and January last year, copper inventories fell by almost 29kt.
In addition, and this is taken as a bonus-bearish signal by quite a few market watchers, the recent price rallies have taken the price of copper back above marginal output costs once again. Most other LME metals prices are still trading a long way below that level. Put simple: copper is carrying the largest downside potential.
Conclusion drawn by resources specialists at Barclays this morning: “nearby copper looks a rather tempting short just now”.
As with everything, it’s not only doom and gloom that is shaping the future for the benchmark industrial metal. Some positives are occurring, but they are unlikely to have much of an impact right now. Producers are still reducing available product with around 100kt of mine closures having been announced in recent weeks, predominantly from locations in the African copper belt.
Also, secondary refined output is now falling because of scrap shortages due to price volatility and lower generation. This, say experts, is contributing to recent strength in Chinese metal imports.
And overall inventory levels, while rising steadily, remain low on a longer-term historical view. There are quite a few experts around, at Barclays for instance, who believe that once the overall economic picture does show promise again, copper prices could potentially jump back up strongly.
But when is that going to happen?
Barclays seems to have a modestly bullish view, forecasting this reversal of fortune could well come as early as the second quarter of this year. But such scenario would be “at the earliest”.
Short, for now, seems but the logical thing to do. (Similar as for crude oil, by the way).