One of the most frequently discussed features of this year's demise of risk-on/risk-off markets has been copper. As can be seen on the chart below, the red metal disconnected from both AUD/USD and the S&P 500.
Several explanations have been put forward: the weakening of the "assetification" of commodities, the growing discrepancies between commodities whose prices are more driven by supply than demand, the relative strength of the USD, the unbundling of growth performances of developed and emerging economies - the latter being plagued by balance of payment imbalances (Brazil), inflation (India), growth model switching (China), and Fed tapering (all of them).
Over the last few weeks, copper and base metal prices have increased in the wake of better economic data, particularly in China. Technicals also seem supportive, with rising physical premium (premium charged for physical delivery) and re-stocking (see the chart below based on an estimate of bonded warehouse in China).
The question now is whether copper prices are driven by the overall improvement of the global economy or by a temporary re-stocking.
Higher physical premiums are generally a bullish signal for commodity prices. As demand for the metal rises and warehouses are slowly depleted (LME rules put some constraints on the pace of "load-out," that is, inventory reduction), the premium paid for physical delivery at a specified location increases. This is obvious in the chart below, but the sharp increases in LME cancelled warrants (% of total inventories earmarked for delivery) and the associated widening of the physical premium are rather unusual.
High physical premium are generally associated with tight supply of a commodity. Yet, global copper stocks have only declined marginally and remain close to their historical high, especially in the West. The usual suspect for this apparent paradox would be financial deals.
Cash and carry strategies (buy spot, carry the cost and sell forward) are linked to the slope of the commodity futures curve. Positive steepness (contango) generally comes along with depressed spot prices. As it generally happens when the economy is weak, interest rates are also low (central banks cut their repo rates). This provides a strong incentive for carry strategies - something that happened on a wide scale in the post-2008 era. The supply glut of commodities combined with the weakness of industrial demand also reduces the physical premium. As a result, high inventories come along with a low physical premium.
This time it's different: the physical premium is high while inventories are apparently high. Is it because a huge amount of metal is stuck in financial deals and cannot be removed? Or is it linked to the sharpness of the economic recovery? Or, from another perspective, is it due the growing concentration of inventories which would make a load-out slower on a global scale.
I would not give too much credence to the first explanation as copper's contango is not wide enough to cover financing and storage costs even though several warehouses have provided incentive (lower) fees. As I will show below the global economic recovery is genuine but fragile. A more plausible explanation comes from the concentration of storage that generates a squeeze: it might be that gains do not come from financial deals but rather from rental fees and the possibility to gain on physical premiums.
Physical premiums are high because of a glut in warehouses. Spot prices have rebounded following better growth data. Is there still potential for higher prices?
I start by comparing the 3-month return of copper prices to a weighted surprise index. The chart below shows that the recent move in copper prices is completely consistent with the recent growth surprises recorded globally. This is good news for investors who continue to believe that demand still matters for the red metal, as the supply side of the market had become the main driver: supply disruption, ore grade decline, high inventories, new mines completed. Nevertheless, the surprise index remains low. Given that global growth is gaining momentum, what kind of target can we get for copper?
The chart below shows the relationship between global PMI (weighted according to the marginal demand of copper from each economic area) and copper prices. It shows that on a 3-month basis, copper has failed to catch up with the broad economic picture. On a 6-month basis the picture is even more impressive. It would suggest much higher copper prices ahead ($7,500 should be a good target in the short run then above $8,000 at the end of this year).
Even though copper prices and physical premiums rebounded together, they are both driven by different factors. Of course, China plays a role both in terms of renewed optimism for global growth (spot price) and inventory building (cancelled warrants and geographical arbitrage), but the widening of premium is much less a reflection of better growth ahead than a squeeze in warehouses.
Nonetheless, and in spite of the upcoming risks (Fed taper, debt-ceiling, banking union, European Commission audits, German elections, potential halt in Japanese growth (despite extraordinary measures by the BOJ), and lackluster (albeit somewhat improved) data coming out of Europe, all in a context of uncertainty in EM countries) copper has still some potential to catch up.