Forward Guidance And Commodity Premiums

Includes: DBC
by: Evariste Lefeuvre

Inventories of many base metals have soared to historically high levels in the aftermath of the Great Recession. In spite of a depressed demand backdrop (slow recovery and China doubts) the impact on spot prices has been limited. If history were a guide, the level of inventories would have driven spot prices below the cost of production. This would have led to a downward adjustment of production, eventually bringing the market into equilibrium.

There are many reasons why this did not happen

1. Inventories are no longer a good indicator of availability. For many metals, the link between the weekly use (ratio of consumption to inventories assessed in weeks for instance) and the spot prices has vanished over the last decade. Many attribute this disconnect to the so-called "assetification" of commodity prices and the growing share of ETFs, CTAs, Hedge Funds and institutional investors in the commodity space. I only marginally agree with this, as the asset under management for base-metal-linked ETFs is very small. I would not use the recent disconnect between stock and commodity prices as an alternative explanation, as it was valid in the early 2000s, long before investors were blamed for skewing commodity prices upward (the disconnect is a sign that fundamentals - and supply- play a much stronger role today).

2. Also, many investors have favored another kind of strategy for metals, namely financial deals (also known as carry strategies). In the aftermath of the crisis, the futures curves of many metals (zinc and aluminum) have shown a steep contango (upward sloping crisis). Copper may be the next victim.

Contango refers to a situation where the future price of the commodity is above its spot price. The equation is as follows: F = S (Rf + Cs - Yc)

Rf stands for the risk free short term interest rates (Libor), Cs the cost (or rent) fee for storage, and Yc the (unobservable) convenience yield. The later was so negative after the crisis (low industrial activity, availability of the metal) that the contango was much higher than the sum of the interest and storage costs, which pushed many investors not only to enter financial deals but also to enter commodity warehousing activity.

3. As huge quantities of metals were locked in financial deals, inventories were no longer a good indicator of the availability of metal. This is why the stock-use/spot price relationship has weakened.

4. There is also a specificity of metal storage: the rules on load-outs of LME warehouses. To avoid volatility in commodity spot prices, warehouse can deliver only a small portion of their inventories daily. Stocks earmarked for delivery (the so-called cancelled warrants) will face long queues. This will not only provide additional rental revenues for warehouse owners but it will also increase physical premiums - the price paid on top of LME price by consumers to receive metals.

5. The impact might not affect consumers' profitability but can distort the price signal sent to producers. With premia making up to 10% of the spot prices (aluminum), medium range producers have been able to survive and the expected curtailments in supply have not taken place.

6. The other impact has been the lower reliability of the signal sent by physical premia. If the premium is more a signal of long queues at warehouses than an early indicator of demand, the forecast of price action is clearly much harder.

Recent actions have been taken to reduce the queues with higher load-outs for aluminum storage houses. This will reduce queues but some kind of bottlenecks will remain. This may also push warehouse owners to increase their rental fees to make up for the lost income.

7. What lies ahead is a (limited) increase in the availability of metal, higher rental costs and - in spite of the Fed's endeavor to flatten the money market curve with forward guidance -higher short term interest rates. This all leads to a much higher contango.

Bottom line: Contrary to post-2009, the post Fed tapering future curve of many metals (Aluminum, Zinc and Copper to a lesser extent) will be driven by a higher cost of carry (rate + rent), not by a negative convenience yield (the demand backdrop is showing some signs of improvement). Financial deals will thus be less alluring. With a huge negative roll, index or ETF investment will lose their appeal. Premiums may dwindle, putting high cost producers at risk.

Hence, for short term forecasts for base metals, forget inventories and cancelled warrant but rely on the macro picture. Charts below show that the pent up demand is strong for the short run, either assessed through global economic surprises or PMIs.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.