The last few days we had an interesting event at the London Metal Exchange (LME). The LME released plans to shorten the warehousing queues by decreasing waiting time duration from 100 days (July 2013) to 50 days (November 2013). This change is set to be implemented from April next year onwards. The question is: "What effect will this have on metal prices. Will it cause more bullion to come into the market short term or will it expose the weakness in the system?" There is an ongoing debate on what effect this will have on metal prices, but nobody really knows what will happen.
What I've read is that traders think it will make prices of commodities go down in general, because all that supply goes into the market and it would become less attractive for warehousing companies to bid for metal. On the other hand, this change in plans is likely to lower warehouse levels and that will make delivery more difficult. There will be delays occurring. What if there is a sudden demand in copper in China while warehouse levels are lower? We already saw these things happening in June 2013 when we saw large delivery requests at the LME copper warehouses. And what if dealers need to deliver on the expiring short positions? We will see backwardation as a result. As a matter of fact, backwardation is correlated with LME copper levels as shown below.
You can see that LME copper levels go up and down (chart 1) in striking similarity with the copper contango curve (chart 2: red graph). It's too early to make conclusions though... But this correlation seems to fit well.
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|Chart 1: Copper Warehouse Stocks Level|
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|Chart 2: Copper Contango Theory|
Moreover, as you know from the copper contango theory: "If copper goes into backwardation, the copper price will tend to go up." That's a fact. So a lower LME warehouse level for copper due to the new rules at the LME will result in higher copper prices. That's my guess.
Remember what we had in the nickel market. We almost had a nickel default at the LME in 2006, if it weren't for the change in rules the LME made.
Excerpts from the LME's press release of August 16, 2006:
Those with short positions in nickel falling prompt on Friday 18 August 2006, and on subsequent prompt dates until further notice, who are unable to effect physical delivery and/or unable to borrow metal at a backwardation of no more than $300.00 per tonne per day, shall be able to defer delivery for a day at a penalty of $300.00 per tonne. Those with long positions for prompt on those days who are subject to deferred delivery shall be entitled to compensation of $300.00 per tonne per day
And what happened when nickel was at record-low stock levels? The nickel price soared afterwards.
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|Chart 3: Nickel stock levels Vs. Nickel Price|
If we fast forward to today, nickel for example is now at record high LME stock levels, while nickel prices are depressed. So if we get a reversal in stock levels, the prices should go into the other direction.
The decision to lower the LME warehouse waiting time duration points to higher metal prices in my opinion. To bet on this, you can buy index funds like the First Trust ISE Global Copper Index Fund (NASDAQ:CU) or the iPath Dow Jones UBS Copper Total Return Sub-Index ETN (NYSEARCA:JJC).
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.