metal, supply, market

Is the metals supply shortfall an illusion?

24.06.2005

by James Ferguson

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It's impossible to write a commodities story without looking first to China. The latest news indicates that its giant economy is still firing on (almostall cylinders. May industrial production grew at nearly 17% year-on-yeaand, with the money supply growing at similar double-digit rates, it seemthe Chinese government¹s stated desire to shift from a production-basegrowth model to a consumption-led one is not, so far at least, in evidenceAt the moment, nearly half of all economic growth is being driven by capitaexpenditure of one kind or another. And if the Chinese money supply, whichas already dropped from over 20% to under 15%, dries up, bank lending stops and new capital projects don¹t get the OK, then the Chinese super-cycle will dip into a super-slump.

Steel prices falling

Because of its sheer size, what happens in China impacts on the rest of thworld. Problems are already arising for certain steel products, for exampleand spot prices are collapsing. One difficulty is that China's steel iincreasingly being exported; it would appear that China's new capacity isat least partially, surplus to requirements. But the demand-supply situatiofor the other metals non-ferrous metals such as copper, zinc, nickel analuminium is still apparently driven by supply shortages. China¹s demanfor the basic raw materials to make goods appears to remain insatiable. Yeraw material reserves are low. London Metal Exchange (LME) warehousstockpiles of copper have fallen to 41,200 tonnes, the lowest inventorlevel since 1974.

Conspiracy theory

The odd thing is that many industry insiders claim that exactly the sampressures mounting on steel producers can be seen in the non-ferrous metamarkets, even though, aside from aluminium, all their prices are still hig and the copper price is at record highs. So if real world demand isn't really any higher for the non-ferrous metals than it is for steel, and if significant new capacity is coming on-stream as soon as next year, which it is, why are steel prices nose-diving and metals prices surging?

The answer, at least according to industry insiders and not a few financiaconspiracy theorists, is that there is a good, old-fashioned merchansqueeze going on. The commodity markets have never been big or deep enough to avoid major players trying to corner the market or engineer squeeze, as it is known. What happens with a squeeze is that one buyecommands a very large proportion of the world's deliverable supply of commodity. There is not enough to go around, so frantic buyers bid the pricup. Once the situation normalises, prices usually fall very fast. In 1980, the price of silver, for example, halved in a day and the Hunt brothers, whhad initiated the squeeze and had been the richest men in America, werforced to declare bankruptcy. The conspiracy theorists claim that what'happening now is a similar price-demand disconnect, but this time it's beincaused by the hedge funds and other financial institutions.

When industry buyers require a commodity, they buy it and take it away tuse it. But when financial institutions buy a commodity, they are speculating on its price rising. They don't intend to use it themselves, merely to wait and sell it to an end-user at a later date for a higher price. As such, they keep the metal they have bought in a warehouse, and the various metal exchanges monitor such warehouse inventories to get an idea of how tight supply has become.

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Thus it is not in the interest of financial buyers to keep their metal stocks where the exchange might monitor them, because if it is kept elsewhere, it will add to the impression that stocks are low which will, in turn, help push prices higher still. And this is indeed what many now suspect has been happening. It's also been suggested that the accumulation of these so-called 'off-warrant stocks', were they to be included in the inventory statistics, might reveal the global supply shortfall to be an illusion.

Conclusion

While it is impossible to say when commodity prices might run out of steamsuch stories do throw into relief some important lessons in finance. We arall guilty of using numbers too simplistly, for instance. In the past, such an approach may well have helped guide our investment decisions, but the devil, as they say, is almost always in the detail.

Certainly, it should never be forgotten that high prices cause changes ibehaviour, initially encouraging substitution by the end-users and, after slightly longer delay, causing new supply to be provided. It is these two factors that keep cycles revolving. In the case of the deep cyclicals, it is simply economic law that what goes up really must come down again.

James Ferguson is an economist working at independent broker PalInternational