London, 15 October 2010

Plans by ETF Securities and others to launch a range of base metal exchange-traded funds (ETFs) backed by metal in LME-registered warehouses rather than futures contracts have been met with a mix of scepticism and fear.

Scepticism because many analysts do not think they will prove any more popular with investors than the futuresbased ETFs already available, which have failed to attract much interest.

Returns on futures funds have disappointed because the cost of rolling expiring contracts forward in a contango has offset gains in spot prices. Physical ETFs are unlikely to perform better because fund owners will be charged fees to cover the cost of storing the metal, which could be as high as 6 percent per year.

But there is fear too that if physical ETFs actually did become popular they would disrupt the normal flow of raw materials from producers to consumers that lies at the heart of the industrial economy.

HOARDING RISK

Physical gold ETFs have encouraged investors to hoard bullion in expectation of further price rises and as a hedge against monetary instability. Physical metals ETFs could encourage similar hoarding in the event of commodity supply or demand disruptions, or as a hedge against inflation and dollar devaluation.

Hoarding bullion is harmless because gold is a relatively pure capital asset with limited consumption characteristics relative to mine production and above-ground stocks. Hoarding base metals such as copper, aluminium and nickel that are the lifeblood of the industrial economy could be much more disruptive.

There are fears that any supply disruption as a result of a mine accident, smelter closure or earthquake would prompt a surge of buying of shares in the ETFs, diverting physical metal from producers and working inventories into the ETF at precisely the time when consumers most need it.

Fears of a physical shortage could quickly become selffulfilling. In 2008, fears about a shortage of rice and other crops prompted export bans, panic buying and hoarding by consumers and speculators that rapidly cleared the supermarket shelves even in an economy as advanced as the United States. Wal-Mart limited buying to four bags per customer.

In the Philippines the government threatened to charge hoarders with economic sabotage. LME Chief Executive Martin Abbott acknowledged those concerns in his speech to the LME Dinner this week when he noted "there is concern that ETFs, if they are successful, will lead to metal being diverted away from the normal supply chain and therefore acting as a distortion on the price".

Consumers are understandably fearful a physical ETF will compete for access to raw materials and leave them with an unpleasant choice between shutting down operations or paying a distorted price to persuade ETF owners to sell. Even producers appear divided. While some welcome the creation of a new source of demand and have been working closely with ETF promoters, others express nervousness about the likely increase in volatility and potential disruption to relations with long-standing customers.

Marcelo Awad, chief executive of copper producer Antofagasta, told Reuters yesterday his company has already been approached by investment banks seeking to secure supplies to back new ETFs, and would sell to them if asked, but called for the market to be regulated very tightly. "We would rather have a steady market than this so-called fictitious market", Awad said.

FUTURES, PHYSICAL NOT THE SAME

In theory, ETFs backed by physical metal are no more likely to disrupt supply chains or distort prices than ETFs backed by futures contracts. Every futures contract provides the right to take delivery of physical metal. In principle, the economic effect of speculating on a rise in prices by buying futures contracts and by buying physical metal is identical.

In practice futures and physical positions are close substitutes but not quite the same. There are subtle but profound differences:

(1) Futures contracts provide for deferred delivery so market participants with a short position in futures have time in which to locate physical metal and arrange for it to be delivered to the buyer. This time dimension is vitally important, especially in a crisis, since it gives panicked market participants time for reflection and provides both producers and consumers with an opportunity to adjust.

(2) Crucially, market participants understand that while any contract could be taken to delivery, in practice most will not be, so sellers and buyers need not always make preparations to make and take delivery of physical stock. Contracts can be closed financially by paying an appropriate price to buy them back (or more typically taking a second offsetting position and paying the difference).

This ambiguity (theoretical obligation to deliver, matched by the near-certainty that in most cases it will not be invoked) is what makes futures contracts useful to hedgers, as the U.S. Eighth Circuit Court of Appeals noted in "Cargill versus Hardin" in 1971. If buyers and sellers of futures contracts were always required to make preparations for delivery, few firms would be able to participate in the market and it would lose most of its usefulness.

Futures therefore represent a contingent and distant claim on the flow of physical raw materials. Speculating on commodity prices by buying units in a futures-based ETF impacts the price of raw materials (at least in the short term, until supply and demand adapt) but does not affect their availability.

Not so a physical ETF. Buying units in a physically based ETF will divert stocks of the raw material from producers and other stocks into the ETF and away from other consumers (and other speculators). It is a form of hoarding. There is a risk that it could accelerate or worsen a physical shortage, just as the panic rice buyers cleared the supermarket shelves.

The risk is real because the base metal markets are small compared with the amount of money investors might want to put into them in response to a supply/demand incident or even just a good "narrative" of looming price rises.

INADVERTENT CORNERING

A related concern is that a popular ETF could quickly amass a dominant position, owning more than 50 percent of the metal in exchange-registered warehouses, and proceed to corner or squeeze the futures market, even inadvertently.

Abbott assured his listeners that ETFs owning LME warrants will be subject to the same lending guidance as other market users.

Physical ETFs would not have any futures positions. In a sense physical ETFs would bystanders in the futures market. Under LME rules they could still be forced to lend part of their warrant holdings to the shorts at a maximum rate prescribed by the exchange if they held a dominant position in warrants.

It raises an interesting question about who would keep the proceeds from lending operations (which allow the lender to charge a penalty rate for lending all but a small part of its holdings); whether it would be shareholders in the fund (which could help cover some of their warehousing and management costs) or retained by the fund operator/ administrator.

In any event, lending guidance would not address the real problem. It would ensure futures market shorts were not squeezed (or at least it would string out the pain and reduce the risk of sudden default). But it would not prevent consumers being squeezed in the physical market. Warrants lent against shorts in the futures market would still tie the ETF's metal up in the warehouses and deny access to end users.

Whether a physical ETF would create more price volatility than a futures-based fund depends on the extent to which futures positions are treated by market participants as identical to physical ones. The evidence suggests futures positions are not in fact treated as directly equivalent to physical metal. Inflows and outflows from a physical ETF are likely to have a much bigger impact on pricing and actual metal availability.

Ends --

John Kemp, Reuters market analyst - for Commodities Now.

The views expressed are his own.