London, 9 December 2010

Large holdings of physical commodity stocks tend (other things being equal) to cause a backwardation in the futures market, as the scarcity of available supplies for immediate delivery pushes prices for nearby future contracts to a premium over contracts for deferred settlement.

Other things are rarely equal. But the statement that large positions tend to produce backwardations where there is already a relative shortage of available supply or lack of willing futures sellers seems both obvious and uncontroversial. It is the stuff of introductory courses to commodity trading.

Recent press reports of a dominant position in the London Metal Exchange ( LME) copper market have nonetheless produced the usual bad-tempered and unenlightening debate about whether the large position is causing or otherwise connected with the emergence of a backwardation in copper futures.

The poor quality of the discussion is dispiriting because both sides seem intent on talking past one another, setting up straw men to knock them down, rather than developing a credible narrative to explain recent price movements.

LARGE POSITIONS, AGGREGATION

As my colleagues have explained, large holdings of physical inventories on the LME can occur unintentionally and are not unusual for large companies with many divisions and clients.

According to the LME there were dominant positions in the copper market on 28 occasions last year, most recently in December 2009. There are also currently dominant positions in the markets for primary aluminium, aluminium alloy, nickel, tin and zinc, according to the LME's most recent warrant banding report, covering ownership of warehouse warrants on Dec. 6, 2010. All the other markets continue to trade in a contango structure, suggesting there are no worries about meeting demands for delivery.

In calculating dominant positions, and managing them by applying the lending guidance, the LME aggregates all positions controlled by a member firm -- including positions held by affiliated companies, as well as warrants held on behalf of customers, for example as collateral for warrant financing deals.

The exchange automatically aggregates nearby positions (warrant holdings, as well as positions due for delivery within the next two business days) of companies in the same group. It will also aggregate positions of unconnected parties if the compliance department believes there is a common purpose, according to the most recent version of the lending guidance published by the LME (May 6, 2010).

If a firm or connected company lends money to a third party to enable them to buy and finance warrants, and takes the warrants as security for the loan, those warrants also count towards the calculation of a dominant position and the application of the guidance.

Stock financing, either by an LME member firm, or on behalf of third parties, is common and concentrated in the hands of a handful of large banks. It has ensured dominant positions have been frequent in recent years, both for metals in short supply (such as copper) and for metals where inventories are abundant (aluminium).

CONTRIBUTION TO BACKWARDATION

Dominant positions reported by the LME should not be confused with "hoarding" the physical commodity to drive prices higher or squeeze the market by exploiting the inability of participants with short futures positions to make physical delivery.

But just because not every dominant position is a manifestation of hoarding or a squeeze, it does not follow dominant positions have no impact on either the level of prices or the shape of the forward curve.

It all depends on the circumstances. In the past there have been clear instances when dominant positions have caused or contributed to a shortage of metal for immediate available delivery and helped force nearby futures prices to a premium over contracts for deferred delivery.

In an indirect acknowledgement of the power of dominant position holders, LME Chief Executive Martin Abbott has repeatedly warned holders of short futures positions they should not assume metal stored on warrant is freely available.

As Abbott has emphasised, every tonne in exchangeregistered storage is owned by someone. Metal owners are under no obligation to surrender it except to meet short-term lending requirements imposed by the LME to safeguard the integrity and soundness of the settlement system and the clearing house. Shorts must not rely on registered tonnes to meet their delivery obligations.

3RD WEDNESDAY IN NOVEMBER

The dominant position in LME copper warrants was first reported by the exchange on Nov. 16, the last trading day for the benchmark third-Wednesday November futures contract.

Nearby spreads started to tighten somewhat earlier, from the middle of October (when the cash to 3 months spread was quoted at $19 per tonne contango), moving into backwardation on Nov. 8 ($5 backwardation) and reaching a peak at $63.50 back on Dec. 1. It is the biggest backwardation for more than two years -- since the financial crisis erupted in the wake of the Lehman meltdown in September- October 2008.

The shift occurred at the same time it must have become apparent to the market the long intended to take physical delivery on a large number of futures contracts due for settlement by the third Wednesday (which was Nov. 17).

Coincidence does not imply causality. Nor does it imply the long has done anything wrong. Every contract on the LME includes the right to take physical settlement. But it is implausible to deny the existence of a relationship. There is at least a circumstantial link between the emergence of a large concentrated position in LME warrants and the shift in market structure.

It is worth noting that the LME's futures banding report shows the presence of a large long position in the nearest to expiry benchmark Dec futures contract (amounting to 30-40 percent of all the open interest still open on that date). There are also two large short positions remaining in Dec (each amounting to 10-20 percent of the open interest) and three large shorts due for settlement by Jan (two at the 5- 10 percent level and one at the 10-20 percent level).

FUTURES PRICE DETERMINATION

It is also possible to dispose of another irrelevant issue raised in connection with the emergence of a large position. Several observers have noted the position is small in relation to the overall copper market. It is, they argue, too small to influence either the absolute price level or the shape of the forward curve.

LME compliance reports show the long with warrants amounting to between 50 percent and 80 percent of copper currently stored in LME warehouses. Reportedly the position is at the lower end of this range, putting it around 175,000 tonnes or a little higher. This is a tiny fraction of the annual global copper market of 19 million tonnes.

But annual production and consumption is entirely the wrong measure for assessing the position's impact. It is irrelevant as far as price determination is concerned. What matters is copper readily available for delivery, which in practice means copper in or near exchange warehouses, or metal that could quickly be diverted to them from another source.

Most copper moves directly from producers to consumers on long-term supply contracts, or is the wrong specification for delivery or held in the wrong shape or wrong location to be delivered against LME short positions.

Of the copper which is readily available for delivery, the long holds a much higher share, which is what could give it some impact on both the level of prices and the forward structure, and why it is now subject to the lending guidelines imposed by the exchange.

Ends --

By John Kemp, Reuters - for Commodities Now.

The views expressed here are his own.