London, 11 December 2010

The last few days have seen an extraordinary amount of media attention focused on the LME copper market, specifically the existence of a dominant long position accounting for between 50 and 80 percent of exchange stocks. Never mind that the LME's daily market reports show similar concentrations of interest in both nickel and tin and a vice-like grip, representing over 90 percent of stocks, on the aluminium alloy contract.

This after all is copper, the LME's "flagship" contract and the one with the highest profile outside of the arcane world of industrial metals trading. Three-month metal trading at new all-time nominal highs above $9,000 per tonne and the front part of the curve shifting into backwardation only serve to accentuate the current media spotlight.

So too does the "outing" of the dominant long as JP Morgan Chase . The investment bank is a multi-role trading entity, even more so since its purchase of the RBS Sempra metals business back in July, meaning that it is far from clear which part of the company is actually controlling the position.

If it is at all. JPMorgan is also a leading LME broker, meaning that the position could actually be held by another entity, channelling its business through the bank. Such nuances have been lost in the media feeding frenzy. Why? Because JP Morgan is also one of the companies planning a copper exchange-traded-product (ETP) backed by physical metal.

The connection between the company's supposed current position and its proposed ETP seems tenuous at best. The timing is all wrong for one thing. Why tie up cash and risk now when regulatory approval of the ETP could still be months away? However, as with all such things, the perception says something important about the market, even if it is false.

BUY NOW WHILE STOCKS LAST

The heightened concern, verging on hysteria, about the current dominant long position is a reflection of an underlying issue facing the copper market. It's called scarcity. It's not a new phenomenon. It has characterized the copper market for many years and its origins are well known.

Put simply, not enough copper is coming out of the ground to meet demand. Under-investment in new mines, particularly large-scale, world-class deposits, has been compounded by a long-running litany of unforeseen disruptions. The return to the news of the Bougainville copper mine in Papua New Guinea is a timely reminder of just how long-running this feature of the copper market has been.

One manifestation of this chronic supply shortfall has been backwardation on the LME contract. Front-date tightness was an integral part of the copper market over much of the last decade.

It was only the Great Contraction of 2008 and 2009 that interrupted the trend. As demand shrank, visible surplus grew and the front part of the LME curve traded in consistent contango.

Things are changing again. The International Copper Study Group's (ICSG) figures suggest that the global refined copper balance has already returned to supply-demand shortfall. Visible inventory in the form of global exchange stocks peaked at around 800,000 tonnes in February of this year. It has since shrunk by 33 percent to 530,000 tonnes. The ICSG is forecasting a market deficit of 435,000 tonnes next year. It's by no means the highest calculation out there. In terms of likely visible stocks evolution over the coming period, the maths is both simple and highly problematic.

What is different this time around, though, is that everyone with even a passing commercial interest in copper knew what to expect. And even if they were slow on the uptake, every analyst at every investment bank has been pumping out the same bull warning/enticement for many months. This is why China's State Reserves Bureau (SRB) started rebuilding its strategic stocks last year, in doing so limiting the build of visible surplus on the world's exchanges.

It's also why investment money has poured into the copper market, even before there was any tangible sign of deficit. It's why physical premiums in Europe are now at four-year highs and it's why new investment vehicles such as physical- backed ETPs are being launched, starting tomorrow with ETF Securities' offering. It's the great physical copper grab and everyone wants a piece of the action.

The result has been to accelerate both outright price and spread development. It wasn't the dominant long position that got copper to $9,000 per tonne. It may be accentuating front-date tightness but it didn't create the necessary pre-conditions for that tightness to persist. The entire market did that.

HUNGRY BACKWARDATION

And as long as LME copper stocks continue being whittled away, there are going to be a lot more dominant positions and a lot more backwardation to grab the news headlines. Backwardation is not in and of itself a bad thing. It signals hunger for units. This backwardation is no different, although it has come earlier in the stocks cycle, thanks to the great collective copper grab.

The only problem is that with consumers, merchants and investors alike looking to stock up on physical copper, the backwardation is not doing what it's supposed to do, namely draw metal into exchange warehouses.

Or not yet. There is one part of the copper market which is (relatively) weak and (relatively) oversupplied. China Copper Inc., the largest collective consumer of the red metal, has stopped buying, just as it did back in late 2007 and early 2008 when the copper price hit what at that stage were also all-time highs.

Indeed, there is a strong sense that those at the wrong end of the recent tightness on the nearby LME copper spreads have been Chinese players looking to defer shipments (and therefore hedge pricing). Physical premiums basis Shanghai are weak. The arbitrage with London is negative for profitable imports. And there has been a build-up of copper in bonded warehouses in China.

Sadly, there are no daily warehouse reports for this metal, some of which has appeared on China's official import figures and some of which has not. Locals suggest there could be somewhere between 250,000 and 300,000 tonnes of metal stuck in this statistical black hole. It could be more. It is almost certainly the largest concentration of unallocated metal in the world.

At the right incentive price, there is nothing to stop it turning around and heading to the nearest LME warehouse locations in South Korea. The level of backwardation seen so far on the LME is probably insufficient to make this happen, or at least in any great volume.

But then this current bout of tightness is probably just a taste of what is to come, a preliminary skirmish for units from a dwindling unallocated stocks cushion.

Full battle is scheduled for next year. The question is who will need it most at that stage? A destocked China or the rest of the world? Backwardation in London and physical premiums in Shanghai will be the markers of how the great physical copper grab evolves.

Ends --

Andy Home is a Reuters Columnist - for Commodities Now.

The opinions expressed are his own.