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A Shanghai warning for the LME

London, 20 January 2012: Reuters

The London Metal Exchange (LME) had an excellent 2011. Trading volumes rose 21.9 percent to a record 146.6 million lots, equivalent to an eyewatering 3.5 billion tonnes of material. The notional value of all that activity surged 32.8 percent to $15.4 trillion, enhancing the Exchange's status as the Western world's leading arena for trading industrial metals.

But which contract, do you think, registered the highest year-on-year growth? Flagship copper? Nope. The LME's Grade A copper contract registered only a 14.7 percent increase in volumes, less than the 21.1 percent growth notched up by its cross-Atlantic CME Group rival.

What about the LME's most liquid contract, aluminium? Nope, although it saw a highly respectable 25.5-percent increase in turnover.

What about the newer contracts then? Steel billet? Cobalt?


Nope. Steel billet volumes grew by just 14.7 percent with a somewhat ominous drop in activity in the closing two months of the year, more on which later. Molybdenum volumes managed only anaemic growth of 0.6 percent and cobalt volumes actually contracted by 3.4 percent in what was only the second year of trading for the LME's minor metals offering. The LME can only hope that a jump in activity in December is more than a one-off.

Step forward unglamorous lead. Volumes of the heavy metal surged by 39.9 percent, eclipsing the 31.2 percent pace registered by the second-fastest grower, aluminium alloy. It's a counter-intuitive result, unless you factor in the series of counter-intuitive squeezes that characterised the lead contract for much of last year.

Persistent front-month tightness saw lead pour into LME warehouses. Registered inventory mushroomed by 69 percent over the course of 2011.  All that metal needs financing and in this regard lead has simply caught up with aluminium and zinc. Both LME contracts are defined by the stocks financing trade and periodic tussles for metal between would-be financiers.

The trade is predicated on one key feature of the current financial environment. Ultra-low interest rates mean cheap money to fund the business and flattering returns by comparison with anything cash can offer. The only problem is that what central banks can give, they can also take away.



As the Shanghai Futures Exchange (SHFE) has found out in fairly dramatic fashion.Its volumes slumped last year. The best performer among the industrial metals traded on the SHFE was copper, where activity declined by "only" 3.6 percent.

Others fared worse. Aluminium volumes shrank by 42 percent. Zinc volumes and steel rebar volumes contracted by 63 percent and 64 percent respectively. Quite evidently this was no reflection of underlying manufacturing activity. China's industrial production growth may have slowed but at an annual 12.8 percent in December, it is still out-performing just about anywhere else.

Metals production and consumption are still both rising. The need for price hedging is therefore also rising. What has changed of course is the availability of credit, as Beijing tightens the screws to damp down inflationary pressures and a previously sizzling property sector.

Some of the speculative froth appears to be coming off the latter with property prices now starting to fall in major cities. And as a by-product a lot of speculative froth has come out of the SHFE market-place.

It's no coincidence that volumes fell off a cliff in both the zinc and steel rebar contracts last year. Both had become a day-trader's heaven because of the relatively low price of both metals, making them cheap punts in a country awash with central bank cash.

The mass departure of the day-trading horde is why trading volumes slumped even while open interest was little changed, down 7 percent in the case of zinc and up 4 percent in the case of rebar. Now, there's no sign of any imminent monetary tightening in most developed countries, least of all the U.S., but what happened last year in Shanghai is a warning that trading volumes on metals exchanges can go down as well as up.

Unless of course you believe that LME trading purely reflects industrial hedging activity with no fund or speculative component at all. Well, do you?


Even after a 64-percent slump in trading volume, Shanghai's rebar contract recorded turnover of 1.64 billion tonnes last year, making it the most actively-traded ferrous contract in the world. That liquidity is attracting the attention of a growing number of Western banks and traders, even though clearing the many hurdles to trade on a Chinese exchange is a tortuous process.

It's a level of liquidity that the LME's own ferrous product, the steel billet contract, is struggling to build. Indeed, volumes and open interest declined sharply in the last two months of 2011.

The suspension of a large number of billet warrants held by bankrupt broker MF Global is part of the reason but a disconnect with the physical market appears to the root cause of waning interest. What was originally intended to reflect physical trade flows in the Black Sea and Mediterranean has migrated to a U.S. Midwest contract. That's where most of the current LMEregistered billet is now stored.

The problem is that it's not a location of net consumption and Detroit in particular poses logistical challenges, undermining the arbitrage between futures and physical markets. The LME's is still the second most liquid steel contract but for how long?

While billet volumes are declining, those of the CME's newer hot-rolled coil contract are accelerating, up 47 percent in its first full year of trading. And growth in both is decidedly pedestrian relative to the iron ore swaps market. Volumes cleared by the SGX exchange in Singapore grew by 148 percent to 3.7 million tonnes last year.

The scrap between exchanges for the giant steel market has only just begun but for now the SHFE leads by a mile. The LME can take some comfort that it's not a direct competitor, thanks to China's strict barriers to Western players.

But it's a Shanghai warning of a different kind.

Ends --

By Andy Home, Reuters columnist - for Commodities Now.

The opinions expressed are his own.


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