London, November 2010

In the last seven days we have seen both J.P. Morgan and BlackRock Asset Management International file applications with the SEC to launch Exchange Traded Funds (ETF) in copper. If these funds receive approval to launch their products we could see LME copper prices soar on the back of a fresh surge of investor demand for a stake in copper.

Theoretically, if fully subscribed these two ETFs would take around 183,000 tonnes off the market. LME stocks only stood at 368,825 tonnes as of 22/10/10. So this would be nearly 50% of total LME stocks. This would almost certainly be described as a “corner” of the market and would most probably be disallowed by the LME under its specialist rules that are triggered off when any market participant becomes the dominant long.

This is just one of the many questions that have to be fully answered by JP Morgan and BlackRock if they go ahead with their ETFs. Their physical ETFs are based on LME warrants. And they would therefore be subject to strict exchange guidelines for managing the effect of a dominant position.

This means that investors in an ETF might be forced to reduce their position because the ETF has become the dominant position holder. Theoretically, this is something that ETF investors and the managers of an ETF could not accept because it would leave them without control over their inventories and would mean the product wouldn’t be properly physically-backed.

The rules are triggered off when an LME member or client holds 50% or more of the warrants and/or cash today/cash positions in relation to LME stocks. For markets like copper, lead, or tin where stocks are tight to relatively tight the chances are much higher that an ETF product would attract enough investment to push it into the category of dominant long.

Diarmuid O’Hegarty, the LME’s head of regulation and compliance and deputy chief executive, noted in a Dow Jones interview some weeks ago that “Anyone with a (electronic transfer system) LMEsword account holding warrants is subject to the LME Lending Guidance rules.” He went on to stress that “The LME monitors the market in real time and publishes a large volume of data publicly to ensure an orderly and transparent market.”

Some Questions That Would-Be Investors Should Ask

So one of the questions would-be investors in the JPM and BlackRock ETFs should ask is just how accountable or otherwise an ETF management company would be to the LME for the size of its ETF holdings. It is beyond dispute, I think, that buying and controlling metal (either on or off warrant) is bound to have a price impact. The bigger the holding, the bigger the likely price impact.

This was, in fact, admitted by Goldman Sachs, which owns the warehousing company Metro which BlackRock intends to use to store its copper. Goldman’s said in a research note that a copper ETF of more than 50,000 tonnes, equating to some 13 percent of total LME stocks, would disrupt the market.

"A physical ETF in copper might exacerbate short-term volatility and perhaps bring forward our forecasted deficit and extremely tight, backwardated market," the report said. In the long term, the bank played down concerns about the impact of these products' on supply, noting that any tightness would quickly generate incentives for investors to sell the metal back into the market.

But views are very mixed about the impact of such funds on the price and supply of metal. Some producers, particularly aluminium producers, consider them a new sales avenue while consumers are concerned that availability of metal will decrease and prices and premiums will rise if material is locked up in funds of this type.

Bloomsbury Minerals Economics’ Copper Briefing Service notes in its October Copper Briefing Service editorial that “The relevance of ETFs to price is still being debated. Clearly, they will tie up metal, and in this respect could be said to be similar to existing long positions in futures contracts. There are critical differences, however, that should exaggerate the price impact. While futures contracts imply physical delivery, in fact this rarely occurs, and even where it does there is time to arrange for it.”

“ETFs, on the other hand, can immediately take metal out of the market, potentially leading to physical scarcity. If investment in ETFs proves to be highly responsive to news, such as an earthquake in Chile for example, a relatively modest supply disruption could turn into a much larger one, directly impacting on the ability of consumers to buy the red metal.”

But BME certainly factors ETFs into its supply-demand equation for 2011. They are looking for ETF holdings to rise to 170,000 tonnes in the fourth quarter of next year. They see holdings reaching 80,000 tonnes by the end of Q1 2011. BME is forecasting a supply deficit next year of around 500,000 tonnes after a deficit this year of some 368,000 tonnes. The cash LME price forecast for 2011 is put at $8,300 per tonne versus $7,468 per tonne this year.

Dealing Costs Are Very Important

Another question to ask is what about dealing costs and possible restrictions on selling. The JP Morgan tombstone with the filing says “The Trust’s fees and expenses are expected to be lower than the costs an individual would incur for the purchase and storage of physical copper.” One would like to see it all spelt out in dollars and cents per tonne and what the management fees will actually be. If copper proves to be as volatile a market next year as I think it will be, then an ability to job in and out of the market relatively cheaply would be a great advantage.

Some months ago I researched a piece on a proposed aluminium ETF that was expected to be launched. This was way back in July. I spoke to a number of friends in the aluminium industry who had been approached to possibly supply metal to the fund. The then proposed aluminium ETF would have worked as follows: You, the investor, would pay the current cash LME aluminium price when you initially invest. You will also pay over time storage costs for the material and, of course, a management fee. You don’t pay any financing costs (though one assumes they are at least partially covered in the management fee).

The sponsors of the ETF (then rumoured to be a Swiss bank and large merchant firm) already owned the stock of aluminium metal which was rumoured to be as high as one million tonnes.

The merchant firm and Swiss bank have, I was told, the sales rights over the metal. They can control the volume of sales from the ETF. If, for example, in any week, say, 25,000 tonnes of aluminium is redeemed by investors, the investors will be paid their money at the then prevailing cash price but the merchant firm and bank may only decide to sell,say,10,000 tonnes into the market. The merchant firm and bank also earn any premia that may exist for the metal redeemed.

So it will be important to know just what restrictions, if any, are imposed on holders of shares in the proposed copper ETFs.

What We Know So Far About the Two Proposed Copper ETFs

This is what we know to date about the two proposed copper ETFs. BlackRock wants to launch a physically backed ETF. It plans to issue up to 12,120,000 shares. The metal will be stored in London Metal Exchange-registered warehouses owned by Metro International Trade Services LLC. BlackRock's initial unit of the iShares Copper Trust Fund will consist of 2,500 shares, called a basket, backed by 25 tonnes of copper. One share would equal 10 kilos of copper (22.0462 lbs) but Black Rock intends that only “baskets” are tradable.

JP Morgan filed with the SEC an application for a physically backed ETF which, if fully taken up, would result in a holding of 61,800 tonnes of metal stored in the bank's Henry Bath warehouses. JP Morgan’s ownership of Henry Bath warehouses was viewed as a key element in the launch of its fund as the cost for storing copper would be low.

Nevertheless, BlackRock claimed in the filing for its fund that it will be "relatively cost efficient. Because the expenses involved in an investment in physical copper are dispersed among all holders of shares, an investment in shares may represent a cost-efficient alternative to investments in copper for investors not otherwise in a position to participate directly in the market for physical copper," the filing said.

More physically backed funds are on the horizion. ETF Securities recently announced plans to launch ETFs across all base metals, while Deutsche Bank and Credit Suisse are thought to be mulling separate aluminum ETFs.

This Will Be a New Form of Demand

Investment going into the copper ETFs will be another form of demand for physical copper. Generally speaking, the effect of fund investment in base metals shows that the price level rises above that which would be expected in the absence of the investment flows and that the new investment also lifts the level of physical stocks that the market has to live with.

So all things being equal, the floor price for physical copper is likely to rise as a result of this new investment demand. The ETF holdings may prove to be “sticky” ones and not as volatile as the normal commercial flow of stocks into or out of LME warehouses. On the other hand, ETF holders may prove to be very active traders. Much depends on dealing costs and the overall level of volatility, which I expect to rise quite sharply next year as more ETF money goes into the market.

Why a Copper ETF Is Much Better Than an Aluminium One

Copper ETFs have two big things going for them. The first is that copper is in a supply deficit situation that is unlikely to be turned around for at least another two or three years. Mine supply is simply not growing quickly enough. Meanwhile, China continues to devour copper as its economy grows and grows.

The second bull point is that the two copper ETFs announced so far are both based in the United States and the shares will be traded on the NYSE. That opens it up to a potentially huge investment market.

An aluminium ETF has, in my opinion, nothing like the bullish conditions going for it that copper has. Aluminium is certainly not in a tight supply situation. True, there is around four million tonnes of aluminium tied up in financing deals both on and off the LME and that metal is unlikely to come out any time soon. But that tonnage will come out some day when the price is right and the financing conditions aren’t.

Secondly, the higher the aluminium price goes the more the Chinese are likely to crank up output from 2011 onwards not to mention all the new capacity that is expected to come on stream in the Gulf and Middle East. The figures speak for themselves. World aluminium capacity is expected to rise from around 52.2 million tonnes this year to 54.9 in 2011 and to 56.5 million in 2012. With copper, mine production is expected to rise from around 16.29 million tonnes this year to around 18.5 million tonnes in 2012.

The general bear point about aluminium is that as an industry it has a natural tendency to over produce. This is very understandable. Economies of scale benefit all producers. The more tonnage they can squeeze out of their smelters the more efficient they can be and the more money they can earn.

When demand falls away, there is always the LME as the market of last resort. And a surprising number of smelters see the LME as just that. The very last thing any smelter wants to do, particularly those lower down on the cost curve, is to partially close down production.

To fully close down production, things have to be very grim indeed. So aluminium is a metal that naturally tends to oversupply.

Conclusion

We are in for much more choppy trading in copper over coming weeks. The ETFs should guarantee more volatility. But so will the gyrations of the dollar and how big or relatively small QE2 proves to be. Meanwhile, the Chinese, the world biggest copper buyers, are holding back from the market for as long as they can. They generally think prices are too high at these levels. They would love to be buyers at $8,000 per tonne and lower if they get the chance.

Ends --

ETFs by Ted Arnold, circulated with his kind permission.

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Please be aware also that BME’s monthly Copper Briefing (Table 9) and rather superb new Quarterly Report on Copper both accommodate ETF physical holdings in their analysis, with forecast tonnages out to end-2011 and end-2015. Both publications also incorporate BME’s specific forecasts of Chinese Strategic Reserve (SRB) stocks. Implicit in these BME statistics is the assumption that ETF competition for stock will drive prices and premiums to sufficiently high levels to prompt the Chinese SRB to dispose of as much as 150 kt of stock over 2011-2012 to assist Chinese fabricators short of feed.

The monthly Copper Briefing, the new Quarterly Report on Copper and next generation Interactive Copper Price Model will be available as a fully coordinated package. Details from Robert Goldstein: This e-mail address is being protected from spambots. You need JavaScript enabled to view it