London, 5 November 2010

China's State Reserves Bureau (SRB) has begun selling some of the metal it bought during the price collapse that accompanied the Great Contraction of late 2008 and early 2009. An initial tranche of 96,000 tonnes of aluminium was sold at the start of this week and the SRB has announced a tender for 50,000 tonnes of zinc on Nov. 9.

More auctions seem set to follow, although Tang Yan, an official with China's top planning body, the National Development and Reform Commission (NDRC), said full liquidation of the stocks of both metals would not be "that fast", a form of words open to almost infinite interpretation.

SRB sales will have limited impact, other than psychological, on either local or international aluminium and zinc markets. The SRB's holdings of copper, however, are a whole different ball-game.

The difference lies in the Bureau's classification of what is strategic and what is not. Copper is. Aluminium and zinc are not. Copper is a strategic holding because China is structurally short of a metal that is essential for its industrialisation programme. It is a point rammed home with each month's import figures.

There is no similar structural domestic shortage of either aluminium or zinc. Indeed, the country has substantial amounts of excess production capacity.

STOCKS AS PRICE SUPPORT

Which begs the question as to why the SRB bought zinc and aluminium in the first place. To answer the question requires returning to the dark days of late 2008 and early 2009.

Global manufacturing activity was contracting at an alarming pace. Metal producers the world over were accumulating mountains of unsold tonnage. And metal prices were accordingly in freefall. China at that stage was not immune from the global turmoil.

Against this doomsday backdrop the SRB's public tenders for 590,000 tonnes of aluminium and 159,000 tonnes of aluminium had a double function. Firstly, they were a way of helping local smelters, or at least a limited number of national favourites, by absorbing some of their unsold stocks. The strategy was replicated at a provincial level with local governments doing the same for key local producers (also key employers and tax payers).

Secondly, the SRB used its buying power to set a de facto floor price within China. The prices it paid for the aluminium were between 5.0 and 15.0 percent above the prevailing SHFE spot price and those for zinc between 3.5 and 9.0 percent higher.

Unsurprisingly local prices quickly moved up towards the intervention levels on the assumption that the government had placed a marker below which it was prepared to buy more.

The key point is that the purchases were intended to mitigate an immediate crisis, successfully as it turned out, not as a signal that the government was adding aluminium and zinc to its list of strategic commodities.

As such, it was always a matter of time before the SRB looked to start selling what it had bought. It has chosen its timing well. The Chinese government's clampdown on heavy industry to meet its energy efficiency targets has hit both aluminium and zinc production sectors.

There is no suggestion that there is going to be a squeeze on metal availability. Shanghai stocks of aluminium at 490,370 tonnes and of zinc at 290,181 tonnes are both close to life-of-contract highs.

However, both local and international prices have been rising on the back of the production cuts and the SRB will be able to book healthy profits on both metals. In effect, this looks like nothing more than good portfolio management.

STOCKS AS PRICE LIMITER

The SRB bought copper in late 2008 and early 2009 for an entirely different reason. It has held strategic stocks of the red metal for many years with the express purpose of supplying the local market at times of extreme shortage.

But the SRB holdings were severely depleted over the course of 2005 and 2006. Particularly galling for the Chinese government was the fact that a significant part of its copper stocks ended up being delivered to LME warehouses against short positions accumulated as part of a disastrous and allegedly unauthorised trading strategy implemented by the SRB's then senior trader Liu Qibing.

Between October 2005 and September 2006 Chinese exports of refined copper ballooned to 300,000 tonnes, much of the metal going to South Korea, the closest LME delivery point.

The collapse in copper prices to the $2,800 per tonne level in December 2008 was a golden opportunity for the SRB to replenish its reserves.

No-one outside the SRB and the top levels of Chinese government knows how much it bought. The purchases of aluminium and zinc were well flagged and held in the form of "public" tenders. The publicity was an important part of the entire operation, intended to send a clear signal to both markets.

The only official comment on the copper purchase programme came from Yu Dongming, an official at the metallurgical department of the NDRC. In June 2009 he told Caijing magazine that the SRB had bought 235,000 tonnes of copper.

Note the past tense. He didn't say whether the SRB was still buying or whether it had future buy orders in place. The authoritative Antaike research house in China now thinks the SRB bought over 400,000 tonnes last year. Nor does the wider copper market know how much the SRB was holding before its 2009 buying programme.

One little titbit that has emerged from this week's aluminium sales is that the SRB held 100,000-200,000 tonnes of the light metal even before last year's purchases, which is not something that had been previously disclosed.

Prior stocks of copper were almost certainly higher, but just how much higher is anyone's guess. At the height of the Liu Qibing affair in November 2005 an unidentified SRB official was quoted as saying the Bureau had 1.3 million tonnes at its disposal, an unverifiable claim that at the time was dismissed as grand-standing.

TIME TO SELL?

With copper prices above $8,000 per tonne and gravitating up towards the all-time highs just shy of $9,000 recorded in early 2008 there has been growing speculation about possible SRB sales of copper (and there are more rumours doing the rounds again yesterday morning).

This speculation looks a bit premature. There is no desperate shortage of copper. Shanghai stocks stand at 106,091 tonnes and global exchange stocks are above 540,000 tonnes. In October 2005, when the SRB last embarked on a wholesale sales programme, Shanghai stocks were below 50,000 tonnes and global stocks just 115,000 tonnes.

Moreover, the current energy efficiency drive appears to have hit Chinese copper fabricators harder than copper producers, unlike the situation in both aluminium and zinc markets. That said, there is a hard analyst consensus that the copper market is already in deficit and about to swing to bigger deficit next year. The International Copper Study Group is forecasting global demand to exceed supply by 400,000 tonnes in 2011.

That implies a return to critically low metal availability at some stage in the next 12 months. It's a situation that is going to be exacerbated by the launch of physical-backed ETFs, some of which will be holding LME-warranted metal. If successful, and that may still be a big "if", such funds will lock up part of the metal in what is supposed to be the market of last resort.

This means that the SRB's copper stocks will be the market of true last resort. How much it holds and how much it sells will be the critical factor in defining the top of the price cycle, just as its purchases defined the trough of the price cycle in 2008/2009.

No wonder then that the Bureau is a little reticent about talking about copper, apparently heeding the advice of Sun Tzu in the "Art of War": "Be extremely subtle, even to the point of formlessness. Be extremely mysterious, even to the point of soundlessness."

Nor does it have to talk about copper yet. The market is doing all the talking for it. And every tender of aluminium and zinc will only fuel the speculation further, the rumours themselves acting as a price dampener.

The SRB's copper sales programme may already have started, even if no metal has actually been sold.

Ends --