(Bloomberg) – What happens when the metal on the London Metal Exchange runs out? This is the question that the exchange is urgently trying to address regarding the major copper contract, which determines the global price of one of the world’s most important commodities.
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The problem stems from the physical nature of LME: anyone with an expired contract becomes the owner of a bundle of metal in the LME warehouse. On the other hand, anyone who sold a coin must hand over the metal when the contract expires.
But with available copper stocks in LME deposits below 20,000 tons – less than what Chinese factories can consume in a day – traders are grappling with the prospect of the metal simply not being available.
The sharp drop in inventories that began in August and accelerated this month sent the nearest London Metal Exchange contract higher to record premiums for copper for later delivery. This is particularly painful for copper manufacturers — companies that turn base metals into things like wires, plates and tubes, which tend to sell futures contracts on the London Metal Exchange to hedge their exposure to their prices.
But dump warehouses have also helped push benchmark prices toward record levels, and copper’s pervasive role in the world means the jump in costs will add to widespread inflationary pressure for manufacturers and builders. And while rising threats to global economic activity raise questions about the outlook for copper demand, stocks on Chinese and US rivals to the London Stock Exchange are also low.
Only a small portion of the world’s copper enters the LME deposit, and copper users tend to enter into long-term contracts with producers and traders rather than seek supplies from the exchange. However, the fact that stock exchange shares are so low – and not just on the LME – shows that the market’s buffer has seriously eroded.
LME took emergency measures Tuesday evening to address the situation. Among them was a temporary rule change allowing anyone with a short position and unable to deliver copper to defer a delivery commitment for a fee.
“This is an unprecedented situation, and nothing like this has been seen in the recent history of the copper market,” said Robin Bhar, an independent consultant who has been analyzing metals markets at the London Metal Exchange for more than 35 years. “These market actions are very draconian, but they are needed.”
The London Metal Exchange has also launched an investigation, asking banks and brokers for information about their and their clients’ activity in the copper market over the past two months. Bloomberg reported on Tuesday that trading group Trafigura has withdrawn a significant proportion of the copper that has been pulled from LME deposits in recent months.
Trafigura responded by saying that it took up LME stocks to offer to end users, assuring that there was strong demand for copper outstripping the available supply. “Trafigura’s role is to ensure the security of supply of goods to its customers,” a spokesperson for the trading company said.
LME procedures are designed to avoid catastrophic outcomes as there is no metal available to fulfill delivery orders. By launching an inquiry, the exchange may make traders and banks think twice before ordering more deliveries.
And with its rule changes, the London Metal Exchange has tried to defuse the possibility of stress spiraling out of control. It allows short position holders to defer delivery commitments – by moving their positions to the next day. It also puts a cap on the amount of more expensive copper contracts that expire in one business day which can be higher than those that will expire the next day.
Finally, the exchange has amended its rules governing traders who own a large proportion of the shares available on the London Metal Exchange. Usually, traders in this mode are forced to lend their positions to others in the market at a very low rate. But with stocks so low, the London Metal Exchange is concerned that this rule could prevent traders from holding their shares on the exchange.
This is not the first time that the London Metal Exchange has intervened in its markets. In 2019, the exchange launched a similar investigation when a rush of nickel withdrawal orders sent nickel prices skyrocketing. The market calmed down, and the London Metal Exchange did not take any further action.
In 2006, amid rising nickel prices, it imposed a $300 limit on the daily decline in the nickel market. And in 1992, when Marc Rich + Co tried to contain the zinc market, the London Metal Exchange imposed many of the same measures it had taken in copper this week: placing strict delay limits and allowing holders of short positions to delay delivery.
Copper tumbled on Thursday, and gains close to recent highs ebbed – perhaps an early sign that the LME’s moves have paid off. The key three-month cash spread fell to $295.75 a ton on Wednesday, still a big lag by historical standards but down from the high of $1,103.50 a ton seen on Monday.
Liquidity in LME contracts tends to focus on the third Wednesday of the month: traders are now hoping for a period of relative calm. However, the LME cannot change the fact that stocks have been depleted across the global copper industry, with stocks on exchanges in China and the US also at historically low levels.
“The LME is in an unenviable position, with very low stocks,” Bahar said. “Hopefully this will be seen as an attempt to calm the red market.”
(Updates with details on copper margins)
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