Copper, aluminum, zinc and tin hit record highs in March. Lead was the only LME base metal to miss the super bull party. After March’s meltdown, however, industrial metals are now in a slump. The LME just posted its biggest quarterly drop since the global financial crisis. Pivoting sentiment from hyper-bullish to hyper-bearish was the February 24 launch of what Russia calls a “special operation” in Ukraine. Fears of sanctions against the Russian metal helped drive prices to those record highs in March. However, Russian aluminum, copper and nickel flows have not been affected so far. Instead, traders are now focusing on the recessionary impact of high energy prices as the Russian incursion continues.
The bears come out to play
Investors’ position in industrial metals has shifted from long to short in recent weeks, with systematic funds responding to chart analysis and bearish price momentum by increasing bear bets. Money managers were net short the CME copper contract at 42,000 contracts in early April. Net short now stands at 25,402 contracts, the lowest position since April 2020. The last remaining bulls throw in the towel. Definitive positive mutual fund positions have shrunk to a two-year low of 33,926 contracts. This is symptomatic of the broader metals investment landscape, with heavier funds limiting passive long exposure and trend-following systematic funds selling on price weakness. LME broker Marex reckons there are now significant speculative short positions across the block in the London market, many of them near multi-year highs in terms of size.
China to the rescue?
It is not difficult to understand the reasoning of investors. High energy prices are fueling inflation and central banks are responding with tighter policy. They are also beginning to relax manufacturing activity. The latest series of purchasing managers’ indexes recorded stalled growth in Asia, the United States and Europe. China is the likely bright spot in the global economy, with manufacturing activity expanding in June for the first time since February as the country gradually emerges from the rolling lockdowns in the first half of the year. However, there is considerable caution that China’s recovery may yet be hampered by Beijing’s policy of zeroing in on Covid-19, with several cities tightening restrictions over the weekend as new cases emerged. It is clear that the Chinese players themselves are playing metals such as copper from the short side. Marex estimates that the collective short position on the Shanghai Futures Exchange copper contact, expressed as a percentage of open interest, is as high as it has been since 2008. This speaks to a lack of confidence in the strength of any recovery in the world’s largest user of metals.
Liquidity trap
The speed of the collapse in base metal prices is partly explained by the liquidity drain on the London Metal Exchange in the wake of the controversial suspension of the nickel market and the subsequent cancellation of trading. LME volumes have been declining since then. Trading activity in the second quarter fell by 13% from the previous period and by 21% in the first quarter of 2022. Nickel is the most obvious casualty, prone to sharp price swings on low volumes, but this is a wider issue for both the LME and the physical supply chain. Lower investor and industry participation in the LME leaves market action increasingly dominated by short-term systematic funds. The resulting increased volatility reduces the funding capacity of physical actors as banks reassess their exposure to the metals sector.
The micro’s revenge?
Such funding constraints are likely to lead to metal inflows into LME warehouses, reversing a defining trend of recent months. Total recorded inventories of all metals stood at 696,000 tonnes at the end of June, down from 2.36 million tonnes a year earlier. LME zinc inventory on hand is currently just 22,050 tonnes, so time margins have tightened as the cash premium over the three-month metal surged to over $200 a tonne last month, even though the final price was falling. This is the disconnect between micro and macro right now. The recession is crushing all the micro positives, such as zinc’s dangerously low stock coverage. Or the lengthening list of aluminum smelter cuts in Europe and the United States as high energy prices take a toll on a notoriously energy-intensive sector. Alcoa has become the latest producer to announce a 54,000-ton capacity cut at its Warrick smelter in Indiana, citing “operational challenges.” The entire western aluminum supply chain is operationally challenged at the moment. The same is true for zinc. Physical premiums for both metals remain extremely high, particularly in Europe, where regional production losses have been exacerbated by logistics problems. It is a sign of extraordinary supply tensions in the West that China is exporting both aluminum and zinc despite high tariffs on outgoing shipments of the refined metal. With no relief in sight for European electricity prices, regional smelters face margin problems until further notice. The LME paper market is pricing in a bearish hit to demand while ignoring the still bullish fundamental story of low inventory and ongoing supply chain pressure. The mismatch is becoming more pronounced and it may only be a matter of time before ever-larger short positions collide with ever-smaller stocks. Coupled with patchy liquidity, there is a good chance that there will be more metal boom and bust in the second half of 2022. (Editing by Jan Harvey)
