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THE COPPER JOURNAL
Prepared by J.E. Gross & Associates, Inc.
The Back Is Back!
(May 15, 2000) For the first time in a long time, the market structure has inverted, thereby signaling tightening of supplies, reducing opportunities to finance inventories and making hedging more difficult if not impossible. Given the significant implications of this change, it warrants discussion.
Generally speaking, futures markets will either be in contango, or backwardation. In a contango market, prices are successively higher the farther one looks out in time, ostensibly to reflect the cost of financing or carrying inventories. A market in backwardation is the opposite of a contango, as prices tend to be lower in the forward months relative to the spot month. The rational for a backwardation occurring is predicated upon tightening of supplies to the extent that buyers are willing to pay a premium to get the metal they require in the short term, thereby putting upward pressure on nearby prices relative to the forward months. Although some may interpret a backwardation to mean that overall market prices are going down, this is not the case. Because hypothetically, if the market were to be unchanged, by virtue of the passage of time, the lower price in the forward month would eventually become the higher spot price.
While this is an over simplification, it nevertheless leads us in to the difficulty of hedging in a backwardation. But the better way to explain this is to first review the contango market and how hedging can not only provide price protection, but financing as well.
For example, if a fabricator bought metal in January for delivery and pricing of product in February, it would be faced with the risk of falling prices before the sale was make. To mitigate this risk, once the metal is purchased, the fabricator could establish an offsetting short position in the futures market, which would then be closed out (bought back) when the physical product is priced and sold.
To hang some numbers on this, on January 4, 2000, spot copper closed at 83.80¢ on COMEX, while the March contract closed at 84.80¢, representing a 1¢ premium. Assuming the fabricator wanted to be hedged, a short position would be established in the market at 84.80¢, offsetting the purchase of physical at 83.80¢.
On February 25, 2000, the fabricator and his customer agree to use the spot COMEX closing price as the basis of their transaction. As it turns out, spot COMEX closed at 81.40¢ that day, while the March futures contract closed at 81.50¢. Thus, while the fabricator lost 2.40¢ on the physical purchase and sale, he gained 3.30¢ on the March hedge, which included the 1¢ contango when the hedge was established. Again, an over simplification because the fabricator incurred the cost of financing his inventory, but this was partially offset by the contango again.
This same transaction in a backwardation yields very different results. On January 2, 1995, spot copper closed at $1.3560, while March closed at $1.3370, representing a 1.90¢ discount. Our fabricator friend is now faced with a serious dilemma. If he hedges (sells March), he is locking into a potential loss. If he doesn't hedge, he is exposed to a decline in the market. Which is the greater risk? He concludes it is the decline in the market and therefore sells the March futures contract.
On February 27, 1995, the fabricator agrees to price the sale of product on that day's close and will also lift the hedge. Spot copper closed at $1.3270, which is also the price for March as it is now in the spot position. Thus, the physical transaction realized a loss of 2.90¢, but the March contract fell only 1.0¢ for a net loss of 1.90¢, representing the initial backwardation.
There are, of course, many other factors that will influence the end result of hedging in a backwardation to include the specific month used, as well as the relative valuation of the spot price. But is should also be recognized that a market in backwardation can provide opportunities for buyers to take advantage of lower forward prices to make their purchases and to the extent the backwardation remains, they will sell at the higher price when it becomes spot.
Although in theory a backwardation represents tightening of supplies in the physical market, we have seen periods where speculative trading has exacerbated the inverted market structure. Further, similar to any attempt at predicting future price levels, there is no way to determine with accuracy the longevity or depth of a backwardation.
The best we can do is pay close attention to what the market is telling us by way of outright prices, forward spreads and conditions in the physical market and make a judgement call as to where the greater risk lies.
Where Do We Stand Now?
--Marching to the cadence of two steps forward and one step back, copper is up almost ten cents from the low in mid-April. Indeed, the combination of strong demand; a significant drawdown of inventories and renewed speculative interest all seem to be working in concert now and reestablishing constructive chart patterns. Basis the active July contract, you can see where the market broke through resistance at 78¢, 80¢, and 82¢, pausing briefly along the way before moving to the next hurdle. Now, however, although it still appears that we have more upside potential, the market is overbought, suggesting the need for a pullback. If we turn lower, support is in place at the previous areas of resistance. On the upside, we may anticipate additional resistance at 1¢ increments right to the contract high of 89.85¢, which of course would include closing gaps at +/-85¢ and +/-88.20¢. On a more macro basis, while it may be premature at this point to get overly optimistic, a case can be made for an inverted head and shoulders formation to be developing, which if valid, targets about 92¢ basis July.
--COMEX and LME warehouse stocks fell 59,849 ST to 803,419 ST since the end of April and are off 216,720 ST from the high of 1.02 million tons in March. During May, LME inventories in Europe fell 19,181 ST to 328,653 ST; Asia is down 9,810 ST to 49,935 ST, while domestic LME inventories fell 22,405 ST to 346,015 ST. COMEX stocks declined 8,453 ST to 78,816 ST. The combined total is now at a seventeen-month low.
--Spreads narrowed sharply, with the near months going into backwardation. May/June closed at a 15-point back on May 4th, but returned to a 15-point contango last week. July/August started the month at a 35-point contango, but traded into a 5-45 point back last week. July '00/July '01 started the month at a 2.25¢ contango, but finished last week at just +10 points. The last backwardation occurred during August-September 1998.
May 15, 2000 J.E. Gross & Associates, Inc. P.O. Box 460, Huntington, New York 516-271-9457
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