Making sense of copper’s perplexing price movements

In early August the price for copper hit US$3.04 per lb. and seemed to be heading into a tailspin. But after several days, the price stabilized and reached a US$3.32 high before closing at US$3.31 per lb. What is going on?

While the bounce back ensured that the price remained within its recent trading pattern band of the last four months between US$3.38 per lb. and US$3.04 per lb., the metal’s recent movements are counterintuitive to many watchers trying to determine the cause of the price action.

One point of perplexity is tied to its movement in late May. Late in the second quarter LME inventories showed a spike in the number of orders to withdraw the metal from warehouses. Most analysts believed this was a sign of surging demand, and braced for stronger prices going forward.

Instead the metal sold off through June, giving back as much as 9% when it briefly touched US$2.99 per lb.

When trying to make sense of such counterintuitive events, it is important to understand that the waters have been muddied in the copper market by a spate of warehouse acquisitions by the big metal traders. Spurred on by, for one, Goldman Sachs’ (NYSE: GS) much-discussed acquisition of Metro and its large metal warehouses, the biggest players in the metal game wanted a piece of the action. So Glencore Xstrata (LSE: GLEN) bought Pacorini Group, Trafigura bought North European Marine Services; the Noble Group bought World Wide Warehouse Solutions; and Louis Dreyfus Commodities’ bought GKE.

What made such acquisitions desirable was that in a low interest rate environment, the big players realized there was much to be gained by storing the metal and earning rental or storage fees for a commodity that could be sold in the futures market at a higher price.

That surge in acquisition activity cut the number of independent London Metal Exchange warehousing companies to just 35% of the industry, by some estimates.

So what does this mean for copper?

This means investors looking at supply and demand fundamentals in the industrial market could be left befuddled going forward. There is now a new factor that needs to be taken into consideration when trying to assess the metals price: its use as a financial instrument.

The problem is that it’s hard to get a handle on just what players like Glencore, Trafigura, Goldman Sachs or Morgan Stanley are cooking. So much so, that one of the main arguments being brought before the Federal Reserve — as it examines whether or not it should allow institutions like Goldman and Morgan Stanley (NYSE: MS) to continue their foray into the commodity space — is that there isn’t a regulator in the world that could unwind and comprehend all the machinations of the firms’ commodity investments in conjunction with their regular financing business.

At least it’s clear that if the copper future curve tips into backwardation, motivation would evaporate to buy the metal on the spot market, store it, earn the storage fee and sell it in the futures market.

Currently the future curve is in contango, but it would be wise for investors to monitor the curve’s movements in the coming months.

And while future curves are an important factor in today’s metal markets, the influence of industrial fundamentals persist as well.

On that front China remains the dominant player in the copper market, accounting for 40% of the metal’s demand — and there are signs that the Asian Tiger is gearing up for more consumption.

The country’s State Council recently announced a small stimulus package after weaker-than-expected growth numbers in the first half. The package includes removing taxes on small business, cutting administrative costs for exporting companies and encouraging private-sector railway investment through bonds.

At the same time, the country is pushing to build affordable housing, which is also good for copper, as it is used in house wiring.

Those moves seem to already work, with the latest numbers out of the country showing that industrial output rose 9.7% in July from a year earlier, after 8.9% growth in June. The country also said its July copper imports rose 12% from a year earlier to 410,680 tonnes, which is the highest level since last May.

Patricia Mohr, an economist with Scotiabank, wrote in a recent report that copper demand had already been robust this year, even before the latest numbers, and argues that the decline in the copper price over the first half of the year had more to do with expected mine development than softening demand.

Turning back to the futures market for clues to the metals movements, it can be helpful to look at what the smart money is doing in terms of long and short positions for the metal.

The best place to get a sense of this is the U.S. Commodity Futures Trading Commission report. By focusing on the Managed Money category, as Managed Money is considered the “smart money,” we see that while short position contracts are nearly double that of long — with 41,414 short contracts compared to 26,753 long contracts, each contract representing 25,000 lb. copper — the short positions have been scaled back recently by 11,162 contracts, while 1,100 long contracts were added. So the trend in the futures market is bullish for copper.

Lastly, let’s turn to some technical analysis to round out our picture of the red metal.

The first thing that jumps out is that the Bollinger bands are expanding after a recent move in price to the upside. This follows a period of tightening — as they have for copper over the last month — is a bullish indicator, and could indicate a break to new short-term highs.

The 21-day moving average also crossed over the 50-day moving average, which is another indicator that the metal is generating momentum.

Finally, stochastic and RSI indicators have just entered the “overbought” zone. This is not necessarily a bad sign — quite often the indicators will remain in the zone for a given period of time as the metal gathers steam.