Funds and the global metals futures markets

Today, funds play an important part in trading activity at all major metals exchanges. A common view is that investment funds dominate metal price movements and that physical developments are largely irrelevant. While this would concern commodity analysts, it is a great worry for other market participants. Consumers fear that investors are bringing metal prices to much higher levels than fundamentally justified, and producers worry that price declines are not in line with market developments.

Large daily price moves are often blamed on speculators. In April, aluminum saw its largest daily fall ever. And copper fell its sharpest in any one single day since 1997. At a time when physical demand is strong, these price changes are impressive. Speculators have brought short-term volatility to metal prices, but also much greater liquidity, which probably means that even sharper cyclical price peaks and deeper troughs in the metal markets have been prevented.

Turnover on the London Metal Exchange, and on other metals exchanges, is rising, not just because of growing consumption and production but also as a result of fund activity. Copper trading volumes on the Shanghai Futures Exchange are up sharply — not least encouraged by arbitrage opportunities between the exchanges. It is difficult, and probably impossible, to quantify what proportion of daily turnover is conducted by investors on the exchanges. But we reckon that on a typical trading day, speculative trading can amount to more than half of turnover. This means the metal futures markets have become much deeper than they otherwise would have been.

A recent survey shows that assets under management at hedge funds now stands at more than US$1 trillion, compared with about US$740 billion only a year ago. In China, the mutual fund industry has boomed over the past two years, and it now manages almost US$25 billion. There are plans for capital market investment rules to be liberalized further in an attempt to ease controls on investment of retail and institutional funds.

New investment money into metals is coming not only from traditional commodity investors; over the past year there has also been a sharp rise in demand for metals as an alternative investment. The search for positive exposure to China has been one key driver of this trend.

The impact from basket purchases of commodities should not be underestimated. The introduction of commodity indices, such as the GSCI or Dow Jones AIG Commodity Index, has been a source of new investment money coming into commodities and metals specifically. A conservative estimate is that about 15% of investment buying into copper during the first quarter this year came through investment in a commodity index. And a crude calculation suggests that between June 2003 and April this year, about 50,000 lots of metal were bought through indices. This would translate to about 600,000 tonnes aluminum and 300,000 tonnes copper. The most widely followed GSCI Index had about US$12 billion tracking it in 2000. This figure has now risen to at least US$20 billion and will almost certainly keep growing. The other key traded commodity index, the Dow Jones AIG Commodity Index, has grown from US$31 million at the end of 2002 to US$4 billion by April.

Liquidity and volatility are two key investment criteria among large investment funds. Still, it is important to appreciate the relatively small size of the base metal markets compared with other financial markets, and also with other commodity markets. For example, a survey of financial market turnover reveals that commodities contracts account for less than 1% of total global OTC derivative positions. This means that only modest changes in investment flows can dominate the commodities markets and have major price implications. Also, an analysis of daily commodity trading volumes shows that base metals account for less than a quarter of combined commodity turnover.

Although far from perfect, Commitment of Traders data from the Commodity Futures Trading Commission (CFTC) provides some firmer data on speculative involvement in metals on Comex. These data provide a breakdown of commercial and noncommercial positions, and give at least an indication of how investment activity has grown. According to the data, speculative exposure accounted for just 5% on average of total copper open interest on Comex in 1987. This trend has steadily increased, with the average reaching 16% last year. In October, this share rose to an all-time high of 44%, but has since eased to about 17%. Both the speculative net long and short positions have grown, and the trend has been similar in other metal markets. However, Comex is not the largest trading platform for base metals, and some speculators would prefer to play the markets outside this framework, and hence not captured within the CFTC data.

— The preceding is an edited transcript of a talk given by the author at the First Shanghai Futures Exchange Conference in late May. The opinions presented are the author’s and do not necessarily represent those of the Barclays group. For access to all of Barclays’ economic, foreign-exchange and fixed-income research, go to the web site at barclayscapital.com. Queries may be submitted to the author at ingrid.sternby@barcap.com