Posts Tagged ‘base metals’

Suspension of demand/supply law for base metals

Sunday, March 7th, 2010

According to the economic law of supply and demand, if there is more and more supply for a given commodity, the prices should decrease if everything else remains equal. Conversely, if the supply decreases, prices should rise.

Normally this is the case for commodities like base metals. The level of stock for a given metal in the London Metal Exchange (LME) should give a good indication of the quantity supplied. So, we invite our readers to take a look at the supply/demand situation for lead, nickel, zinc, copper and aluminium. In particular look at the 5-year charts for the trend starting in January 2009. What do you see?

When? you look at the charts, you will notice something very strange. Since January 2009, the prices of these base metals rose as the supply grew as well. What is going on? Had the economic law of supply and demand being suspended as well?

Good question.

Remember what we wrote in Does rising house prices imply a housing shortage??

The belief that prices will always go up forever and ever can create its own artificial demand. The insidious thing with this belief is that it is a self-fulfilling prophecy- belief leads to increased ?demand,? which in turn leads to higher prices, which reinforced the belief, which in turn leads to increased ?demand? and so on and so forth. When this happens, higher prices lead to even higher ?demand.? Such artificial demand can act as a sink-hole for whatever quantity of supply until money runs out in the financial system (which is not possible under today?s a fiat credit system).

Indeed, this is our interpretation of what happened to base metals as well. The expectation of rising prices acts as a sink-hole for whatever quantity of supply. The most common word used to sum up this phenomenon is “speculation.” Another word that is also often used is “investment demand.”


When you look at the big picture, there is a big growth in “speculation” and “investment demand” over the past 10 years. From real estate, stocks, bonds, commodities, foreign exchange and even art-work (see Epic, unprecedented inflation). Today, with advances in financial engineering and information technology, it is possible to speculate in the global commodities market in the comforts of your home with the click of a mouse.

What is the root cause of this? As we wrote in Why oil cannot function as currency reserves?,

… when governments undermine the store-of-value function of money (something that can only be done in a fiat monetary system), investors will flock to useful, vital and scarce commodities to store their wealth. This in turn will result in those scarce commodities becoming scarcer. The food riots around the world in 2008 were an example of how this can happen (see Who is to blame for surging food and oil prices?).

For the fundamental economic law of supply and demand to work, prices have to convey accurate market information. Prices are expressed in terms of monetary units. That means the monetary unit is the yardstick which is used to measure the relative value of things. What if the integrity of this yardstick is being compromised? As we wrote in our book, How to buy and invest in physical gold and silver bullion,

Let?s suppose you want to compare the length of two boxes. You may use a ruler to measure their lengths and from the results of your measurement, conclude which one of them is longer. A ruler can do such a job because its length is reasonably consistent for the foreseeable future.

Now, imagine that ruler is as elastic as a rubber band. Do you think it is still a useful tool to measure the length of the boxes? An elastic ruler is useless because you can always make up the measurement of the boxes to whatever you please just by stretching the ruler such that the edge of the box is aligned to any intended measurement markings in the ruler.

Now, let?s take a look at oil prices. Since oil is priced in US dollars and if the supply of money and credit (in US dollars) can be expanded and contracted by monetary inflation and deflation, how useful do you think it is as a calibration for measuring the value of oil relative to other things?

The rise of “speculation” and “investment demand” is a sign of a funny monetary system.

Is China going to dump their excess metal stockpiles?

Tuesday, February 9th, 2010

Back in Will there be a commodity price crash?, we wrote about a curious phenomenon in China,

… as prices for base metals rebounded, so did their inventory stockpile levels. This is a tell-tale sign that much of the price rise are due to the rise in investment demand instead of real demand.

When we wrote that article, we should have used the word “speculative” instead of “investment.” Indeed, back in September last year, there were signs of base metal speculation in China, as this Bloomberg article reported (China?s Pig Farmers Amass Copper, Nickel, Sucden Says)

Private investors in China, the world?s largest metals user, have stockpiled ?substantial? quantities of copper as the government ramps up stimulus spending to spur the economy, according to Sucden Financial Ltd.

Pig farmers and other speculators may have amassed more than 50,000 metric tons, Jeremy Goldwyn, who oversees business development in Asia for London-based Sucden, wrote in an e- mailed report after a visit to China. That?s about half the level of inventories tallied by the Shanghai Futures Exchange, which stood last week at a two-year high of 97,396 tons.

Sucden?s estimate underscores the difficulty analysts face in gauging metals demand in China amid increased speculation by retail investors, whose holdings remain outside the reporting framework undertaken by exchanges. Private investors in China also had as much as 20,000 tons of nickel, Goldwyn wrote.

This is a tell-tale sign that the ‘demand’ for base metals from China is not fully substantiated by the demand from the real economy. Even the demand from the real economy are not fully substantiated by the real needs of the people. To understand what we mean by that, think of where all these credit and stimulus money has gone to in China. It has been reported that most of them had gone to fixed asset investments and infrastructure. But according to Marc Faber in a recent interview (and many eye-witness report), there’s an oversupply of apartments and commercial real estate in China i.e. vacancies are already too high. Therefore, the pace of China’s fixed asset investments have to slow down. Should that happen, you can be certain that demand for steel and cement will fall substantially. That means the demand for Australian iron ore is going to fall as well.

Now, we are hearing rumours that the Chinese are trying to offload their excess metals. As this article reported (Rogue Aluminium Shipments Suggest Chinese Metal Stockpiles are Being Re-Exported),

Something strange happened in Japan in December. Shipments of aluminum from Mozambique and Brazil showed up in the northwestern ports of Fushiki and Fukui.

Shipping aluminum to Japan isn’t weird. The nation is an important consumer. But shipping South American and African aluminum to northwest Japan is strange.

These are minor ports. Usually such imports would be unloaded on the Pacific side, at Yokohama, Osaka or Nagoya.

Where did this “rogue aluminum” come from? Traders think it might be from China.

Not only that, according to that article, there’s a divergence between the Baltic Dry Index and Chinese Shipping Index.

Next, listen to what Marc Faber has to say:

What is the implication for Australia? If you accept the theory that Australia owes much of its economic rebound from Chinese demand for Australian resources, then what follows will be very negative for the Australian economy. As we wrote in Hazard ahead for Australia- interim crash in China,

Therefore, investors should understand this basic principle: because of the leverage that Australia is exposed to China, any slowdown in China will have a leveraged effect on Australia.

Will there be a commodity price crash?

Thursday, December 3rd, 2009

Remember, back in January 2007, in Analysing recent falls in oil prices?real vs investment demand, we discussed about the difference between investment and real demand for a commodity,

What makes up the demand for oil? There are basically two types of demand for oil: (1) The physical demand where the real side of the economy uses for its everyday needs and (2) The investment demand where the financial side of the economy shifts the money here and there from one asset class to the other.

Lately, we are asking ourselves the same question for the broader range of commodities, particularly base metals. In particular, we draw your attention to this news article,

London Metals Exchange (LME) inventories for most metals have been rising strongly of late. For example, aluminium LME inventories are 75 per cent higher than the prior 20 year high set in May 1994. Nickel inventories are only 6 per cent below the 20 year high set around the same time. Zinc inventories have risen six fold since the start of the subprime crisis in September 2007. Lead inventories are up five-fold over the same period. While not at a record, copper inventories have increased for 20 consecutive weeks and are up 70 per cent since 30 June.

Now, this is a curious phenomenon- as prices for base metals rebounded, so did their inventory stockpile levels. This is a tell-tale sign that much of the price rise are due to the rise in investment demand instead of real demand. This investment demand is based on the same idea in Does rising house prices imply a housing shortage?,

The belief that prices will always go up forever and ever can create its own artificial demand. The insidious thing with this belief is that it is a self-fulfilling prophecy- belief leads to increased ?demand,? which in turn leads to higher prices, which reinforced the belief, which in turn leads to increased ?demand? and so on and so forth. When this happens, higher prices lead to even higher ?demand.? Such artificial demand can act as a sink-hole for whatever quantity of supply.

So, base metal prices are vulnerable to a correction. Current prices are based on the belief on the exaggerated sense of the China (and India) growth story. If this belief is ever molested by some reality check (e.g. see Is the Chinese economy a house of cards?), chances are, base metal prices will fall. There are even reports that China is pretty stocked-up with those commodities as we speak and may be going through a de-stocking phase next year. At the very least, base metal prices may be pretty subdued next year.


P.S. Check out Economy to ride a second wave of China stimulation. The Chinese are preparing to fire a second stimulus that is aimed at boosting consumption. Our interpretation is this: the Chinese government needs to flood the economy with more money, otherwise the bubble will burst. Result: more corruption, speculation and inflation.

Will Chinese economic pick-up save Australia?

Sunday, May 10th, 2009

Recently, one of our readers wrote in to ask,

I wonder if you could share your views on the short and long term impact of the current economic circumstances on major mines such as Roxby Downs in SA, which has the world’s largest deposit of uranium oxide, copper, gold and silver.  There still seems to be conjecture as to whether the major expansion of that particular mine will proceed, of which much  reliance on the local economy has been placed.  In recent times, many staff have been laid off due to the cut in production.

Do you feel there will be any circumstances which will see mines like this one pick up again, and what timeframe may this occur?  I have read previous comments that China will begin stockpiling commodities again  now that the prices are low, however I also read yesterday that their economy has been shrinking at a rapid rate of recent times.

I also know several people who own investment properties in mining  towns.  Do you think it could be wise for those people to get out while they can, or is the medium-long term picture rosy for mining town economies?

First, we must again stress that we are not providing investment advice here. Thus, we cannot advice whether this stock or that property in whatever village is a good investment or not. All we provide here are general opinions.

Now, back to our reader’s question. Essentially, this query was about when and whether China will restore itself to the gangbusters economic growth of 2007 to restart the commodities boom again. That in turn will provide hope for Australia’s economy to recover sooner.Let us take a look at base metal prices below:

5 Year GFMS Base Metal Index

As you can see, base metal prices made a double peak in 2007 and the first half of 2008. Then it crashed to a record low in around January 2009 before making a slight recovery since then.

The first question to ask ourselves is this: When prices hit the record highs in 2007/2008, were they primarily driven by real demand from China or by speculative forces? This question reminds us of an article (“Who is to blame for surging food and oil prices?”) we wrote 12 months ago,

So, let?s say a passer-by told you that petrol price had doubled more than 2 ½ times over the past 2 years, would you laugh at the passer-by? ?Yeah right!? you may say. ?Where?s the queue and rationing??

The crash of 2008 makes it clear that it was speculative forces (abetted by monetary inflation) that drove prices to such bubbly high levels. But isn’t China going to grow to a super power and thus, require colossal amount of commodities? As we wrote 14 months ago in “Example of a secular trend- commodities and the upcoming rise of a potential superpower”,

Armed with the understanding from our previous article, Understanding secular vs cyclical, you can see that the rise of China (and India, Russia, etc) that we just described is a secular trend. Thus, the demand for commodities that supports this secular trend must also follow a secular trend too.

But does that automatically mean that commodity prices will go up and up for ever and ever for a very long period of time? From the short-term bubble in metal prices in 2006, it is obvious that there are many speculators who misapplied the commodity super-cycle theory to the extreme.

Sure, commodity prices can even correct 50% in the short to medium term, but do not let the cyclical sub-trends cloud your understanding of the underlying secular trend.

Let’s take a look at Australia. There is no doubt that Australia benefited greatly from the lead up to the bubbly prices of 2007/2008. The bubbly prices brought in huge amount of revenue for Australia’s mining companies. So, property in mining towns sky-rocketed. But that new found prosperity had a dark side- debt. Many mining companies borrowed deeply to fund expansions and developments. In order for such high level of debt to be a winning strategy, the bubbly prices have to be maintained. The crash of 2008 exposed these debt-laden mining companies to be swimming naked (we wouldn’t name names here, but you know at least a couple of big names).

Sure, as we said before in “Example of a secular trend- commodities and the upcoming rise of a potential superpower” and “The Problem that can throw us back into the age of horse-drawn carriages”, the secular growth of giant nations like China and India will mean that the demand for the earth’s resources will have to grow tremendously over the decades.

One of the most important virtues required of an investor is patience. The secular growth of China/India will not occur overnight because it is a trend that will take decades to mature fully. The problem is that many investors/mining companies are so leveraged to the secular growth of China/India that the mighty boom has to occur overnight to make windfall gains. But, as we explained before in “Answer to quiz: error in long-term gearing,” if that does not happen, they can be wiped out in the interim,

The problem is that asset prices do not go up in a straight line. This is especially true if the investor bought the asset at bubble prices (e.g. before the panic of 2008). In the short-run, asset prices can suffer major correction. During bubble prices, when the risk of a major correction is at its highest and investors? optimism at its peak, applying this logical error on one?s investment can result in devastating losses. When the price correction occurs, losses are magnified and the investor?s equity can get wiped out. Then subsequently, when asset prices recover, the investor will not have the equity to take advantage of the upswing. Even if the investor has the equity to take advantage of the upswing, so much capital had already been lost that the overall return in nominal terms can still be negative.

Even if no leverage is involved, buying at bubbly prices will mean that your patience has to be tested significantly. So, the next question is, how long do we have to wait? As we wrote before (in January 2008) in “Can China really ?de-couple? from a US recession?

The needs of the Chinese consumption economy are different from the US consumption economy. Some Chinese are rich. But some other parts of China are unbelievably poor. Wealth distribution in China is rather uneven and there are still many pressing social and environmental issues to be solved. Currently, the Chinese export economy is tooled towards US consumption. To re-tool and re-configure the Chinese economy towards its domestic needs requires a period of adjustment in which capitals are destroyed and built.

Also, consider the sober warning from a Chinese government economist at “China won’t see quick recovery: govt economist”,

Fan added that China still suffered from excess capacity in some industries, meaning that some obsolete production capacity should start to be phased out starting from this quarter, a process he said could take several years.

The process would be painful, but necessary, he said.

Are stocks good value?

Monday, January 1st, 2007

In 2006, we ended the year with the Dow up by 16%. The market cheerleaders in the financial media had been busy extolling the performance of the stock markets. In fact, stocks around the world, from China to Australia, performed greatly in 2006. It seems that the best place to make money is in the stock market. In Australia, the market professionals see that with the weight of the masses? superannuation money needing to find a resting place, the stock market is sure to continue its momentum upwards in 2007. Indeed, for one to suggest otherwise, one runs the risk of being labelled a fool.

For us, as contrarians, we have reservations on the whole charade. The truth is, there is still too much liquidity (money, credit, etc) in the financial system. And this liquidity is the driving force behind the stock markets? performance. Sure, stocks can continue to rise in 2007 due to the sheer weight of money sloshing around the globe. But we would like to repeat the point we made earlier in Divergent sentiment: You can make the Dow climb as high as you want as long as you print enough money (that is, provide enough liquidity). In fact, if you run the printing press hot enough, anything that you ?invest? in will increase in price. As mentioned in an example in How is inflation sabotaging our ability to measure the value of things?, with Zimbabwe?s inflation rate in the order of thousands of per cent (in May 2006), almost anything you buy in Zimbabwe will increase in price by 100-fold after a year has gone by. But are you better off by a 100-fold if you do that? Of course not! In Zimbabwe?s case, all it meant was that the money had become worthless!

This is the point we are trying to make.

Although a hot printing press may make stocks rise giddily in the short term, they will eventually lose their value against something that is fundamentally valuable. So what if the Dow rose by 16% in 2006? From 14th January 2000, the Dow was at a high of 11722.98. Today, the Dow is only 12463.15. In 7 years, the Dow had only risen 6.3%, which is only a growth rate of 0.88% per annum! Therefore, if you invest in the Dow over that period, you are poorer in real terms (that is, after price inflation is taken into consideration)! Gold, on the other hand, rose from around US$280 in 2000 to US$634.30 today. In 7 years, gold had rose 126.5%, which is a growth rate of 12.50% per annum. And this is just gold. If we bring on silver, zinc, copper, oil and so on, it is clear that metal commodities beat stocks by a far margin!

The truth is, it is not just that metals had soared in prices. Rather, global currencies (including the US$) had lost their value against the metals. As we said before in Entrenched perception on the value of paper money, with the way central banks around the world are inflating the supply of currencies, there is little wonder that currencies are increasingly becoming more worthless. In addition, with the rise of China and India, the increasing physical demand of these metals is not going to abate anytime.

Is stocks generally still good value? We doubt so. We still prefer hard assets (or stocks of companies that are producing these hard assets).