The demise of the LME

The London Metal Exchange has always been hallowed ground for commodities. As custodian for much of the world's metal inventory, including the physical volume that underlies the futures trade, data from the LME is keenly watched to determine moves in metal prices.

In BHP's long march to China part 2, for example, we noted that LME stockpiles and metal prices were rising at the same time – an indication that demand and supply weren't driving commodity price movements. LME data was crucial in determining that prices would fall and commodities weren't cheap. That ended up being the right call.

So what to make of news that prices and inventories are both falling simultaneously? Is this a sign that fear has overcome a nervous market? Let's look at inventories a little more closely.

LME copper inventories over the past 12 months have fallen from about 460,000 tonnes to about 240,000 tonnes. You can see this here. Yet the copper price over the same period has fallen from US$4 a pound to $3.40 a pound (see here). The data is clear; copper prices have followed inventories lower. This is unusual. Is it an opportunity?

Not quite. The copper market is changing and, like most things commodities, the role of China is crucial. China now accounts for almost 40% of global copper demand and the Shanghai Futures Exchange has become an increasingly important warehouse for inventories. It currently holds about 140,000 tonnes of copper. More importantly, however, copper has become a de facto source of finance in China.

In an economy where capital is allocated by the state, copper has become the centre of a shadow finance system where businesses borrow against copper holdings. 'Inventory finance' has become an increasingly popular way of bypassing the central governments squeeze on capital. Businesses can purchase copper on margin and use the metal to borrow additional cash. The tremendous increase in copper prices over the past decade has made this a popular and one sided bet. As prices increase, so does access to cash. By some measures, an additional 500,000 to 1 million tonnes of copper is stored in China unofficially as a result. Vitally, this tsunami of supply isn't counted on the books of warehouses like the LME or the Shanghai Futures Exchange.

The fact that LME inventories are falling is inconsequential against the official and unofficial metal holdings in China. The days where LME data alone was enough to make judgements on the copper market are over.