Copper bottomed? Don't be too sure
Last month, Hong Kong Exchanges and Clearing sealed a HK$17 billion deal to buy the London Metal Exchange.
HKEx was prepared to pay so much largely because it wanted to get its hands on the LME's copper futures contract, the main price discovery tool for the global copper market.
On paper, running the world's leading copper contract should hand HKEx a licence to print money.
Last year, China swallowed up some 40 per cent of the world's copper supply. Yet on a per capita basis, it consumed only 5.6kg per head.
If China's economy now follows the same development trajectory as Japan's did 40 years ago, its per capita demand for copper could double over the next 10 years.
Such heavy demand growth is expected to propel the price of copper, which has already doubled over the last seven years (see the first chart), to even greater heights. For the operator of the world's principal copper contract, that should mean a handsome increase in profits.
But things may not go smoothly either for HKEx or the price of copper.
At first glance, China's copper demand is soaring. According to Ross Strachan, commodities analyst at independent research house Capital Economics, if you add domestic production of refined copper to China's imports and changes to official stockpiles, then it appears that copper consumption leapt 22 per cent in the first seven months of 2012 compared with the same period last year.
But if you look at the volume of copper products actually turned out by China's factories - pipes for air conditioners, windings for electrical transformers, foil for circuit boards and the like - then output was flat in July compared with a year earlier (see the second chart).
Weak output makes sense. Together, manufacturing industries, home appliances and the construction sector accounted for half of China's copper consumption last year.
With economic growth now slowing and property investment weak, demand is bound to be soft. Analysts at Credit Suisse expect China's copper usage to grow by just 2 per cent this year and 1 per cent in 2013, in contrast to the 26 per cent growth seen at the height of China's stimulus effort in 2009.
This gaping discrepancy between apparent demand and actual consumption implies there has been a massive build-up in unreported stocks of refined copper held in bonded warehouses and elsewhere.
Strachan at Capital economics believes these stockpiles have climbed by 900,000 tonnes since the middle of last year. Standard Chartered puts the total amount held in bonded warehouses at 600,000 tonnes, together with another 400,000 held elsewhere.
To put these figures into perspective, the LME's worldwide network of warehouses reports copper stocks of just 231,000 tonnes.
In other words, China is sitting on a huge overhang of refined copper.
This partly reflects state corporations' efforts to build strategic reserves of the metal. But it is also the result of massive speculation in copper.
The details of the trade are complex. But in a nutshell, companies buy copper on margin, then use the metal as collateral to obtain low-cost loans, using the proceeds to bet on higher-yielding assets.
This is troubling, because any weakness in the international price of copper, say, because of recession in Europe, will erode the value of Chinese borrowers' collateral.
In turn that could lead to a mass unwinding of positions, in which forced liquidation of copper stocks drives down the metal's price, further eroding collateral values. The result, some analysts warn, could be a supply glut big enough to drive the price of copper down by 20 per cent. In the near term, such a heavy fall would leave HKEx's purchase of the LME looking very expensive indeed.