Doctor Copper Is Sick

“I used to sleep nude - until the earthquake.” – Alyssa Milano

Exchanges backed by physical product are a marvel of markets. They facilitate standardization of product and price, enable efficient planning for producers and consumers alike, and create venues for speculators that allow transmission of market signals into the real economy. In the long run, physical exchanges lower the price and increase the use of the underlying commodity being traded.

Sometimes, things get weird in physical exchanges and prices go to places no market participant imagined were possible. What the regulators do in such circumstances is telling and has huge potential impact on the future for the commodity experiencing such dislocations.

On Monday, April 20, 2020, the price of oil fell to minus $37.63 a barrel. How did this happen? Somebody was long an oil contract and was obligated to take physical delivery. They had no place to put it. Somebody else had the ability to take physical delivery at that moment in time and demanded $37.63 a barrel to do so. To use language the apes at WallStreetBets might understand, somebody got caught naked long and the market taught that person a severe lesson.

Of course, there isn’t really “a price” for oil. There are many prices, depending on when and where physical delivery occurs. The front-month May 2020 West Texas Intermediate (WTI) for delivery in Cushing, Oklahoma is the contract that traded negative and – critically – the Chicago Mercantile Exchange (CME) allowed it to happen. Here’s how the Wall Street Journal reported on it shortly after the historic event:

“CME Chairman and Chief Executive Terrence Duffy said in an interview that WTI futures worked as designed, and their foray into negative territory was a signal of real market forces at work.

‘It’s not a price that makes you feel good,’ he said. ‘But the reality is, there is oversupply, there is under-demand that’s virus-driven, and there is nowhere to put the stuff.’”

Whatever you might think about the CME’s decision, few doubt the sanctity of that market now. Participants understood the rules, the rules didn’t change, a clearing price was found, and life went on. Production of oil was curtailed, creative storage solutions were implemented, prices recovered, and excess inventory was worked off in an orderly fashion as the economy rebounded.

Ironically, we may soon find ourselves in the opposite situation in the months ahead, as demand for oil grows and Cushing’s inventory continues to fall. As we’ve chronicled on several occasions, governments in the West are crimping the supply of oil. If these trends continue, we expect the price of oil to go significantly higher, which would serve as yet another strong market signal to all participants. Based on the CME’s behavior last May, don’t expect them to step in and bail out participants caught naked short in a no-offer market.

Not so in the copper market. A key exchange for copper broke last week, and regulators stepped in to bail out short sellers who couldn’t deliver. The London Metal Exchange (LME), which has been home to copper trading since 1877, saw its physical inventory nearly drained. Here’s how the Financial Times covered the events:

“Unlike most futures exchanges, the LME’s contracts are based on physical metal that sits in its network of warehouses, which stretch from Rotterdam to Malaysia.

But large requests to withdraw metal over the past month have left extremely low levels of copper stocks on the exchange, which threatens the LME’s connection to the physical market. This week backwardation on the copper contract reached $1,104 a tonne, a record high.

Commodity trader Trafigura has been behind the requests to withdraw the metal, Bloomberg reported on Monday. Trafigura said the metal was for its customers.”

Let’s deconstruct what happened. Below is the 3-month spread chart for copper. Essentially, somebody was caught naked short and could not make delivery. They collected money from another trader at some point in the past on the promise that they would have copper to give them, but when the time came, they couldn’t make good on their contractual obligations. The price of copper for immediate delivery skyrocketed compared to the price of copper for delivery in three months. Traders call this situation backwardation and view it as a sign of extreme tightness in the physical market.

Instead of following precedent set by the CME last May and letting the market find the clearing price of copper for immediate delivery, the LME intervened. Bloomberg gives us the details (emphasis added):

“The LME emailed members late on Tuesday asking for details about client activity in copper warrants going back to early August, according to people familiar with the matter. The email asked for the business reason for members’ and their clients’ transactions, the people said.

That came shortly after the exchange announced a set of rule changes that included limits on the nearest-term copper spreads and allowances for holders of some short positions to avoid delivery.

As the world’s largest futures exchange for industrial metals and the operator of a global warehouse network, the LME plays a key role in maintaining an orderly market during periods of supply stress. The additional actions announced Tuesday have been ordered by a rarely used special committee, which has the power to impose controls to limit the impact of shortages on buyers.”

Copper inventories at the LME have been falling for some time. Demand for copper is growing as the economy recovers and the automotive market shifts toward electric vehicles. New supply for copper is coming online slowly, mostly due to regulatory and political challenges in copper-rich regions. If you were foolish enough to short copper with these market dynamics, punishment should have been swift. If you were shrewd enough to take the other side of the trade, rewards should have been realized.

Instead, the LME engaged in temporary price suppression. Some will blame Trafigura for market manipulation because they took physical delivery of so much copper, but Trafigura wasn’t responsible for letting inventory levels get so low in the first place – the LME controls its own warehouses. More importantly, the LME damaged its credibility in the marketplace. It either facilitates price discovery and thereby serves a useful purpose, or it doesn’t. Apparently, it doesn’t.

Attempts to suppress price inevitably cause product shortages and higher prices down the road, and we expect this time to be no different.  If a well-run physical exchange facilitates lower prices and assures ample supplies, surely a broken exchange does the opposite.

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