John Mauldin has some more on it in his weekend letter. Simon Says Sell Copper "But first, I want to briefly comment upon what will be for most of you an obscure drama happening in the copper trading pits of the world. I call it to your attention because it illustrates the growing importance, and potentially growing sophistication, of China to the world commodity markets. My source for the following is a series of letters from Simon Hunt. There is no better authority on copper and China than Simon. He travels extensively each year in China going to producers and buyers to get a real feel for what the demand for metals will be. Now let's go to the drama. China is massively short of copper, on the order of hundreds of thousands of tons. The exact amount it still subject to rumor. Why would China, who needs more and more copper each month, be so short? The market thought it was the Chinese State Reserve Bureau (SRB). However, the SRB announced a few weeks ago, amidst all the wild rumors, that it was a trader associated with them and not the SRB that was responsible for the shorts. Shades of Nick Leeson. "When asked about the rumored shorts of the SRB in the market done by its previous senior trader, he replied, "The shorts done by him are his and not ours. We have no evidence about the shorts. The trader was on leave and would be back to work soon. When he has come back we may want him to clarify it." (Simon Hunt) "...Wild rumors have seen the front pages of the world's press in recent days. In our view, the media stories for the most part are a mixture of mistruths and half-truths. The SRB is short of 100-200kt; the losses run into hundreds of millions of US dollars; the SRB has little copper and most of that is old, domestically produced material; they are bluffing, because they cannot even deliver 200kt; the senior trader of the "Centre" has gone missing; brokerage houses stand to lose millions; senior executives have either resigned or been fired. It is a tale fit for a James Bond movie not an event that embraces China and the LME [London Metal Exchange]." (Note to financial press: if you want to really know what is happening, call Hunt. Leave the rumor mongering to the tabloids.) In the same release they also said they were going to deliver into the market 200,000 tons of copper. (As noted above, many market participants think they are bluffing.) The missing trader, Qibing Liu, did in fact turn up. It seems that he was trading for a group that is definitely associated with the SRB, if not directly the SRB, and perhaps for some well-placed Chinese individuals. They are in fact massively short, but short over a three year period, through what appears to be some sophisticated spreads. The Chinese are well aware that traders are taking price benefit of their need for ever growing amounts of copper, and that Chinese demand is a big part of the rising copper price. Quite simply, they are being taken advantage of, and they don't like it. Their manufacturers are taking truly massive losses because of the price rise. Many of these are state companies. We should be sure of this. When the Chinese say they are going to deliver copper into the market, they are not bluffing. They cannot bluff on this and ever be taken credibly in the copper or any other market. If they say they are going to deliver 200,000 tons of copper, believe it. It looks like China has some 1.5 million tons of copper in its reserve. With announced plans, it also appears that they can simply dip into those reserves until the middle of 2006 without putting stress on their true reserve need. If China does not import copper for six months, it is going to have a severe (in my opinion) impact upon the price of copper. And now we depart from Simon's wise words and go to Mauldin's wild conjecture. Let's say you are the Chinese powers that be, and are sitting around in a restaurant, bemoaning the fact you are getting screwed (that's a technical financial term) by foreign traders on metal prices in general and copper in particular. Someone quips, "We should show them and not buy any copper for a few months and let the price drop." And then the light bulb comes on, because with your massive reserves you could do just that. And not for just a few months. You could cause some pain in trading rooms all over the world. And so you decide to do it. But now you know that the price of copper is going to take a big hit. So what do you do? You build up a massive short position over a long period of time (say a three year spread). You know you will take some hits early on, but you meet those margin calls (Simon says it is around $20 million and not the hundreds of millions being quoted in the press) with either physical metal or cash, which is essentially pocket change for the SRB. Then you meet your own copper needs for the next six months with copper from your reserves. You can go longer if you need to. China is a huge factor in the copper market, and if they take no imports for six months, we will see copper back up into the market and start spilling onto the docks. Prices will drop and drop some more. You cover your shorts, making a very tidy sum for your beneficiaries, whoever they are. You teach the market a lesson to not jack with you, because you could come into any commodities market at any time and do the same (assuming you have built up reserves). Prices should be more moderate in the future, with less of a China demand premium. You replace your reserves with lower cost copper in the process, partially paid for by your profits from the shorting. Of course, there is the possibility that Quibing Liu is a Chinese version of rogue trader Nick Leeson, who took down Barings with his yen trading. But somehow I doubt it. There is still a lot of mystery to this, but as things get sorted out, I think the Chinese are going to look smarter than those on the other side of the trade. And it will make those traders less willing to put in a long term Chinese demand premium if they know they can get caught with their long positions by a bureaucratic decision to use reserves at any time. Interesting times. And now, back to Our Brave New World. "