Thursday, December 20, 2012

Why a Physical Copper ETF Might be a Really Big Deal

By Tim Husson, PhD and Tim Dulaney, PhD

JP Morgan recently obtained approval by the SEC to launch a new copper ETF that, instead of holding derivatives linked to copper, will actually accumulate physical copper itself.  While this may not seem like a thrilling market development, there are serious concerns that if this ETF becomes popular and garners significant assets, the world market for copper might be upended.  Here's why:

Think of demand for copper as having two components:  demand for industrial or productive uses and demand as an investment.  Currently, the two are fairly separate, in that investors typically purchase copper futures (or ETFs which purchase copper futures) and non-investors buy physical (or 'spot') copper.*

But with a physical copper ETF, the economics of the physical copper market might change.  Consider that when an ETF purchases physical copper and stores it in a warehouse, that copper is no longer available for productive use.  Therefore the amount of physical copper that is actually available for use has been reduced.  As the ETF grows, it removes physical copper from world supply, perhaps leading to a shortage.  There is some academic research providing evidence that large players in a market have the ability to, perhaps unintentionally, manipulate prices and increase market volatility -- even adversely impacting other asset prices.

However, this type of shortage would be different than artificial shortages caused by market manipulation. When someone tries to corner a copper market as 'Mr. Copper' did in the 1990s, the price of copper increases and traders respond by shorting. But as the manipulator keeps buying at higher and higher prices, a 'short squeeze' is created where traders have to buy in order to cover their shorts, sending the price even higher. Presumably, traders would not short in response to increased copper prices resulting from the ETF's purchases, because those traders would know that price change reflects actual market demand. Nevertheless, if the ETF grows and must hold large quantities of copper, that reduction in supply could increase copper prices, which may have an effect on construction and industrial costs.

Interestingly, almost two years ago JP Morgan made a large purchase of physical copper, and some suspected it was intended as the initial purchase for a physical copper ETF.  That initial purchase alone amounted to "between 50% and 80%"  of the reserve supply at the London Metals Exchange (LME) where copper is most actively traded  -- if JP Morgan has held that copper since then, they've incurred a pretty hefty loss.

The SEC has apparently been studying the effects of a physical copper ETF on world copper markets, but some commentators argue that their approach misses the point and that the risks are apparent and real. It remains to be seen how world markets will respond if this ETF accumulates substantial assets.

Another consequence of a physical copper ETF would be to move some of the investment demand for copper from the futures markets to the spot market. All else equal, this should lower futures contract prices and raise spot market prices, leading to increased backwardation (or a moderation of contango) in the copper market.

We'll be looking more closely at the copper ETF market and the possible effects this move could have on the term structure of copper futures contracts.
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* Since some companies may also use copper futures to hedge exposure to copper price fluctuations, there is some overlap in this classification.

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