October 9, 2006

In a MIDAS back on April 12th, David R and I proposed the "China Hoard" theory to help explain the wildly surging base metals prices – most especially copper. We proposed that China was acquiring and stockpiling base metals as a monetary strategy. Now that six months have gone by, it is time we revisit the market action and see how the China Hoard theory has held up.

At that time, sharp commodity analysts such as Frank Veneroso and Peter Grandich had called copper overbought and looked for a correction. Yet copper continued to rise, outperforming even the impressive moves in gold and silver. Commodity analysts were at odds to explain the apparent surging physical demand. They considered the demand to be in excess of what Chinese industrial demand should have warranted. Frank Veneroso claimed copper was being hoarded to keep it off the market, to manipulate prices higher, and expected a significant copper crash.

We were interested by a remark in MIDAS by Jeff Dahl of Samex, who had heard at a meeting in London that the Chinese Central Bank had begun declaring copper as part of its monetary reserves. We suggested that perhaps China was intentionally stockpiling copper and other base metals as a way to exit its mountain of devaluing dollars. Doing this would cloak China’s monetary demand in its industrial demand, supporting prices more strongly than analysts expected. We further suggested that China might also be acquiring base metals as an energy play. Facing surging internal demand, with oil possibly peaking, and blocked from acquiring precious energy assets such as Unocal, the Chinese might have decided to use their dollar credits to stockpile metals that other nations had spend their energy imports to extract and refine.

To assess how well the China Hoard theory had held up, I started with the market action. In the six months since April 12th, the precious metals markets have spiked, suffered a wrenching sell-off, stabilized and then been hammered mercilessly down. December gold has moved from about $580 to $740 and back again. December copper, by comparison, spiked, sold off some, but stabilized right around its high; it has gone from about $2.10 to $3.75 and now is at $3.40. Here is an instructive comparison chart:

http://www.futuresource.com/charts/charts.jsp?s=RHGZ06&o=GCZ06&a=D&z=610x300&d=medium&b=bar&st=

The copper price has resisted selling off, and shows enormous support underpinning copper movements.

We called the major non-ferrous scrap metal dealers to investigate the physical market. Scrap copper cannot be delivered against a contract without further processing, so we thought it would represent a true view of physical demand. One executive we spoke with traveled to China very often to meet with new customers. Here are the notes from his remarks on Chinese demand:

[…] was unquestionably bullish on Chinese growth. He noted that the Chinese have only a vestigial consumer economy; their enormous demand for metal is driven not by consumers, but by internal infrastructure needs. He observed that China determines the well-being of the scrap industry in the U.S. and Europe, and China dictates the price. His observations supported the view that a Chinese contraction might cause a commodity slump in the U.S. and America – but that China remained firmly in a long-term bull market that the West simply did not fully comprehend.

Chinese physical demand for base metals appears to be quite robust even at these historic price levels.

I looked at the Chinese Central Bank website to see if I could confirm Jeff Dahl’s remark. I could find no specific breakout of copper or other base metals on the central bank balance sheet, and no policy notes on auditing base metal stockpiles. The remark may have been incorrect, or the information may not be broken out separately. Gold is listed separately; the reserves list no silver. Chinese gold reserves have apparently not changed this year, at least by the government statistics (which may or may not be trustworthy).

We cannot conclusively prove or disprove whether the Chinese are hoarding metal, or whether they are doing so as part of a strategic plan to diversify out of dollar reserves. However, physical demand does remain unexpectedly strong. The theory has modeled the market action well – and the copper shorts have gone from being burnt to a crisp to being atomized. I am inclined to think that Frank Veneroso is correct that the Chinese are hoarding copper, but I am not so sure that this copper will come back into the market anytime soon – or ever.

Looking at the scrap metal trade with China gave me some other things to think about. I hope to discuss the trade situation and expand on the China Horde theory some more in an upcoming MIDAS.