Industrial Metals: Copper, Aluminum, and the Global Economy
Book: Commodities: Markets, Performance, and Strategies
Editors: H. Kent Baker, Greg Filbeck, Jeffrey H. Harris
Publisher: Oxford University Press, 2018
ISBN: 9780190656010
This is Part 2 of Chapter 11 by Greg Leonard and Chanel O’Neill. Part 1 covered precious metals. Now we get into the non-ferrous base metals (aluminum, copper, nickel, zinc, lead, tin) and ferrous metals (iron ore and steel). These are the metals that actually build the physical world.
China Dominates Everything
If there is one takeaway from this section, it is this: China consumes roughly half of every major base metal on the planet. Here are the numbers:
- Aluminum: 50% of global consumption
- Copper: 48%
- Lead: 43%
- Nickel: 50%
- Tin: 45%
- Zinc: 48%
- Steel: 48%
The United States is the second largest consumer across most of these metals, but at 7 to 15 percent market share, it is far behind. This concentration of demand means that Chinese economic data, Chinese industrial policy, and even decisions by China’s Strategic Reserve Bureau (SRB) can move global metal prices.
In 2005, authorities discovered that a trader for the SRB had manipulated the LME copper price. In 2008, during the financial crisis, the SRB purchased about 2 percent of world annual demand for copper and aluminum to prop up prices for Chinese metal producers. China is not just a consumer. It is an active market participant that can and does intervene.
Aluminum: Energy Is Everything
Aluminum is the second most used metal after iron. It goes into cars, planes, trucks, packaging (cans and foil), construction materials, appliances, electrical transmission lines, and machinery.
The production chain is: bauxite (ore) gets refined into alumina (aluminum oxide), which is then smelted using electrolysis into aluminum. That electrolysis step is incredibly energy intensive. Electricity typically accounts for about one-third of aluminum production costs. So aluminum prices are partly a proxy for energy prices.
China produces more than half of the world’s aluminum but only mines about 20 percent of the bauxite. It imports the difference. Pure aluminum is very soft and is almost always used as an alloy with other metals. Both aluminum and aluminum alloy contracts trade on exchanges.
The LME dominates aluminum trading, with 59.9 million contracts (about 1,497 million metric tons) traded in 2015. The SHFE also has significant volume with its smaller 5 MT contracts.
Copper: Dr. Copper and the Economy
Copper is often called “Dr. Copper” because its price supposedly has a PhD in economics. When copper prices rise, it suggests industrial activity is growing. When they fall, it suggests a slowdown.
Most copper goes to electrical uses. Chile is the world’s largest source of mined copper, producing about one-third of the global supply. That concentration means developments in Chile’s mining sector can impact copper prices worldwide.
Copper has an interesting processing step that other metals lack in the same way. Copper ore is initially processed into concentrate (about 30 percent copper). The cost to turn that concentrate into refined copper is called treatment and refining charges (TC/RCs), which add 5 to 20 percent to the final price. TC/RCs are publicly available indices and are often written directly into supply contracts: purchase price equals LME price minus TC/RC.
Copper trades on the LME, SHFE, and CME. The LME copper contract had 38.6 million contracts (964 million MT) in 2015. The SHFE had 88.3 million contracts but smaller volume in MT (442 million) due to its smaller 5 MT contract size.
Nickel: The Indonesia Ban That Changed Everything
Nickel’s primary use is in stainless steel (65 percent). The big story in recent years has been supply disruption from Southeast Asia.
A decade ago, Chinese producers shifted from importing high-purity, expensive nickel to importing low-grade nickel-iron ore and refining it into “nickel pig iron” (about 10 percent nickel, 90 percent iron) as a cheaper input for stainless steel. Most of this ore came from Indonesia and the Philippines.
In early 2014, Indonesia banned metal ore exports. The goal was to force companies to build smelters in Indonesia, creating local jobs and moving up the value chain from raw materials to finished metals. The Philippines became the world’s top nickel ore exporter overnight, now supplying about one-quarter of global mined nickel.
The ban had real price effects, and in January 2017, Indonesia partially eased its export restrictions.
Lead, Zinc, and Tin
These three metals round out the LME’s non-ferrous lineup.
Lead is mainly used in batteries (80 percent). China produces nearly 40 percent of the world’s lead.
Zinc goes primarily into galvanized steel (50 percent) and other alloys (34 percent). China mines and consumes about 40 to 48 percent of global zinc.
Tin is used as a protective coating and in solder. China and Indonesia together produce more than half of worldwide tin. Indonesia’s ore export ban reduced its production, with Myanmar stepping in to supply China.
Lead and zinc mine sources are generally found together, similar to how gold and silver co-occur.
The LME Warehouse Problem
One of the most interesting stories in the chapter involves LME warehouse delivery. When you hold a physically-settled futures contract to delivery, the seller gives you a warrant for metal in an LME-approved warehouse. The buyer has no control over which warehouse.
LME warehouses are not required to deliver metal within a fixed period. They just need to deliver a minimum amount per day. This system led to wait times exceeding two years at some warehouses, peaking between 2011 and 2014. Warehouse owners charged rent the entire time. This was particularly bad for aluminum.
The long wait times had several effects. Government agencies investigated. Private lawsuits were filed. And regional price premiums over the LME price spiked. Aluminum premiums, traditionally under $200 per metric ton, consistently exceeded $200 between 2011 and 2013.
In response, both the LME and CME introduced regional premium contracts on aluminum. The LME also implemented new rules to reduce load-out times. By December 2016, wait times were down to 20 days or less at all warehouses except one aluminum facility in the Netherlands (still at 8 months).
This warehouse situation also helped the SHFE gain market share. Traders who wanted reliable delivery in a specific region could use SHFE warehouses in China or CME warehouses concentrated in the U.S. instead of dealing with the LME’s global but sometimes dysfunctional system.
Iron Ore and Steel: The Newest Derivatives Markets
Iron ore and steel derivatives barely existed a decade ago. Now they have the largest trading volumes of any metal contracts.
Iron ore pricing used to be simple. For more than 30 years through 2008, the “Big Three” producers (BHP Billiton and Rio Tinto in Australia, Vale in Brazil) set prices through annual negotiations with Asian steelmakers. That system broke down in 2009.
In 2008, Platts, Metal Bulletin, and The Steel Index each launched iron ore price indices for delivery into China. OTC trading based on these indices followed quickly. The Singapore Exchange launched clearing of iron ore swaps in 2009. In 2013, China’s Dalian Commodity Exchange (DCE) launched physically-settled iron ore futures. DCE’s trading volume quickly surpassed Singapore’s. Goldman Sachs estimates that individual (non-institutional) traders account for 70 percent of Dalian iron ore volumes.
Steel followed a similar path. Three Chinese exchanges tried trading steel in the 1990s but all closed by 1994. The LME and CME launched steel futures in 2008. The SHFE launched steel rebar futures a year later and now has by far the largest volume. The SHFE steel rebar contract was the most traded metal futures contract in the world in both 2014 and 2015.
Steel production is massive. More steel is produced every year than all other metals combined, making up over 90 percent of total metal production. Nearly 98 percent of iron ore goes into steel. About 35 percent of steel production comes from recycled scrap.
The China Factor
The overarching theme of this chapter is China’s growing dominance. Chinese exchanges are already the dominant venues for ferrous metals. For base metals, the SHFE is steadily gaining on the LME. For precious metals, the Shanghai Gold Exchange and SHFE are expanding their roles.
The LME and CME remain the reference price sources for now. But the authors suggest that status may soon be shared with Chinese exchanges. The numbers back this up: Chinese exchanges have enormous trading volumes, domestic warehousing that the LME lacks, and a captive market of Chinese industrial consumers and individual traders.
My Take
Two things stand out from this half of the chapter. First, the warehouse delivery problem at the LME is a cautionary tale about market infrastructure. When wait times for metal delivery exceed two years, the futures market is no longer properly connected to the physical market. That disconnect creates all sorts of pricing distortions and erodes trust.
Second, the speed at which iron ore and steel moved from annual negotiated pricing to active futures markets is remarkable. In less than a decade, these commodities went from having no derivatives to hosting the most traded metal contracts in the world. And the center of gravity for these new markets is firmly in China.
Previous: Precious Metals: Gold, Silver, and Safe Haven Investing