reserve management parts i and ii wbp public 71907

8/3/2019 Reserve Management Parts I and II WBP Public 71907

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World Bank Presentation Page 1 6/14/2007

Reserve Management

The Commodity Bubble, The Metals Manipulation, The Contagion Risk To Gold

And The Threat Of The Great Hedge Fund Unwind To Spread Product

To: Global Central Bankers at the World Bank Executive Forum

From: Frank Veneroso

April 17, 2007

Revised as of today July 19, 2007

Introduction

Thank you for this second invitation to speak at your treasury management conference.Last year I was asked to speak only because Larry Summers, who was scheduled tospeak, could not make it at the last moment and I was asked to fill in. I chose to speak onthe subject of the global commodity bubble as well as the U.S. housing and housing

finance bubble and their eventual bursting. My presentation was a bit on the histrionicside, and I know it was greeted with a certain amount of amusement. But I certainly didnot expect that it was of enough interest to warrant a second invitation to speak on thesame topic particularly with the more august speakers available such as LarrySummers.

Perhaps I am reading more into this invitation than I should, but it seems to me that theevents that have transpired over the last year must have intrigued some of you with thethesis that we have had a commodity and a housing bubble, that they may be in theprocess of bursting, and that this may have some relevance to central bankers and toreserve management.

Last year, I did not really focus on central bank reserve management, but I thought thatthis year I might direct my train of thought to some reserve management issues. So, inwhat I have to say today, I will try to work towards two assessments: first, the outlook forgold as a reserve asset, and second, the outlook for spreads and the yield curve, which isobviously very relevant to reserve management.

The following paper is very long. So let me give a road map of where I will be going.

In the first part of this paper on the Commodity Bubble, I make the case that, in realterms, we have had an unprecedented commodity bubble in this decade. This bubble hasoccurred because of unprecedented investment and speculation in commodities, largelyby way of derivatives. The far more important engine of this bubble has been leveragedspeculation by hedge funds. Over the last two years prices have climbed even though themicroeconomic fundamentals of commodities have deteriorated. There lies ahead abursting of this commodity bubble. It is now being triggered by deterioratingfundamentals and it will be exacerbated by eventual investor revulsion which will reversethe extraordinary fund flows that have created this bubble.


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In part two, Metals: A Speculation to the Point of Manipulation, I turn to the leadingedge of this cycles commodity mania metals. In base metals and to some degree inwhite metals hedge fund speculation has extended beyond derivatives to purchases of thephysical. This has resulted in several variants of classic market squeezes across themetals sector. These squeezes in the context of a runaway speculative fervor have

resulted in increases in real prices for some metals that are far in excess of anything thathas ever occurred before for these metals, in particular, and almost all commodities ingeneral. Because of the extraordinary amplitude and duration of these price moves, themicroeconomic responses will be stronger than ever before, generating record surplusesthat will ultimately lead to reversion to the mean or marginal cost. Investor revulsiontoward this commodity subsector should prove to be greater than for other commodities.A consequent reversal of fund flows and the eventual liquidation of physical stocks heldby hedge funds should lead to severe undershooting of marginal cost in the years tocome.

In the third part of this paper, I consider gold. Golds fundamentals are far better than

those of base and white metals. Unlike other commodities, there is zero mine supplygrowth in gold. Unfortunately, growth in physical demands for gold in jewelry, small barand official coin has been surprisingly negative over the last decade plus, especially informer gold loving Asia. The net flow of gold from official stock liquidation in all itsforms, which had been depressing the gold price, has now disappeared, eliminating aformer potentially bullish factor for gold. The last advance in the price of gold since mid2005 has been driven by funds. Gold and other metals have been especially closelycorrelated in this cycle, perhaps because funds have similar portfolios driven by a similarpsychology toward all metals. Therefore, a revulsion by institutional holders fromcommodities in general and the metals sector in particular constitutes a serious contagionrisk to the gold price.


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Part I: The Commodity Bubble

Microeconomic Dynamics Dictate Commodity Cycles

Let us first consider the bull market in commodities in this cycle. That is a first steptoward drawing some implications regarding the outlook for gold as a reserve asset.

I will start with a recap of my thesis from last year.

Commodity prices move in cycles. Their cycle tends to be strongly correlated with thebusiness cycle. However, since the end of the 1970s our business cycle expansions, inthe United States at least, have been longer than in the past. The expansion of the 1980slasted eight years. The expansion of the 1990s lasted ten years. Commodity cycles have

not tended to be this long.

G 75 CRY Reuters


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GSCI Commodity Spot Index

Note: The GSCI chart is very heavily weighted with energy, hence the brief spike in 1990with the onset of the Gulf War and the rally in 2000 when most commodity prices werevery weak. The CRB chart tracks most other commodities including metals.

The above charts make this clear. In the 1980s there was a recovery in commodity pricesfrom the depths of the deep global recession. But it did not last for long. Themicroeconomics of the supply and demand for commodities led to a sharp correction inthe mid 1980s, despite an uninterrupted global economic expansion. Around 1984industrial metals were the first to sink back to close to the recession lows. The price ofoil, held up by OPEC supply cutbacks into 1985, was the last commodity to undergo asevere correction in the middle of that decade.

Later in the decade sustained global growth along with restrained supplies owing to thefall back in prices put upside pressure once again on the prices of commodities, thoughnot uniformly. When commodity prices went up again later in the expansion the rise inmetals prices was particularly strong, while the price of oil barely recovered as itbounced along its new bear market base (until the 1990 Gulf War).

In any case, late in that decade most commodity prices started down once again by 1989,well before the 1980s business expansion ended.


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A similar pattern whereby the commodity price cycle was much shorter than the businesscycle occurred again in the 1990s. A rolling global slowdown from the U.S. recession tothe Japanese and European recessions delayed the onset of a new full fledged commoditybull market until the middle years of the decade. A few years later peaks were reached in1996 and 1997. Then, once again, long before the end of the U.S. economic expansion,

and for that matter the global economic expansion, commodity prices started down. Thesevere economic weakness of Asia in 1998 contributed to this decline. However, it wasnot enough to take global economic growth below its trend. Nonetheless, the price ofcrude oil fell to $10 a barrel in 1998 a multi-decade low and the prices of industrialmetals fell to close to multi-decade lows in 1999 even though the U.S. economicexpansion remained in full force.

I believe it is safe to say that commodity bull cycles tend to be shorter than the unusuallylong U.S. economic expansions that we have had since the onset of the so-called GreatModeration that began in the early 1980s. Why was this the case?

I think the answer is very simple. Although cycles in global aggregate demand greatlyinfluence commodity prices, in addition to these macroeconomic determinants ofcommodity prices there are the microeconomic determinants of supply encouragementand demand rationing. A global economic expansion may pull commodity prices up.But once prices are well above marginal cost, supplies are encouraged and substitutionand economization lead to the rationing of demand. These microeconomic dynamics inthe end drive commodity prices lower, even if a global business expansion remains intact.

At least, until this cycle.

Until Now. In Real Terms, The Biggest And Longest Commodity Bull In History

The commodity bull market of this decade has been unusually high in amplitude. Bysome measures real (inflation adjusted) commodity prices have risen more in percentageterms than they have in any prior half-decade bull market. As we will see later in thisdocument, the percentage rises in price in some industrial metals have broken allhistorical records.

The bull moves in some commodities in this cycle have also broken records forlongevity. By one compilation only two of the commodities traded on U.S. futuresexchanges have ever had single cycle bull moves in a century and a half of economichistory that have lasted as long as some of the most persistently bullish commodities inthis cycle like nickel and lead.

It would seem that the microeconomic dynamics that have reversed commodity prices inthe past have either been absent or overwhelmed. Let me illustrate these points.


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Look at the above chart of commodity prices over two and a half centuries. What is mostimportant about this bull cycle is that it is a commodity price rise that is without anaccompanying generalized inflation. This makes it larger in real terms than any inhistory over a single cycle. It is the amplitude of this bull in inflation adjusted termsthat makes the current cyclical bull move in commodities anomalous indeed.

In nominal terms, this cyclical bull move exceeds in percentage terms the move from1968 to 1974 and, again, the subsequent move from 1976 to 1981. To be sure, the entirenominal price move from 1968 to 1981 exceeds that of this cycle but the time periodinvolved was twice as long. Also, there was a huge increase in the general price levelfrom 1968 to 1981. Then almost all indices of general price inflation increased by almostthree times. So most of that overall increase in nominal commodity prices was due toinflation in the general level of prices and not to the relative price of commodities.

By contrast, inflation has been minimal since late 1999, making the increase in the realprice of commodities in this cycle greater than even that of the very long 1968 1981super cycle.


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If you look across this chart youll see that most of the big moves in commodities weredue to inflations that were related to wars. That was true for the bull move at the time ofthe Vietnamese War from 1968 to the mid-1970s. It was true of the increase incommodity prices from 1939 to 1951 a period that spanned the Second World War and

the Korean War. The bull market in commodities that ended in 1920 resulted from themonetary issuance associated with the First World War. Again, the bull move that endedin 1864 was associated with the inflation of the Civil War. And the moves that ended in1815 and in 1781 were associated with the War of 1812, the Napoleonic Wars, and theaftermath of the US Revolutionary War.

What this look back at history tells us is that price spikes in commodities have alwaysbeen due in some way or other to the onset of generally inflationary conditions, usually asa result of war time finance or its aftermath. Inflation adjusted or real commodity pricessimply have never had long and lasting bull markets.

Again, until this cycle.

The New Era Thesis

In my experience, when a cyclical price trend persists for longer and to a greater degreethan has happened in the past, market participants declare a New Era to not only explainthis unusual continuation but to also justify the persistence of the trend forever forward.

This has certainly happened with regard to commodity prices in this cycle.

There has emerged a host of New Era advocates who share the following commonarguments. The very healthy growth of the emerging economies and the super stronggrowth of China and India have made world economic growth different this time. We arein the midst of a new global supercycle in commodity demands that has relegated thefairly short commodity price cycles of the past to a history that is no longer relevant.

The same New Era thinking extends to the supply of commodities. We are most familiarwith such thinking as regards the oil market. The Peak Oil thesis says that discovery ofall the easy to find large oil reservoirs with low extraction costs are behind us. Yes, thereare smaller, higher cost oil reservoirs to be found and exploited. But decliningproduction from the large mature fields we largely rely upon offsets these new sources ofoutput. For all the new drilling and development we do, we find ourselves simplyrunning fast to stay in the same place, as decline rates on our old reservoirs pull theground out from underneath us.

New Era commodity bulls extend this supply side thesis as it applies to oil to many othercommodities. In agricultural commodities, we are facing limits to the expansion ofarable land. In industrial metals the easy to find deposits have been found and, inexisting mines, ore grades are declining, and so forth.


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It is my belief that these many claims for a New Era of explosive demand growth andsupply constraints are largely erroneous. This is best argued by looking at individualcommodity markets, for there we can document in detail if trend demand growth hasaccelerated or if rapid supply increases have become impossible. I will do that in what

follows. We will see that the analysis of individual commodity markets shows clearlythat the New Era hypotheses are wrong. But one can also make a few generalizationsthat are pertinent.

Two decades ago I participated in a huge study of the copper market under the auspicesof the IFC and the other partners in a project called Escondida a project which was tobecome the largest copper mine in the world. We had the resources of the World Bank,BHP, RTZ, and an array of the worlds best consultants. If I go back to that copper priceforecasting exercise at that point in time it becomes very clear that, despite the higheconomic growth in the emerging world in this decade, we are not in a New Era, we arenot in a new supercycle in commodity demands.

Making long term commodity price forecasts is largely an exercise in extrapolation. Atthat time, two decades ago, we were extrapolating based on the economic growth trendsof the prior several decades. The emerging world was growing very fast, though thecontributors to its growth were somewhat different. In those days Brazil was a 7%grower, Mexico a 6% grower, Korea an 11% grower. Their economic growth rates todayare perhaps half of what they were. This is something of an offset to the recent high 9%growth rates of China and India.

But, you will respond, the economies of the emerging world overall are now a muchlarger share of the world economy overall. And, to be sure, that is true. But offsettingthis is the fact that the large developed economies were then far faster growers. Japanseconomy grew at a 9% rate in the 1960s and almost at that rate in the 1970s. It now has asecular growth rate of perhaps 1.5%. Europe overall had a growth rate of 4%-5% in the1960s and 1970s. It now has a secular growth rate of perhaps 2%. For the largest shareof the global economy the attainment of the technological frontier, which implies lowerproductivity rates, plus adverse demographics, has now reduced its economic growth ratedramatically. If you take all the economies in the world, valuing GDP based on exchangerates, the overall global growth rate has not significantly changed since the mid 1970s.And so the demand pressures on commodities should not have significantly changedeither.

And, in fact, as the chart below indicates, global economic growth and hence growth incommodity demands were higher in the period immediately prior to the mid 1970s. Thenmuch of the global economy was still recovering from a prior war ridden epoch when thedisasters of wartime had set back so many economies from a greater potential madepossible by the interim advance in the technological frontier. Now these industrializedeconomies have matured technologically and demographically. Other emergingeconomies are following their former path, providing the new leadership to globalgrowth. But the overall pace of that global growth has not appreciably changed since the


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mid 1970s and is considerably lower than the growth that was achieved in the first postwar decades.

Global Real GDP, % Annual Change

(Exchange Rate Based)

0

5000

10000

15000

20000

25000

30000

35000

40000

1900

1905

1910

1915

1920

1925

1930

1935

1940

1945

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

0

0.01

0.02

0.03

0.04

0.05

0.06

0.07

0.08

Series1

Series2

Source: IMF, Contributed by Lars Pedersen

Mega Speculation and The Explosion In Commodity Derivatives

So if it is not a new era of supercycle demand growth and supply restraint, what has ledto such a high amplitude and long duration bull market in commodities in this cycle. Myanswer is speculation nothing more. And speculation on an unimaginable scale.

Our first clue to the scale of this development is data compiled since the mid 1990s on

over the counter commodity derivative positions held on the books of the worlds banks.Compiled by the Bank for International Settlements, it shows striking growth over thepast several years.


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Integrated Oil Update, Mike Rothman,ISI, December 19, 2006

Though the six-fold increase in such positions over a few brief years is dramatic , it is the

magnitude of these positions that is most alarming. From what we know of this datathere is considerable double counting. But, offsetting this, this compilation is incomplete.It excludes the positions of some investment banks who are extremely importantintermediaries in the commodity derivatives markets. And it excludes all futures andoptions positions on commodity exchanges, which may add another $2 billion or more tothe global total. Taken all together the global total for all commodity derivatives isprobably much more than $10 trillion.

It is hard to know what to make of this data. But it is noteworthy that several years ago,at the then prevailing lower commodity prices, the entire above ground stock of allcommodity inventories was only in the hundreds of billions of dollars. Even if only a

fraction of the increase in global commodity derivative aggregates in recent yearscorresponds to a net long position of investors or speculators, implying speculative andinvestment positions of a few trillions of dollars, it would appear that this increaseddemand for commodity derivative positions has overwhelmed what have been relativelysmall markets.


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No wonder, then, that this cycles bull market in commodity prices has gone higher ininflation-adjusted terms and for longer than in all prior uninterrupted half-decade cyclesin the past.

Investment Or Speculation?

The question arises, who are these new investors or speculators in world commoditymarkets and what is their behavior?

Investment in commodities today probably refers above all to pensions and endowmentswho have made long term strategic allocations to commodity futures index baskets fordiversification purposes. However, the total assets of all these baskets is somewherebetween $100 and $200 billion up from perhaps a total of several tens of billions at thestart of this decade 7 years ago. These investment positions are quite straightforward;

there is little in the way of spread products or options or leverage that would augment thisoverall position. If so, one is hard pressed to explain the increase in recent years incommodity derivative positions in the many trillions of dollars by citing such strategicallocations into commodity baskets.

There is another alternative: speculating hedge funds. It is estimated that the total assetsof hedge funds of all types globally now approaches $2 trillion (up from several hundredbillion 6 years ago) and many of the types of funds who speculate in commoditiesemploy huge leverage. The increase in gross assets of those speculators could accountfor much more of the growth in commodity derivatives. But do they?

We got something of a window on this world at the end of the third quarter of last yearwith the collapse of the hedge fund Amaranth. Apparently, this fund lost perhaps $6billion or more in one commodity U.S. natural gas in a matter of weeks. Themagnitude of this loss and the change in natural gas forward prices at the time implies agross position in that commodity that was at least a small whole number multiple of the$6 billion loss. By contrast, the nominal value of all the U.S. natural gas derivativepositions of all outstanding commodity baskets was not much larger than Amaranthsloss.

Clearly, in natural gas one speculative hedge fund, Amaranth, was many times larger inthe gas forward markets than all the worlds investors in commodity baskets. AndAmaranth was only one hedge fund. According to one compilation there are nowhundreds of hedge funds dedicated solely to the commodity sector, and all kinds of morediversified funds like global macro funds who speculate in commodities. So hedge fundpositions in commodity derivatives outweigh pension and endowment investmentpositions, and by a very large margin.

So if unprecedented speculation is responsible for the amplitude and duration of thiscommodity bull cycle, it can be attributed, for the most part, to hedge funds.


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How Investment And Speculation In Commodities Inflates Commodity Prices

In the above discussion there is an implied assumption: hedge fund speculation in

commodity derivatives has overwhelmed commodity markets and has driven commodityprices way beyond levels justified by fundamentals. Also implicit is the assumption thathedge funds can employ vast leverage using such derivatives, so that limited pools ofspeculative capital can create huge demands for commodities.

I believe these assumptions are valid. But there is a widely held and respectable counterargument. Derivatives are simply contracts for future delivery between two parties. Tobe sure, a speculator can take a long position in a commodity with only a small margincommitment by going long a derivative contract. But, for his long position, there must bea counterparty short position. The counterparty taking the short position need put up onlya small margin also and can apply the same degree of leverage. So the two sides of the

contract balance out. And the leverage employed using a derivative by both the long andthe short balance out. Hence the proliferation of derivative contracts does not influencemarket prices, despite their leverage potential. Because the longs and the shorts basicallyhave the same access to leverage and take offsetting positions.

Since the mid 1990s Fed chairman Alan Greenspan and Treasury Secretaries RobertRubin and Larry Summers were pushed repeatedly by Congress to bring the OTCderivatives market under regulatory scrutiny and control. The concern of someCongressmen was that the shadowy world of OTC derivatives could increase the leverageof speculators and thereby the risks to markets and ultimately to economic activity.

Greenspan, Rubin, and Summers fought off these efforts by Congress with unfailingdetermination. Their argument was that derivatives simply reallocated risk; they did notincrease risk. And this reallocation spread risk among a greater number of marketparticipants, including participants who were better suited to bear it. Therefore,derivatives were reducing- not increasing- the risks to markets.

This sounds like a solid argument with theoretical underpinnings. But, for many marketparticipants, it just does not seem realistic. We know of too many instances wherespeculators have used derivative contracts to take on very large leveraged positions andhave thereby exaggerated price movements which ultimately led to crashes.

There are two famous examples. The first is the 1987 stock market crash which resultedfrom the widespread adoption of portfolio insurance which was based on the relativelynew introduction at the time of derivatives and synthetic derivatives on the stock marketindices. The second example is provided by 1998. In that episode it was not just LTCMwhich experienced severe difficulties; many of the large dominant macro funds at thetime took very large losses in only a matter of a few months. And Bankers Trust sufferedsuch losses it had to be merged into Deutsche Bank. These funds and prop desks hadpushed a whole set of markets to extremes which then all violently reversed in unison. In


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many of these markets, like the fixed income and currency markets, the price distortionswere aided by the use of derivatives and the subsequent crashes were exacerbated by theunwinding of derivative positions.

Many have argued that the explosion in fixed income and forex derivatives in this decade

which one sees via the published reports of participating commercial banks- has notresulted in market excesses as a result of their explosive growth since the end of the1990s. That is probably correct. For so far, at least. So, the experience of these marketsand their derivatives can be marshaled to support the Polyanna thesis of Greenspan,Rubin, and Summers. But one can do this only if one conveniently chooses to forget thederivative-related debacles of 1998.

How does one settle this dispute? By looking closely at the interaction of derivatives, theunderlying, and the price mechanism in specific markets. So let us look at all these inthe commodity space.

First, we must decide on what constitutes the underlying. Commodity derivatives tendto arise through the hedging of the stock of commodity inventories and anticipated futureproduction. Before the commodity bubble of this cycle- when commodity prices wereclose to marginal cost- the total money value of all commodity inventories worldwidewas on the order of several hundred billions of dollars. Some of this was hedged, givingrise to commodity derivatives. And a small part of future production was hedged, givingrise to yet more commodity derivatives. Taken together all of these commodityderivatives were comparable to a portion of the money value of the outstanding stock ofcommodity inventories and a little forward production. The worlds commodityderivative aggregates made sense.

As a result of the bubble in commodity prices in this decade the money value of theoutstanding stock of commodity inventories and physical production has doubled ortripled. But the outstanding commodity derivatives, partly visible through the window ofcommercial bank books, has gone up by more than six fold. Now the commodityderivative aggregates seem to be outsized relative to the underlying.

Has this explosion in commodity derivatives distorted prices and increased market risk?It is apparent from my use of the term bubble and the way I have framed the above thatI believe it has. Let me explain the process whereby it has.

Roughly four or five years into this decade- and two or three years into this cyclicaleconomic expansion- commodity markets experienced a big bull run. Without going intothe details, I think it is easy to make the case that microeconomic and macroeconomicfundamentals were responsible for the first stage of this bull move. But once it wasunderway the superior performance of commodity prices attracted attention. Long-terminvestors like pensions and endowments began to consider commodities as a new assetclass and hedge funds, always looking for fast action to justify their costly 2% plus 20%compensation arrangements, began to chase commodities.


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As is apparent from the above chart, the first phase of the commodity bull move occurredwithout huge growth in commodity derivatives. But from the beginning of 2005 onwardthere has been a vast explosion of hedge funds and pensions and endowments who havetried to get longer and longer commodities by way of the purchase of long positions incommodity derivatives. Looking at the pattern of expansion of commodity derivatives

one can make a prima facie case that the investment and speculative flows intocommodity derivatives with their huge implied leverage pushed commodity prices furtherthan they otherwise would have gone after 2004.

How could this have happened? Initially, before the explosion in commodity derivatives,the structure of commodity derivatives markets was as follows: speculators tended to benet long, commercial consumers tended to be net short as they hedged some of theirinventory, and producers were mostly net short as they hedged some inventory and somefuture production. The speculators were able to increase their long positions incommodities by way of derivatives because commercials, who were natural hedgers ofsome of their inventory and some of their nearby future production, were willing to

increase the volume of their hedges.

How did this come about? Speculators wanting to go long had to create a price signalthat would lead to an increase in the supply of these derivatives, since for every longthere must be a short.

Buying pressure by the longs through commodity derivatives raised the price ofcommodities above their marginal cost which is their long run price equilibrium.Commercials, recognizing where marginal cost lay, were encouraged by higher prices tohedge more of the outstanding stock of inventories. They were also encouraged to sellmore of their future production forward.

In past cycles, when commodity prices soared, spot prices tended to rise much morerapidly than forward prices. Hedgers did not forget that the long run price equilibriumwas still marginal cost. As a consequence these markets went into steep forwarddiscounts or backwardations.

But, in this cycle, so great was the buying pressure of the longs in commodity derivativesthat, starting in 2005, far forward prices were pushed up along with spot and nearbyforward prices. When speculators and investors go long derivatives they are going longthe forward price. If speculators want to take on positions that are ever larger relative tothe underlying they have to push up far forward prices further and further in order toinduce producers to sell future production ever further forward- and thereby provide theincreasing supply of derivatives that accommodates the new speculative demands.

In keeping with the unprecedented explosion in commodity derivatives in this cycle, thisentire process has happened in spades. Most striking has been the case of crude oil. Inthe past, whenever crude oil was at marginal cost, the forward market was in a smallbackwardation. When the crude oil price rose sharply the backwardation became huge.In this cycle it has been totally different. As investors and speculators bought more and


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more oil by way of derivatives the far forward crude oil price was driven to a hugepremium over the spot price- something that had never, ever happened before. Why?Because this is what it took to get commercial hedgers to generate the unprecedentedcrude oil derivatives supply that rabid investors and speculators now demanded.

Let us go back to the Pollyanna thesis of Greenspan, Rubin, and Summers; in derivatives,for every long there is a counterparty short, and therefore behavior in the derivativemarket is price neutral. To be sure ex post there is always a leveraged short to matchevery leveraged long. But the process is not price neutral. Ex ante the rabid demands ofinvestors and speculators overwhelm the commodity markets and push up the forwardprice. And it is only that price signal that brings forward the commodity derivativessupply that ex post completes the identity of longs and shorts, supply and demand.

Does this price impact create a market risk? Of course. How?

If a tsunami of rabid investment and speculative commodity derivative demands hits the

commodity markets, it must drive the forward price more above marginal cost than in anormal bull cycle. The higher the price is driven above marginal cost the more newsupply will be encouraged. These high prices will also lead to a more assiduous effort bycommodity consumers to economize and substitute, thereby rationing demand. Ifunusual commodity derivative demands take prices very high and on a sustained basis,the resulting surpluses that will eventually take down these prices will be all the larger.

But there is another facet to the increase in risk in commodity markets created byderivative tsunamis. It is the financial risk created by the vast implied leverage ofderivatives. Speculators, by putting up only limited margin, can take on hugeleveraged positions. Pyramiding speculators can employ ever greater leverage as pricessoar. For those leveraged speculators it takes only a partial correction of the price rise towipe them out. In this way hedge funds can fail, as LTCM would have totally failedwithout its bailout, and as Amaranth almost failed a mere seven months ago.

The Pollyannas about derivative leverage always emphasize symmetry in the derivativemarkets: for every long there must be a short, the leverage of the longs must be matchedby the leverage of the shorts. But in the commodity markets there is not symmetry ofbehavior.

How so? The pyramiding leveraged speculators in commodity derivatives must meetmargin calls when the price eventually goes against them. They may not be able to do so.Then there will be failures. There is no parallel to this with regard to hedgingcommercials who are short by way of derivatives. Yes, they may be leveraged, but theyhave the commodity in inventory on the shop floor or on the production site or in awarehouse somewhere. Or they have future production secured in the form of extractablereserves in the ground or the wherewithal to produce another crop. Whoever are thedealers the hedgers have their margin position with, the odds are that they have thestuff to deliver against their forward sale when it comes due; hence, there is no margincall or the margin call will be financed by their dealer.


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It is this situational and behavioral asymmetry between the leveraged longs and theleveraged shorts in commodity markets that creates financial risks and the potential forcrash dynamics when derivative leverage creates excessive bull moves in prices. Forthe speculative longs who are leveraged, when the leverage goes against them they get

margin calls. And when the margin calls come fast and furious they must sell or be soldout. Not so for the hedgers who are short and who are carried by their dealers on pricerises that go against them. More importantly, when prices fall such commercial hedgersoften just sit with their shorts. They know they have the stuff to deliver when thedelivery due date comes, and they may simply wait until that due date and then delivertheir stuff against their short. So the longs are forced to liquidate. But the hedgingshorts may not be inclined to accommodate them by buying in their shorts. It is thisbehavioral imbalance that creates crashes.

A Brief Note On Oil

My objective is to get in the end to our topic of reserve management which are gold andcredit spreads. But it is probably worthwhile to touch on the single most importantcommodity first, which is crude oil, before we go on to metals and gold.

The price of crude oil has appreciated almost as much in this cycle as the most bullish ofall the commodities the base metals. So, one may ask, is it a bubble? Two years agothe noted money manager Jeremy Grantham posed this question in an interesting way.He presented a chart of the real inflation adjusted oil price going back to 1875.

He then noted: Over the years we have asked over 2000 professionals for an exceptionto our claim that every asset class move of 2 sigmas away from trend had broken, and notone of the 2000 has ever offered an exception! This should be scarier than the fact thatGMO has tried so hard to find one and failed. But we always have said that intellectually

you can imagine a paradigm shift in an asset class price, even if we have been unable todocument one yet in history. Exhibit5 shows the price of oil and 1 and 2 standard

deviation bands. If the new price averages $50 and above, it will look suspiciously likethe real McCoy. Chinese growth and supply problems coulddo it. Its the best


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possibility Ive seen in my career. But the investment desert is littered with the bones ofthose who bet on new paradigms.

So for Grantham any asset class that moves more than two standard deviations from trendis apparently a bubble and history says that such markets absolutely always mean revert,

such bubbles always burst. This happened with the bubble in oil in the 1970s. ButGrantham opens the possibility that crude oil this time could be the first exception.

Why? As alluded to above, it is a popular view (the peak oil thesis) that, in this cycle andmaybe forever forward, the supply of oil will be severely constrained. And that this willbe even more so if there is an adverse geopolitical development in the Middle East thatdisrupts global oil supplies. If oil is the first exception in history to the bursting of allbubbles, this will be why.

Let us look at oils fundamentals. When one looks at the supply/demand data for crudeoil over this cycle it falls within ranges that I would regard as reasonable relative to

history. Demand growth, which averaged perhaps 1.6% per annum in the prior decade,was elevated in 2004 to a 4% rate by a synchronous global expansion led by the emergingworld and by a power generation shortage in China that led to a transitory need to uselarge quantities of diesel to supplement the coal fired power grid until new power plantscame on line. That rate of global oil demand growth has since been tempered. This hasbeen due in part through conservation and substitution (price rationing), as one mightexpect. It has also been due to less reliance in China on diesel for power as the coal firedpower grid has expanded. So based on the global demand data, the emergence of Chinaas an economic power has not changed the global demand trend by that much. On theother hand, so far at least, we have not seen any of the severe demand rationing thatoccurred after the 1970 bull market in oil which led to a very large outright decline in oildemand in the early 1980s.

On the supply side, the depletion of the large mature oil fields found decades ago that theworld now relies upon and the absence of comparable sized new discoveries has surelyconstrained supply. Global capacity growth has been positive, but it has only risen froma 1% annual rate to only a 3% plus rate this year, despite the high prices that haveprevailed in this cycle. So the fundamentals of oil supply suggest more supply restraintthan in the past. But so far there is no peak oil; high prices still encourage some supplygrowth.

So if one looks at the global oil market, demand growth exceeded capacity growth earlyin the decade by a small margin (2%-3%). Now, in response to the very high oil price,demand growth has come down by two or three percentage points, capacity growth hasgone up by perhaps 2 percentage points, and a buffer of unutilized capacity has slowlyemerged and is gradually on the rise.

In the case of the oil market we are looking at modest changes in the supply and demandgrowth rates. This is typical of most commodity markets. There is nothing reallyshocking about any of the fundamental developments in this sector. There is none of the


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huge increases in primary supply that we are now seeing in base metals, as I willillustrate later. And there is none (so far) of the massive demand destruction that hitmetals and oil in the 1970s and 1980s respectively.

That said, I believe that much of the explosion in overall commodity derivatives over the

last half-decade must be attributable in part to investor and speculative long positions incrude oil. This investor and speculation pressure is most apparent in the emergence of asupercontango a premium in the futures and forwards curves that recently hassometimes been several times the cost of carry. Theory says such forward premiums orsupercontangos should not occur because arbitragers should buy the physical and hedgewith a forward, locking in an enormous riskless arbitrage profit. I believe that such asuper contango can exist only if investment and speculative demands in the forwardmarket are so large that virtually all available storage is filled by arbitrageurs, making itimpossible for them to arb away any further such a supercontango.

For this reason I believe that investment and speculation in crude oil derivatives has

materially inflated the price of oil, even though the supply and demand fundamentals arenot seriously out of whack. The tsunami of hedge fund speculation in commodities isresponsible for much of the amplitude and duration of the bull move in most commoditiesin this cycle. This no doubt applies to crude oil to some degree. But not to an absolutelyoverwhelming degree, as I believe is the case in the metals sector.


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Part II Metals: A Speculation to the Point of Manipulation without Precedent in the

History of Commodities

Preface

Before proceeding with this section, which is replete with extreme statements about thecurrent state of the metals markets, I believe a reminder to the reader is in order. Adecade ago a famous manipulation of the copper market was revealed. This led to a bigbear market in copper and many class action lawsuits against the perpetrators as well asdealers and banks who were peripherally involved. That these things happen in thesemarkets seems to be forgotten in todays euphoric market environment. But, at thisvery time, after many prior settlements of similar claims with large awards to theinjured, the last such case is now being taken to court. I think it is worthwhile to quotea recent description of this coming court case and its claims to remind the reader thatwhat follows does not lie outside the realm of plausibility in metals markets.

Last legal action from 1996 copper scandal to go to trialMetals Insider - 3 May 2007

A US federal judge in Wisconsin has ordered a trial next month in a long-running

antitrust lawsuit claiming J.P. Morgan & Co. Inc. conspired with Japanese trading houseSumitomo Corp to manipulate the copper market in the mid-1990s. It is the last legal

hang-over from the 1996 copper crisis with most of the other claims long settled out ofcourt. This action is a consolidated law-suit brought on behalf of around 20 US copperconsumers seeking an estimated $1 billion in damages from J.P. Morgan Chase & Co.,the successor to J.P. Morgan. "We're going to show a jury of good Wisconsin citizens the

chicanery and manipulation that went on and how manufacturers of copper wire andcopper rod suffered," Atlanta lawyer James Bratton, who represents Southwire Co. andGaston Copper Recycling Corp, told local media. "We're looking forward to getting abig verdict." The centrality of the allegation against the bank is that it provided

financing to Sumitomo to artificially inflate the copper price. The bank argued in courtdocuments that its transactions with the Japanese company were proper and did not have

an impact on copper prices. However, its motion to dismiss the case was rejected by USDistrict judge Barbara Crabb and the trial is scheduled to begin on May 29.

Introduction

In every market bubble there is some cutting edge where the greatest extremes are to befound. In retrospect, the extent of the speculation has always seemed almost impossible,though, amidst the fury of the bubble, very few recognized it for what it was. Thechronicles of bubbles in the past like Charles Kindlebergers Manias, Panics, andCrashes, and Edward Chancellors Devil Take the Hindmost show that, in almost allsuch bubbles, at such a cutting edge speculation is not only unimaginable but involvessome measure of fraud and manipulation.


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I alluded to some such behavior in the metals sector in my presentation to you last year,though with little specificity. This year there will be no allusions. I think we knowenough to say that speculation in metals markets in this cycle has gone further than in anyother cycle in history. What we have been undergoing is a speculation to the point ofmanipulation, perhaps involving collusion, across a whole array of related metals

markets.

1

I argue that it is as though the famous episode of the Hunts in silver decadesago has now been taken to a power.

I understand that these are very strong words. To back them up I will discuss a few basemetals where it has become quite apparent that something like this is happening. I willthen touch briefly on a few others as well as the white metals before we get to thesubject of gold.

My reasons for making such an unusually strong claim are many. Some come frominside reports about the activities of hedge funds and others operating clandestinely inthese markets. Some come from analysis that points to large anomalies in these markets

over recent years. And some come from claims and analyses about extreme speculationto the point of manipulation that has fallen into the public domain.

In fact, since I last spoke to you a year ago, a great deal of commentary has surfaced inthe public domain. We have put together a compilation of this commentary which we areattaching as an appendix. In what follows I will avoid all inside information andconfine myself to analysis and a small subset of this commentary that we have culledfrom the public domain.

But let me just say, we have many, many reports from market participants that are morespecific than the statements we have culled from the public domain. Also, many of thesereports are from investment firms who distribute bullish metal market assessmentssupposedly based on facts to their clients when, at the same time, they privately reportmanipulation and collusion as the dominant force in these markets.

In analyzing base metals one has to bring up an all important and unsavory but perennialfeature of these markets: the emergence again and again in past bull cycles of squeezes orattempted corners. (In this regard, see the quotes from Paul Krugman in a later sectionentitled, The Risk of Revulsion II, Revulsion From A Hamanaka on a Massive Scale.)In the past metal merchants, faced with a bull market environment, often hoardedphysical metals. By taking metal out of circulation prevailing shortages wereexacerbated. This amplified panics by consumers caught short of physical, which in turnfueled further the bull market move. This happened in many cycles in base metals sincethe late 1960s. But in these past cycles such merchants usually sold when the marketshad not yet gone into significant surplus. In effect, they tended to get out when the goingwas good.

1 Am I going too far with these words? The head of the enforcement at the CFTC just issued a warning:Regulators need more funds to guard against fraud and manipulation. Why this choice of words? Seethe above preface. And see more on this later in this text.


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A squeeze operation like this, by taking metal out of circulation, always distorted thesupply, demand and stock data. As hidden stocks were built, visible stocks declinedfaster and fell further. Market conditions appeared tighter than they really were.

Not only was the stock data distorted, so was the data on demand. We define the demand

for a metal commodity not as the demand for that metal in all the products thatincorporate it which consumers buy that measure of demand is far too hard to calculate.To simplify, statisticians in commodity markets define demand as simply the absorptionof metal by first stage processors. Take for example copper. The primary product acopper cathode is put into a furnace by a wirerod mill or a brass mill. The wirerod millproduces wirerod which is then turned into wire. And that wire is incorporated in manyproducts that consumers buy. Copper demand is defined as the absorption of the metalby a wirerod maker rather than a wire manufacturer or the maker of final products thatembody wire.

But even this concept of demand is hard to calculate for almost all economies. It turns

out it is simply too taxing to monitor the purchases of metals by first stage processors.To simplify yet further statisticians, for the most part, use a concept of apparent demand.Demand is defined for a given country as domestic production plus net imports (in otherwords overall supply) adjusted for the change in visible stocks in that economy. Theresidual produces the estimate of apparent demand.

It follows that, if there are builds of unreported stocks (due to commercial inventorybuilding or merchant squeeze operations), total supply from production and imports willhave to be higher and the residual, which is apparent demand, will have to becorrespondingly higher. So squeeze operations, with their typical hidden stock builds,not only portray less inventory than actually exists; they inflate apparent demand relativeto the true level of demand.

Earlier in this paper I described an almost unimaginable explosion in commodityderivatives due to massive investment and speculation by pensions and endowments andhedge funds. It would not be out of keeping that some of these investment andspeculative demands would have spilled over into the accumulation of physical stuffrather than just derivatives. But, remember, all the physical commodities in the world atthe prices of several years ago only had a total value of several hundred billions ofdollars. At todays prices the value of these above ground stocks is much higher. But itis still a very small fraction of the total mountain of commodity derivatives and probablythe total net investment and speculative claims on commodities by way of derivatives. Ifthis is so, even a moderate spillover of such investment and speculative demands intophysical stuff could involve an accumulation of physical inventories which is largerelative to total inventories and the flows of supply and demand.

Has such a spillover occurred? Yes. There are now commodity-oriented hedge fundsthat make it clear in their documents that they purchase physical commodities as well as


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commodity derivatives.2 It has also become fairly clear from detail provided on theownership of metal on warrant with the commodity exchanges that hedge funds hold verylarge amounts of these physical stocks a point I amplify on below. So if hedge funddocuments declare that such funds may own physical, if exchange reports suggest theysometimes own very large amounts of visible exchange warranted physical stocks, it is

certainly possible they own off warrant material as well. So the issue is not one ofwhether we have investment and speculative holdings of physical stuff in the cycle; it israther a question of how much and in what form.

Unless the holdings of physical commodities by institutional investors and speculatorstake the form of exchange warrant claims on exchange stocks, there will be no record ofsuch physical holdings. These stocks will be hidden. Increases in such hidden stocksare recorded by statisticians as increases in apparent demands that exceed the increase inreal demands. In effect, just as with our case of the merchant squeezer, the spillover offund speculation into physical commodities may result in an understatement of the truelevel of above ground stocks and an overstatement of the level and growth rate of

demand. Where markets are balanced, they will appear to be in deficit; where marketsare in surplus, the surpluses will be understated. Given the possible magnitude of suchinvestment and speculation in physical commodities indicated by the new Mount Everestof commodity derivatives, these distortions in the stock data and the supply and demanddata could be very large.

Now, let us put together the historical behavior of merchant squeezers and the morerecent behavior of institutions speculating in commodities including the physical. Aquestion arises, have hedge fund forays into physical commodities, and particularly intometals, occurred simply as passive investments or have they occurred with the objectiveof conducting squeezes and corners as merchants and speculators have done in the past?

The answer is clear in many cases the motive must have been to squeeze or corner.Why is it so clear? Because there is considerable evidence that, in the metals markets,hedge funds have taken positions in exchange warrants, which are physical holdings,even though these markets have been in significant backwardations. And, as so many ofthe commentators in our appendix indicate, these funds have held off warrant material aswell. In a backwardated market holding a forward (which is at a discount to the spot)provides a positive return as one rolls ones future or forward into a successor contract.In the last two years, there have been periods when this roll yield into a significantbackwardation has been extremely high perhaps as much as 20% -30% annualized. Bycontrast, holding exchange warrants and off warrant physical provides no positive rollyield; rather, one must pay the cost of financing plus storage and insurance. Why wouldany fund hold physical at a considerable carrying cost rather than a future or forward

2 Even Britains Financial Services Authority has acknowledged this. In a recentlypublished paper, the FSA observed: A more recent development into the market is thearrival of specialist commodity hedge funds that are trading in just a single commodity,and in some instances are willing to play the physical underlying market by takingdelivery of physical commodities for future resale on exchange/OTC.


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with no such cost but with a handsome positive roll yield instead? The only reason Iknow of is to conduct a squeeze or corner operation that yields other returns if thesqueeze succeeds. (Again, see Paul Krugmans comments later in this paper.)

If hedge funds decide to conduct squeeze plays and attempted corners as merchants

traditionally have but with their far vaster financial resources we face the possibilityof builds of hidden stocks and distortions in our measures of inventory, apparent demand,and market balances that could be far greater today than they were at any point in thepast.

It is my position based on much information that this is in fact what has occurred over thelast two or three years. As I have said above, I am not alone in this regard by any means.Just scan the appendix with our compilation of commentaries on such speculation andmanipulation of metals markets from many market observers. And, as an example, lookat his recent commentary on this very subject by J.P. Morgan:

This week we examine the tension in the metals market between (visible signs ofweakness in) industrial trends and the impact of the now super larger and superleveraged commodity funds. We test the water to ask if there is manipulation or collusionof if the sector has inadvertently become a price support and inventory sterilization

mechanism without consciously planning to be.

The author then cites two historical examples where price support was done through theaccumulation of physical commodities: De Beers in the diamond market and a producercartel in tin during the early 1980s.

Excess inventory gives consumers pricing power and low inventory gives producerspricing power. This is something that the tin cartel realized and for years that industrythought that it may have found the holy grail of production, inventory and price controlbut the eventual and inevitable demise of that cartel was a history lession showing that

such systems cannot last forever, even if they can last for quite some time.

In the current base metal markets it is possible that such a system is operating eitherunintentionally, by default, or intentionally. Whenever there is a possibility thatcommodity funds with huge cash flow decide to make their investments not only viafutures and options but by holding metals then there is the risk that a crude De Beers type

inventory limitation is in place.

The Nickel Market: How Speculation To the Point of Manipulation Makes The

Impossible Happen.

On to examples.

Today the price of nickel is close to $50,000 a tonne. Its historical mean is more like$7,000 a tonne. The price of nickel in this cycle has now risen almost 900% from itsprior cycle low. Above I showed Jeremy Granthams chart of the real oil price over


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130 years. The move in the real nickel price is an even greater deviation from the meanthan was oil in the 1970s. That is really amazing since, with oil in the 1970s, there wasthe very inflationary psychology of the era which fostered hoarding, there was the loss ofroughly 10% of global output with the revolution in Iran, and there was the price supportprovided by the OPEC cartel.

If Jeremy Granthams observation that all such two sigma plus departures from the meaneventually end in reversion to the mean, if this rule proves right once again in regardsto nickel, we will see in the years to come that nickel will be $7,000 a tonne again. Orlower.

How did the nickel price get to such a lofty level?

The Wall Street analysts will tell you that it has done so because demand is super strongbecause of the booming economies of China and India. They will tell you that supplygrowth has been restrained for many reasons. As a result, the market has been in an acute

deficit and prices have soared.

On the face of it this argument seems to have some merit. There have been manyprimary nickel projects that have been delayed. Demand for stainless steel, which is theprincipal market for nickel, soared an amazing 16.7% last year. And the officialstatisticians of the market the International Nickel Study Group calculates the marketwas in a deficit last year of 30,000 tonnes which was a little more than 2% of globalsupply/demand of 1.3 1.4 million tonnes.

But people close to the nickel market argue otherwise.

About two years ago there was a meeting of nickel producers and consumers in Portugal.That meeting ended in a dispute between nickel consumers and producers that wasdisorderly to a point approaching pandemonium. At the time nickel consumers claimedthere was no shortage of nickel and that an artificial shortage had been engineered byhedge funds. They claimed that speculation by funds on the LME had divorced the priceof nickel from reality and that the LME had ceased to function as a mechanism for pricediscovery.

These claims have never ceased. You will see in our appendix references in the press tohedge funds that own all the physical nickel. Only recently at an industry conferencethere were calls to delist LME nickel.

Metal BulletinKyoto 5/21/2007 9:24

Take nickel off the LME, stainless forum told


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The latest surge in nickel prices has sparked renewed calls for the contract to be removedfrom the LME and replaced by a system of bilateral negotiations between suppliers andbuyers.

Officials at several major stainless producers told MB they were growing increasingly

concerned at what they said was the inability of the LME price to correctly reflect thefundamentals of the nickel market, and its supposed vulnerability to speculators.

The LME has become a big casino. Funds withdraw money from the LMEs ATM andits stainless steel people who have to pay the price, said Horng-Sheng Sheu, senior gm

at Taiwans Walsin Lihwa Corp.

One of the most interesting complaints has been made by Chinas largest nickelproducing company, the Jinchuan Group. This company is largely owned by the Chinesestate and is the fifth ranking nickel producer in the world. Jinchuan says more than onceon its website that the LME nickel market is excessive of speculations and with a

suspicion of manipulations, the LME is no longer a place for fair dealing of metals buta paradise of speculations. It warns customers not to be puzzled by deceptiveinformation of nickel stock, conditions of supply and demand, as well as price releasedirresponsibly by a few foreign agencies. Part of its ire seems to be directed at the LMEwhich allows such shenanigans to run amok. Lots of doubts were aroused in a surveyabout LMEs fairness, justice and openness, and also about its role in price discovery.

As I have said, the Jinchuan group is not alone. Speaking about the last run up in thenickel price to its peak the Russian nickel producer Norilsk made the following comment:David Humphries, chief economist for Norilsk Nickel, said hedge funds had moved infor the kill, triggering a violent short squeeze on the futures markets. Implying thatphysical stock is being hidden, ABN Amro notes, The task of the nickel longs is to keepinventories at these critical levels. They will then be rewarded with acute pricingtension.

Since that conference in Portugal two years ago, those who have complained about anunrelenting short squeeze by hedge funds and merchants, often suggested to be operatingin collusion, argue that the market is ceasing to function as a market. This may be true.Recently, the nickel price made a new high above $50,000 a tonne. An LME traderreports it was done on no volume, with the usual comments about the lunacy of themarket.

Nickel's three-month price broke the $50,00 mark at 9am London time on Thursdaymorning when 1 lot traded at this level in a market traders have dubbed "lunatic".

The price of the alloying metal has not traded below $49,200 since the start of the

trading day, after it closed at $49,400 on Wednesday, but volumes have been extremelythin, with only 28 lots having traded by 9:29am on Thursday morning.


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"This is lunacy," said a physical trader. "I better close shop and come back when we areat $40,000 again. The phone has not rung once this morning. But we're heading for afall at these levels. Material is coming from consumers now offering to us. Not smalllittle consumers. The big [stainless] producers."

He said the market lacked natural sellers, and the price surges are on speculative tradingonly.

"It's completely artificial. There is no connection whatsoever between the LME and thephysical market now. The LME has its own life." (Metal Bulletin, April 5, 2007)

The nickel squeezers which allegedly encompass hedge funds may have pressured somany short side participants out of this market that it has been reduced to the trading of amere handful of lots on what would seem to be a price pivotal day.

Let us assume that much of this is correct. Then hedge funds and/or merchants have built

hidden stocks. The metal is not as scarce as it seems. More importantly, apparentdemand has been inflated by the build of hidden stocks. Most statisticians and analystslike the International Nickel Study Group assume the nickel market was in a small tomoderate deficit last year. But, instead, if there was a build of hidden stocks, the marketmay have been in a surplus rather than a deficit.

Jinchuans website goes far beyond complaints about speculation in, and manipulation of,the nickel market. They provide documentation of a very rapid move towards lowernickel bearing stainless grades and non-nickel bearing types of stainless steel. They citea proliferation of primary nickel projects down the road which they believe will not beneeded. They fret that todays price distortions will lead to permanent demanddestruction for nickel producers and a painful glut when the speculation is over.

And that point may be not far off. Stainless steel demand was up 16.7% last year. Part ofthat was a rebound off a prior year where there was a global stock liquidation. But evenso, it is a growth rate of perhaps three times the past trend. It must have reflected verysubstantial stock building in stainless. This is what is now being reported by manystainless producers and the service centers that distribute stainless. The very pronouncedinventory cycle of stainless may have now gone so far that a reversal is probablyunderway. MEPS, an industry statistician, reflecting this, is predicting a 4% decline instainless steel demand this year. Add to this the economization and substitution in nickeluse that Jinchuan and many others talk about and a significant decline in nickel demandshould be at hand.

How great can such substitution and economization be? The steel giant Posco has justannounced that it will use 14% less nickel in stainless production this year as it turns tonon-nickel bearing stainless. Posco has developed a new process for developing stainlesswithout nickel with better properties than existing non-nickel bearing stainless. Part ofthe reduction in its use of nickel is due to the initial introduction of this product this year.


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It expects good customer acceptance and more extensive recourse to this product nextyear. And other stainless producers are expected to follow.

Is this all happening? Apparently it is. In Europe there are excess inventories. TheEuropean stainless producers report falling orders. The price of stainless has fallen from

1900 euros a tonne to 1300 euros a tonne in six weeks. If one treats the steel, chrome,other metals and the cost of processing as constants, the implied price of nickel embodiedin stainless, which accounts for 70% of all nickel production, has fallen in half in thesemere six weeks. Not surprisingly, major producers like Outokumpu have announced10% production cuts.

But the turning point dynamics do not end there. Last year China, looking to bypass highnickel prices and the alleged shortage of nickel, began to access already mined lateriteores, largely from the Philippines. At first they used idle blast furnaces to process theseores. The investment involved was minimal, as the ores have been mined and there wasample blast furnace capacity everywhere in China. Last year nickel output from such

laterites rose from almost nothing to perhaps 30,000 tonnes. Early this year a Chineseconsulting firm, Antaike, predicted an increase to 60,000 tonnes, representing asurprising 5% increase to global nickel supply in a mere two years from this newunconventional source. But the story does not end there. There has been a series ofdisclosures that point to production from nickel laterites by China and Japan could bemuch higher than 100,000 tonnes this year.

How can this supply surge come out of nowhere? This is an interesting case study in themicroeconomic response of supply to a large rise in a metal price. It is worth lookinginto.

First, a bit of background. Nickel has been produced from laterites since the late 19thcentury. However, in the first half of the 20th century most nickel production came fromthe processing of nickel sulfides and by 1950 almost all global nickel production wassulfide based.

In the late 1960s there was an enormous spike in the price of nickel. This led to anacceleration of renewed interest in nickel laterites as a source of primary nickel. Theselaterites are a surface material resulting from weathering. They are abundant in tropicalzones. In fact, they are simply a kind of red dirt, and one analyst has quipped, find atropical island with red dirt and you probably have found nickel laterite. Being meredirt, these deposits are very cheap to mine. The problem is that the grades are on the lowside (1% to 2% usually) and extraction of the nickel from the laterites is not easy. Theupper layer of the laterite, called limonite, is more difficult to process than the deeperlaterite. Hence, most of the nickel laterites that have gone into production removed thelimonite as overburden and only mined and processed the deeper laterites.

Starting around 1970 there were many major nickel laterite projects. The total addition tonickel capacity resulting from these projects was very large; the laterite projects from


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1970 to 1986 represented a 43% addition to outstanding global nickel mine capacity in1970.

As I said, in these very substantial laterite operations over the last several decades thelimonites were, for the most part, overburden that was pushed off as waste. It is these

already mined limonites that the Chinese began to import at the end of 2005 and threwinto blast furnaces to create a nickel pig iron which can then be processed into stainlesssteel. To an increasing degree they have also been importing the deeper nickel bearingsaprolites as well which have been thrown into electric arc furnaces to produce a highergrade nickel pig iron.

Most of todays conventional nickel laterite projects have very high capital costs. Bycontrast, the production of nickel pig iron has virtually no capital cost as the limoniteshave already been mined in projects with established infrastructure. Also, China, as aresult of modernization of its steel industry, has a huge amount of unutilized blast furnacecapacity and some unutilized electric arc furnace capacity.

When the Chinese first began to produce nickel in this way, analysts assumed it was asmall and transitory development. After all the previous efforts to economically processnickel laterites it was assumed that such a simple process of extracting the nickel in ablast furnace must have limitations; if it did not, why was this method not used earlier?

There were other sources of skepticism. It was widely argued that the process is toopolluting to be done on a major scale. Many thought it was an extremely high costprocess with production costs of $15 a pound. Lastly, nickel laterites containphosphorus. Phosphorus is anathema to the production of steel and stainless steel.

So why have the Chinese moved ahead with this process of converting nickel laterites,especially limonites, into nickel pig iron? First, the Chinese claimed to have solved thephosphorus problem.

Second, they assert that production costs are now down to $8 a pound and are falling.Many of their contracts for obtaining nickel ore appear to be tied to LME price of nickel.So, if the nickel price crashes, as it eventually will, the ore component of total costs willfall.

Third, the Chinese are apparently improving their operations. New larger scale blastfurnaces and new electric arc furnaces are being commissioned which supposedly willreduce operating costs.

Lastly, as to the pollution problem, it seems that this process is not as polluting as manythink. The Chinese producers claim that the blast furnaces they will be using to producenickel pig iron will all meet the new Chinese national environmental standards onemissions.


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How much nickel will be produced from laterites in the form of nickel pig iron? As Isaid earlier, three months ago many expected that China would double its production ofnickel using this process from 30,000 tonnes last year to 60,000 tonnes this year.However, recent high volumes of laterites imported into China indicate the increment toChinese production will be much larger.

In 2005 China imported 500,000 tonnes of laterites, mostly at the end of the year. Lastyear, they imported 3.6 million tonnes of laterites.

In the first four months of this year China has imported 3.5 million tonnes of laterites.On first pass, this might seem to imply an almost tripling of its nickel production fromlaterites over the 30,000 tonne level of last year. However, closer scrutiny suggests aneven Greater Leap Forward.

It appears that China is now accessing higher-grade ores with higher nickel content. Lastyear China imported mostly from the Philippines where ore grades are about 1.2%. This

year they have been importing more ores from Indonesia and New Caledonia which moretypically grade 1.5% to 2%. Also, this year China will have greater recourse to electricarc furnaces, which have much higher recoveries than blast furnaces. The combination ofthe further steep rise in import volumes, a mix shift to higher grades, and higherrecoveries suggests that there could be far more than a tripling in Chinese production ofnickel from laterites by some time later this year.

In addition, to this the world will finally see a significant ramp up in the primaryproduction of nickel from more traditional sources in 2007 perhaps on the order of 3% -4%. This implies an overall increase in primary supply of 10% and possibly significantlymore.

When I look at all these impacts on the balance a reversal in the stainless inventorycycle, substitution and economization, increases in conventional and non-conventionalsupplies it would seem that the market balance in nickel could swing from 2006 to latethis year by 15% of demand/supply.

And more of a surplus will be forthcoming next year. Conventional and unconventional(nickel pig iron) supplies will continue to soar. CVRD, with one sixth of global marketproduction last year, expects to double its output over the next five years. This oneconventional producer alone will add 3 percentage points to growth in global nickeloutput on average over the next five years. As for nickel in pig iron, more Chinesecompanies are entering this business and there is some talk about imports of laterites intoJapan for this purpose. The crazy high nickel price has set into motion a new way ofprofitably processing super abundant ores. This business will grow as long as prices arehigh enough to make it profitable. And when prices fall every effort will be made by thenew producers to cut costs and still survive.

The size of the current and coming future swing in the nickel market balance isextraordinary. At the same time, adjusting for distortions in the apparent demand data,


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the market may have already been in balance or surplus last year despite a likely largestainless inventory build associated with that 16.7% rise in stainless demand. In effect,the nickel market may already be moving into a vast unprecedented surplus.

And yet, owing to the LMEs paradise of speculation and manipulation the nickel price

has been soaring ever further beyond its two standard deviation bubble status threshold.

Copper

The price of nickel in this cycle has gone up almost 900% from it prior cycle low. Therise in the price of copper has not been quite so extreme. It rose 570% above its cycletrough at last Mays $4.07 a pound high. It rose well in excess of five times in real terms,and is within 10% of last Mays price peak almost a whole year later. This deviation ofthe real copper price from trend may also surpass that of crude oil in the late 1970sdespite the generalized inflation psychosis of the 1970s, the Iranian revolution that shutdown one of the worlds biggest oil producers, and the support of OPEC, the most

famous commodity cartel in history. By Jeremy Granthams criteria, copper in this cycleis a two standard deviation bona fide bubble event.

You can divide copper cycles in different ways depending on your choice of endpoints.If ones choice of end points is half decade cycles in inflation adjusted terms, the increaseof the copper price in this cycle was already greater than in any cycle since 1900 once wegot to $1.90 a pound in 2005. By this measure no rise in the inflation adjusted copperprice has ever approached what has since happened in this cycle.


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The above refers to cyclical moves in the copper price in real or inflation adjusted termsfrom 1900 forward. I have found a similar analysis of copper cycles in nominal dollarssince the year 1860. This analysis considers longer duration cycles, out to as much as tenyears. This period, starting in 1860, encompasses the Civil War, the First World War, the

Second World War, the Korean War, and the Vietnamese War. Wars tend to consume alot of copper. Wars also spawn generalized inflations, and this period since 1860encompassed the inflations of the Civil War, the First World War, the Second WorldWar, the Korean War, and the persistently inflationary period from the mid 1960s to wellinto the 1980s. This period also encompassed the advent of electricity andtelecommunications in the late 19th century. This was the most important technologicalrevolution and economic engine of those decades. Copper was the material essential tothat New Era industrial boom.

Even though this history since 1860 encompassed all these wars and inflations and acopper critical industrial New Era the largest percentage increase in the nominal dollar

copper price in any of these past cycles was only 246%.

BY CONTRAST, IN THIS CYCLE, IN A MERE FOUR AND A HALF YEARS INTOMAY 2006, THE COPPER PRICE ROSE 575% AMIDST THE LOWEST INFLATIONIN THE U.S. GENERAL PRICE LEVEL IN ANY ECONOMIC EXPANSION INALMOST A HALF CENTURY.


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Some will say, this must surely be because of a new era of super cycle copperconsumption led by China, India and the emerging world. In fact there is absolutelyZERO evidence for this in the official data on global copper consumption.


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Global Copper Consumption

Average Annual Growth

1980 2005 2.3%

1990 2005 2.6%

2000 2005 2.6%

2006 2.3%

Source: ICSG

Simon Hunt, Simon Hunt Strategic Services

In general, when confronted with this data, people simply refuse to believe. It is obvious,they say, that copper consumption in China has been booming; therefore, such data mustbe wrong.

But what has been happening is something that has been going on for decades. As Idescribed above, base metals consumption is defined as the absorption of metal byprimary processors. Since the 1960s the primary processing of copper cathodes has been

migrating from the first world to the emerging world because such fairly low techmanufacturing makes more economic sense in emerging economies than in higher costdeveloped economies. Now that China, with its super high investment ratio, is displacingmore and more manufacturing that heretofore had been done in the U.S. and otheradvanced economies, its booming copper fabrication industry is displacing at a dramaticrate this industry in the advanced countries of Europe, the United States and Japan.


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World Consumption

2000 2006

Average Growth Per Annum

W. Europe -1.5%

USA -5.5%

Japan -0.6%

China 12.6%

Contributed by Simon Hunt, Simon Hunt Strategic Services

In the end, amidst all this furious migration of the primary processing of copper cathodesfrom the first world to China, the trend in the overall global consumption of copper hasremained basically the same.

If this is so, why has the price of copper soared way, way beyond all historical precedentsin this cycle? Is it a constraint on primary supply unlike the world has ever seen? In fact,that has not been the case either. Yes, a reduction in new investment in primaryproduction and a closure of mines followed the period of depressed prices at the end ofthe 1990s. This resulted in a lagged production response when this global economiccycle took off, thereby creating a deficit in 2003 and 2004. But, despite that lagged

supply response, the trends in copper supply growth look, if anything, more positive thanin the past.

Primary copper production comes in two forms: the production of ore concentrates whichmust go to smelters and direct on site production of refined cathode using solventextraction (SXEW).


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World Concentrate Production

Growth Rates Per Annum

2000 2006 2.4%

2007 2010 4.1%

2007 2015 4.3%


World SxEw Production

Growth Rates Per Annum

2000 2006 3.9%

2007 2010 8.9%

2007 2015 4.1%


Last year was a year marked by an unusual number of work disruptions in copper mining.The global mine capacity utilization rate was very low. Nonetheless, copper mine andrefined production grew at or above the long term trend. Based on a recent return to ahigher capacity utilization rate and a round of mine start ups and expansions early thisyear we should expect in 2007 much higher mine output growth and continued wellabove trend growth in refined output. Looking further ahead, almost all compilations offuture total primary production (both SXEW and concentrates) based on what has beenannounced to date results in a supply trend of close to 5% for years to come a rate thatis almost two times the historical average rate.


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It should be noted that such projections are based on what has been announced. Whenprices are high exploration budgets rise. Exploration produces results. Existing depositsbecome larger, additional investments are therefore made, and surprise expansions tendto proliferate. Also, new low cost projects are found. In the past, at least, theseunforeseeable successes have proved to be the most important engine of supply

expansion over time.

So what then has caused the copper price to soar? Once again, unprecedentedspeculation to the point of manipulation. In the case of nickel, I gave you accounts of therole of speculation according to Chinas leading nickel producer Jinchuan and analystsfrom investment banks. In this case of copper I will provide you with an account basedon two recent presentations of Nexans, the largest copper fabricator in the world. Nexansoperates in 33 countries and accounts for about 7% of all copper wire manufacturedglobally. Nexans has laid out its analysis of the copper market in two power points usedin two recent public presentations

Nexans starts their market analysis by noting the difference between official statisticsbased on apparent consumption and real consumption that is, what is going intofurnaces. Nexans believes the copper market has been in an increasing surplus, possiblysince autumn of 2004. Where has this surplus gone, since there has only been less than a200,000 tonne increase in visible exchange stocks over this period?

February 8, 2007

Who hoovered away so much physical copper?

February 8, 2007


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Again, in a second presentation:April 20, 2007

In our appendix you can find

reserve management parts i and ii wbp public 71907

Documents