It might seem unimportant to know exactly why copper has been added to the list of sick commodities, but if it is more than a fright over excess supply and slack demand then we could be on the verge of a rerun of the GFC.
It might seem unimportant to know exactly why copper has been added to the list of sick commodities, but if it is more than a fright over excess supply and slack demand then we could be on the verge of a rerun of the GFC.
The original cause of the collapse in prices for coal, iron ore and oil was unquestionably too much material hitting an oversupplied market – a direct result of over-investment in new mines and oilfields during the China-driven resources boom.
However what happened last night was something different and had the appearance of a financial market panic, as investors in China dumped holdings of copper.
The initial explanation was that a report from the World Bank, which cut forecast global growth for this year from 3.4 per cent to 3 per cent and for next year from 3.5 per cent to 3.3 per cent, triggered the panic selling of copper, the most extensively used industrial metal.
A deeper look at the stampede for the exits in the copper market points to something far more significant, especially when the Chinese habit of using copper as a financing tool to secure bank loans is considered, along with the prospect of US interest rates rising sometime this year.
At the heart of what is a complex problem, it seems the central issue is a variation on the financial games that caused the 2008 sub-prime crisis in the US, and the ensuing GFC.
In two words, the cause is ‘leveraged debt’ of the sort used by investors to buy bundles of sub-prime mortgages taken out by people who could not service the obligation (and marketed by banks that didn’t care if they were selling a financial time bomb).
This time around the problem of leveraged debt has spilled over into the commodities world, with the same banks (or their descendants) selling products that offer exposure to a range of commodities, complete with access to a loan to help the investor dramatically magnify his exposure, sometimes by as much as 10-fold.
Exchange-traded funds, hedge funds and over-the-counter products are all available to investors who believe that demand for commodities will remain stronger for longer, and that while the price might oscillate from time to time the long-term direction will always be up.
There are four problems with that belief.
• The commodities boom has run out of puff, a result of growth in China slowing (though not stopping) and because the mining and oil industries have been too successful in bringing additional product to market, which means the price direction is not always up.
• Slower global growth means slower demand for raw materials, which is part of the normal commodity cycle of supply chasing demand and vice-versa.
• Banks and their clients have used the ultra-cheap loans made available courtesy of the government stimulus programs and money printing that followed the 2008 financial crisis to gear up their investments in commodities.
• With interest US interest rates likely to start rising later this year (and with other countries inevitably following), the debts taken on by investors to play the commodities market have taken on a fearsome appearance – triggering a rush for the exits in everything from oil to iron ore and now copper.
Adding to the belief that what’s happening is a financial event layered on top of a commodity correction is the fact that last night’s sell-off started in China, heart of a series of commodity financing scandals.
The worst of those scandals was false bookkeeping at the port of Qingdao, where the same stockpiles of copper and other metals were used to secure multiple bank loans – yet another example of banks not checking the credit-worthiness of a client, or perhaps even actively participating in a blatant fraud.
To the Qingdao case can now be added what seems to be a worldwide crisis in commodity derivative trading, which bears the hallmarks of the 2008 sub-prime crisis – a combination of greed, bad loans and fraud.
The problem for Australian miners and oil producers is that they’re at the bottom of the pile, forced to bear the cost of crashing commodity prices as financial deals are unwound and speculators cram the exits before they’re caught with exposure to a commodity that is falling in value, while also carrying a bank debt on the deal – a debt which seems likely to soon carry a higher interest rate.
How big is the problem? According to some estimates there could be more than $US20 trillion in commodity derivate deals somewhere in the banking system and in the hands of panicky investors.
The wild ride that started in mining and oil markets last year looks like it could get a lot wilder this year, with banks being sucked into the mess as they scramble to claw back loans on commodity speculation that should not have been made in the first place.
The level of Australian bank exposure to what’s happening will be watched closely; though at this early stage it seems that local banks have been bystanders, with the major players in the commodity gearing game being Chinese, European and US banks.
