Market and product

May 28 (Reuters) - Copper spreads on the LondonMetal Exchange (LME) tightened sharply last week as the marketfinally started reacting to the continued steady erosion ofavailable stocks.

The previous disconnect between dwindling stocksavailability and a relatively loose market structure had causedmuch collective head-scratching in the market.

The conundrum looks as if it is now being resolved asfront-month backwardation returns to levels historicallyassociated with the current low level of stocks.

A research note by Goldman Sachs, advising shortposition-holders to roll out of the front part of the curve,seems to have acted as a collective wake-up call.

Analysts at the bank warned that the benchmarkcash-to-three-months time spread CMCU0-3, valued at $83.50 pertonne backwardation at Tuesday's close, could flex out to$100-$150 imminently. ("Copper, expecting very near-term LMEspread tightening", May 22)

Stock trends now hold the key to how tight this market couldget. The LME system needs fresh supply, and to get it, thebackwardation must move to a level that incentivises deliveriesinto LME sheds.

In practice, this means a tug of war with Chinese buyers forthe metal sitting in Shanghai's bonded warehouse zone.

A CROWDED SPACE

Wednesday morning's daily LME stocks report <0#MCUSTX-LOC>showed registered inventory sliding another 6,725 tonnes to169,825 tonnes. That's the lowest level since August 2008.

Even more significant is the continued erosion of on-warranttonnage, since this is the market's ultimate liquidity pool.

At 94,325 tonnes, it has fallen to the lowest level sinceApril 2008, thanks in large part to a 19,750 tonne burst ofcancellations at New Orleans last Thursday.

New Orleans is where most of the exchange-registered stocksare located. The U.S. port currently holds 83,825 tonnes of thenon-cancelled total.

The next two largest concentrations are at Rotterdam andSingapore, both of which hold just 2,500 tonnes.

As stocks liquidity shrinks, the front part of the LMEcopper curve is becoming a crowded place.

The LME's daily market reports are now showing three largeholders of cash and "tom-next", the shortest-dated spread in themarket's prompt date system. <0#LME-WHC><0#LME-WHT> Between themthe positions are equivalent to at least all of thenon-cancelled stocks, quite possibly more.

Unsurprisingly, "tom-next" is itself backwardated, flaringout to $8 backwardation on Tuesday and trading on Wednesdaymorning at $1-2 backwardation. And equally unsurprisingly, thecash-June spread has also tightened, currently trading at justover $30 backwardation.

Spread volatility seems assured as shorts try and escape thecash-date squeeze by moving down the forward curve.

WHERE'S THE COPPER?

There is nothing particularly sinister about this. None ofthe major long positions on the cash date are outrageous inoutright terms, but collectively they are huge relative towhat's available in the LME system.

The key issue here remains that of low tonnage.

Backwardation is needed to attract more metal into LME sheds- particularly that metal sitting in the liquidity pool that isthe Shanghai bonded warehouse zone.

Estimates inevitably vary as to the size of this unreportedstockpile, but there are thought to be around 600,000 to 700,000tonnes in Shanghai, much of it pledged as collateral againstlending in the shadow credit market. That's more than the totalamount of copper sitting in the world's three big copperexchanges combined - LME, COMEX and the Shanghai FuturesExchange.

Goldman's assessment of the likely tightness over the comingmonth or so is based on a calculation of how wide thebackwardation will have to be to unlock this material and enticeit back towards the LME system.

There are, as the bank points out, several moving parts tothis calculation, including LME spreads, Shanghai physicalpremiums and the profitability of the copper collateralfinancing trade, the latter a multi-dimensional phenomenonitself.

NOT YET

What is clear is that the LME backwardation is not yet wideenough to draw metal out of China.

Its April trade figures showed refined copper exports of21,499 tonnes, very much within the range of the last sixmonths. Cumulative exports so far this year of 77,000 tonnes aredown by 50 percent on the equivalent period last year.

Import flows, by contrast, remained strong at 341,000tonnes. China's net draw on refined copper from the rest of theworld has increased by 560,000 tonnes so far this year.

So, it's not too hard to work out why exchange stockseverywhere else are so low.

The problem for LME short-position holders, however, is thatthere is no sign this flow of metal into China could be abating.

Deliveries into the LME warehouse network so far this monthhave totalled a paltry 2,325 tonnes and only 25 tonnes of thatat any Asian location.

Higher Chinese imports this year are thought in part toreflect higher term bookings by fabricators. If so, suchmaterial will not be available for LME delivery, least of allduring a seasonal high spot for end-user demand.

That leaves the "known unknown" that is metal being importedfor financiers, but here too things have been complicated byreports that the government stockpiler, the State ReservesBureau, has been buying up bonded stocks. And that materialwon't be available any time soon either.

Goldman expects the Chinese market to loosen up in aroundthree months as the seasonal demand peak passes and domesticproducers ramp up after maintenance closures.

Three months is a long time for holders of LME short-datedpositions, though, and there is too much uncertainty about themultiple moving parts in the Chinese import equation to draw anyhard and fast conclusions as to what may happen in the interim.