Wiktor Bielski, VTB Capital. Speculators or fundamentals who drives the copper price?

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1 Wiktor Bielski, VTB Capital Speculators or fundamentals who drives the copper price?

2 Copper has a long history of speculative trading The most common question from investors interested in commodities over the past years is, how much impact do speculators have on prices? Copper markets have been strongly influenced by major trading plays since the mid-1980 s, including two high profile trading scandals: The Sumitomo trading scandal, which had its roots in 1986 and was maintained for more than 10 years before unravelling in 1996; The SRB/ Mr.Liu trading scandal in Speculative investors began to be heavily involved in the market in the early 1990 s and they have steadily increased their influence, culminating in two near-vertical price moves: The squeeze on hedge fund shorts which drove prices from $5,000/t to $8,790/t in just six weeks in April/ May 2006; The price collapse from $7,300/t in September 2008 to $2,850/t in December Several large traders and hedge funds are regularly reported to strongly influence prices. Nevertheless, fundamentals still play a dominant role in driving copper prices.

3 LME futures volumes have more than doubled Source: Reuters, VTB Capital Research

4 LME and Comex open interest has steadily increased Source: Reuters, VTB Capital Research

5 Commodities as an asset class driving investment flows Changes to investment rules for institutional investors (20% can now go into alternative investments) opened commodity markets to a huge new pool of capital in the mid-2000s. Assets invested in commodity products Commodities have been aggressively promoted as an alternative asset class and a leveraged play on the China story. Exceptional growth in hedge fund assets (close to $2 trillion) and CTA s. Very significant expansion in index and structured products, ETFs, swaps, and options has driven a prodigious increase in speculative trading in commodities. Speculators provide liquidity and volatility, and they generally trade directionally with (not against) the fundamentals. Source: Reuters, Barclays Capital, VTB Capital Research

6 Copper fundamentals have been consistently very strong Copper markets have been in supply deficit in 13 of the last 20 years: clearly very supportive for prices and attractive for speculators. YoY changes in copper prices have been closely aligned with market deficits or surpluses. Consistent market deficits have resulted in extended periods of very tight spot availability, so that the LME cash-3 months spread has traded in backwardation more often than contango in the past 20 years (it is the only LME metal which has done so). Backwardations create attractive roll yields for investors. Total reported global inventories (LME, Comex, SHFE, DM producers and DM consumers) have been historically low and below critical levels for almost 10 years. Historically, price forecasting was driven by supply-demand balances, the resulting net inventory change and the relationship between prices and the stocks-consumption ratio. This has permanently changed: at low stock levels the potential price range is very wide, volatility is accentuated and the influence of speculative traders is greatly enhanced. In this environment, the market becomes defined by the clearing price that the most squeezed consumer or short position holder is required to pay.

7 Copper market balance vs YoY change in copper price Source: CRU, VTB Capital Research

8 Copper has been in backwardation more often than contango Source: Reuters, VTB Capital Research

9 Stocks-consumption ratio vs LME cash copper price Source: CRU, VTB Capital Research

10 Stocks-consumption ratio vs LME cash copper price Source: CRU, VTB Capital Research

11 Will ETFs have a significant impact? Out of 183kt of copper ETFs registered, take-up to date is just above 1,000t. Total LME copper stocks are valued at about $4bn, while open interest in gold ETFs currently totals $92bn with a further $15bn in silver ETFs. We believe that launching physically-backed ETFs in a commodity that is widely expected to be in significant deficit over the medium-term, while industry stocks are near historic lows, is ill-advised and inappropriate. As a result, the risk of a very significant market squeeze is greatly increased, which could potentially result in artificially high backwardations and exceptional price volatility. We believe regulators should have acted to prevent these risks.

12 Conclusions Fundamentals, investors and speculators are equally important in driving copper prices: investors and speculators tend to accelerate and enhance underlying strong fundamentals. The long period of high prices (five years of average prices above $5,000/t) has failed to generate a substantial supply-side response (to date), clearly illustrating copper s strong fundamentals which should support an extended period of even higher prices ahead. Industry hedging strategies have changed and adapted: producers are now largely unhedged to maximise leverage to price upside, while the world s largest consumer (China) has recognised the need to build/ increase strategic stockpiles. Copper ETFs could substantially increase volatility and price risk given very low stocks. Investment flows will continue to grow as commodities become ever more favoured as a new (alternative) asset class with direct exposure to the secular growth story in emerging markets. Copper price trends will inevitably become more difficult to predict due to increased volatility and ever wider trading ranges.