As the London Bullion Market Association has opened negotiations with London Metal Exchange to distribute its new gold forward curve, the question of the relationship between gold and base metals is again beginning to haunt investors’ minds.

The relative liquidity of the copper contracts, and the presence of this metal on COMEX means that the gold-to-copper ratio is the most frequently quoted comparable between the precious and base metal sectors. And although many gold-rich epithermal systems are found around large copper porphyries, the geological relationship between the two metals does not necessarily extend into the markets. For one, as expounded before on these pages, gold seasonality is quite strongly tilted towards strength in the second half of the year. On the other hand, base metals – and in particular aluminum, zinc and copper – are known to enjoy stronger demand in (northern) Spring, although falling merchant premia since the Chinese New Year seem to suggest that it may not necessarily be the case this year.

Of course, the most notable difference between gold and the base metals has for years lain in the shape of the forward curve. Gold resides in a permanent contango (forward prices higher than spot prices), owing to its abundant liquidity and the fact that storage costs outweigh convenience yield. Base metals, on the other hand, were historically characterized by entrenched backwardation (spot prices higher than forward prices). Until the middle of the past decade, the backwardated forward curve offered fairly predictable gains in the futures market. An investor could buy a futures contract 2 months before expiration and then sell it to avoid physical delivery, while buying another one with later expiration. The price difference offered by the backwardation is commonly referred to as roll yield. Between 1959-2004 investors could earn this way over 10% excess return over risk free rate.

However, just around the time this passive strategy was heralded for its low correlation with the rest of the portfolio, money poured into commodity index funds, increasing the level of offsetting inventories and leading to prolonged periods of contango. Although the interest in the commodity space was initially triggered by the structural shifts in the physical demand, engendered largely by the construction boom in the emerging markets, the appearance of the contango also reflected low financing and storage costs. The problem for investors was that contango left the aforementioned passive futures strategy with a negative roll yield (essentially, what you bought after selling your previous contract was more expensive). This development proved to be particularly damaging at the front end of the curve, which is more volatile and – as in copper – more amenable to twists into a contango.

The base metals experienced rising prices along stock surpluses for the first time between July 2005 and March 2006. Much to the surprise of gold investors, some market participants began to consider copper (rather than gold) as a “hedge against inflation”. In the process, the market cap of the major mining companies for the first time reached levels previously reserved exclusively for oil majors. In May 2006 copper hit an all time high of $8800/t. Later that year the copper/gold copper ratio rose to a record 1.7x (it subsequently collapsed to 0.4x in December 2008). The second “surplus investment” period began in 2009, this time driven by Chinese merchants’, dealers’ and investors’ unprecedented level of stockpiling. For many of these players the red metal constituted a hedge against inflation, broadly anticipated in the credit-swamped economy. And, as in the heyday of gold miners’ hedging, forward sales by the holders of physical inventory could negatively affect the prices. However, long positions accumulated in commodity index funds now significantly outweigh these hedges.

Nowhere is this situation more striking than in aluminum. Between 75% and 90% of aluminum stocks are now tied in financial arbitrage deals, facilitated by low 3-month Libor and low storage costs. The metal is not instantly available for physical consumption and will only be freed either when the forward curve flattens or when the prices go up enough to offset the cost of breaking the warehousing contracts. As in gold, or in early stages of the silver cycle, this “investment” demand is now being associated with stock surplus, not with the deficit.

If the contango persists, it could encourage further over-production, most easily achieved in aluminum and zinc markets. But this is only sustainable for as long as interest rates are low and Chinese “speculators” continue to enjoy access to easy credit. Metal financing deals won’t suffer from a small rise in interest rates because the cost base is very low. Importantly, the $200bn stack of unused corporate loans in China would indicate that the party could go on for longer, regardless of PBOC’s interest rate decisions. The optimistic view is that even if the contango in aluminum disappears, it will take up to 3 years to reduce the stocks currently tied up in financing deals.

How significant are these developments for gold investors? First, regardless of the surplus stock building, the base metals are still a far cry from the investment-related inventory levels supporting the gold contango. Even counting all the exchange stocks, smelter and merchant inventories, Japanese port inventories, physical investment, China’s strategic reserves and whatever generous statistics we can offer to the rumored private stocks of the base metals, they mostly amount to around 15% of annual market. Meanwhile, just the gold ETFs and Comex net long positions correspond to nearly 70% of the size of the annual gold market, and as we know there are many other sources of liquidity, potentially available to this market. In other words, base metals cannot “replace” precious metals as an inflation hedge, not least because the resulting price level would actually feed back into inflation expectations and eventually a higher PPI.

But the eventual disappearance of the contango in base metals could dent investor sentiment vis-à-vis the commodity markets. This is not insignificant for gold, given the level of gold allocation in the main commodity indices – 2.8% in GSCI index and 9.15% in DJ-UBS index. This allocation is only marginally lower than in 2009 and gold retains some sensitivity to broader commodity sentiment.

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Tags: backwardation, base metals, China, contango, forward curve, inflation hedge, stockpiling