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Posts Tagged ‘Grasberg’

20
Jan

NOT THE RIGHT TIME TO FAVOR RED OVER YELLOW

   Posted by: Mr. Gold    in Uncategorized

On a day when Freeport announces its quarterly results, it is probably a good opportunity to reflect on the question I have recently received from a successful option trader in the city. It came with an anaphora (“gold is a bubble and copper has real demand”), and so “isn’t it time to short gold and go long copper”. Indeed, this week again, copper hit an all-time high in dollar terms, leaving gold behind with its most recent record notched several weeks ago now.

Freeport’s numbers later today may serve as a good starting point to discuss this issue. After all, we know from the company’s guidance that as copper volumes would have fallen in 4Q, while its gold production would now return to annualized 1.5moz. In other words, Grasberg remains, by far, the largest gold mine in the world and nothing on the horizon appears to challenge the Indonesian producer’s leadership (the biggest upcoming kid on the gold block is Barrick/Goldcorp’s Pueblo Viejo in the Dominican Republic, which expects 1.2moz p.a. production). Grasberg represents the stunning 2% of the entire global gold mining production and since it is not mined specifically for its yellow by-product, its sizable swings in the precious metal’s output have a considerable impact on total gold supply data.

Despite Grasberg’s pit widening and the impending transition to block caving, Freeport remains one of the key players in the copper universe, which in 2010 experienced again multiple disruptions and production disappointments. In the last 5 years, despite comfortable margins, the global copper mining production has increased barely by 1% per annum. By comparison, provisional data for 2010 point to a nearly 10% increase in global gold mining production. Global copper deficit estimates for 2011 range between 400kt to 650kt. So the question returns – is this the time to long the red and short the yellow?

The story of copper, however fundamentally sound, has been with us for several years now: tight elasticity of supply, deep BRIC deficiency, falling grades, few new SXEW finds, slow decay of the largest producers (e.g. Escondida). The fact that China’s secretive Strategic Reserve Bureau considers copper a “strategic asset” has added to the allure. SRB, whose only officially confirmed purchase goes back almost two years now, is believed to be holding between 0.5mt and 1.5mt of copper and is rumored to have targeted a 2mt worth of copper war shield by 2015. There is no denying that the underlying demand – from the power sector and construction – is sound, even though most analysts have now learned to infer China’s restocking and de-stocking cycles from the discrepancy between end-user data and the so-called apparent demand (production plus net imports +/- change in Shanghai stocks).

Yet, in the short term, there are some clouds over the red horizon.

First, after significant restocking in the rest of the world throughout 2010, in the near term the market will be over-dependent on one crucial market – i.e. China, increasing the concentration risk.

Secondly with changes to VAT regime for bonded warehouses in China, it is now entirely plausible that the arbitrage between London and Shanghai prices may function both ways – including shorting LME and long SME.

Third, with the new copper ETF products coming on line this year, it is entirely imaginable as these new products gain liquidity, arbitrage opportunity could emerge between copper futures and ETFs whenever the forward curve goes into backwardation.

Fourth, a seasonal increase in Chinese imports in 1Q may reflect more the record liquidity conditions generated by Chinese banks this month and some delayed delivery of last year’s orders than the actual demand growth in this key market, sending a misleadingly bullish signal to overseas traders.

Finally, if the LME curve flattens into contango, it is not entirely impossible that some producers may engage in selective locking in of the current record prices.

Some other market indicators also invite caution. Copper’s 3m implied volatility lies in low stasis, diverging from the spot metal price and forming a spread from where the underlying usually corrects. Bizarrely, near term 25 delta puts have recently had a volatility premium vis-à-vis at-the-money option. And last but not least, the copper/gold spread has turned positive.

This has only happened for the second time since the heyday of June 2008 commodity peak, and when it did (in April 2010), it did not last. Indeed, such is the precariousness of the global order that any glitch – EFSF discord in Europe, more forceful inflation-busting in China, another flare-up in North Korea – may quickly reverse the new trend. Any volatility inducing event will lead to losses in red copper/short gold trade. In fact, the opposite trade could be treated as debit spread betting on volatility returning to both metals, yet in an asymmetric fashion.

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