June 10 2014 SHANGHAI (Scrap Register): An official investigation of a major Chinese commodity port of Qingdao, in north eastern China, has rattled markets last week. The investigation has fueled concern s about the allegedly fraudulent use of warehouse receipts. While disputed material has been blocked, shipments at the ports have been running smoothly according to 21st Century economic report , a local newspaper.
Metal imports have been partly used as a means to raise finance, where traders can pledge metal as collateral to obtain better funding terms. In some cases the same inventory can be pledged to more than one bank, fueling hot money inflows.
According to the 21st Century economic report, a small/medium sized trading merchant, specialized in alumina imports, was under considerable funding pressure and may have used multiple pledges of warehousing receipts to obtain short-term financing.
The discrepancy is estimated to be around 80,000 tons of aluminia and 20,000 tons of copper, with a possibility that this estimate is conservative . While iron ore may also have been used in multiple pledges, no tonnage has been reported. Related trade finance banks are concerned about their exposure and whether the collateral pledged against those exposures exist.
Multiple pledging in China’s commodity financing market is not a new phenomenon. A similar type of activity was prevalent in steel financing a few years ago, which has resulted in a loss of confidence in steel mills and associated warehousing companies. Deutsche Bank believes that current investigation is likely to raise market awareness of risks involved in commodity financing. In this report, Deutsche Bank presents their initial take on the short term and medium implications.
Short term implications
Heightened concerns are likely to lead to a “freeze” in activity, which in combination with the increased difficulty to obtain repo financing, is likely to ease the current physical tightness in the copper market.
Deutsche Bank believes that the immediate impact is negative on the copper market with a sharp fall in bonded zone premiums and a rapid flattening of backwardation at the front end of copper term structure, both indicative of an easing physical market. Deutsche Bank notes that copper spot to 3m spread has fallen significantly from multi-year highs.
Medium term implications
In our March special report ‘Copper & Iron Ore: Are Chinese Financing Deal Fears Overdone’, Deutsche Bank presented different case studies of commodity financing in China.
In the Appendix, Deutsche Bank highlights the various steps in a complete financing deal under different scenarios. We would like to highlight that multiple pledging of materials normally takes place during the repo part. The repo deals are mostly done by western banks. Note that the initial stage of financing ie the L/C issuance process is not affected. The L/C issuance is typically done by a Chinese or western bank, they added.
While there is considerable uncertainty regarding the degree of alleged fraudulent activity, Deutsche Bank presents four scenarios as to how the closer scrutiny will impact the copper market.
Deutsche Bank thinks the ultimate impact will be price weakness in the copper market. This will be triggered by the continuing decline in bonded warehouse premiums.
Deutsche Bank notes that previous lows were around $40-50/t. China copper bonded premium has exhibited a loose correlation with LME inventory draws over the past year. If bonded premiums continue to decline towards the previous lows, this would result in a slowdown in LME inventory draws or even a net increase in LME inventory with materials flowing out of China bonded zone.
Deutsche Bank currently estimates that bonded copper stocks are around 850kt. As global exchange inventories have fallen to multi year lows, this flow reversal is likely to ease physical tightness. A rise in LME warehouse stocks is likely to lead to downward pressure on copper pricing, as the market still seems to take its cue from the LME stock movements.
However, confidence for repo financing may gradually be restored after a sustained period of regulation enforcement. The degree to which the copper price declines, depends on which scenario unfolds. Scenario 1 is the least severe, whilst scenario 4 is likely to have the most significant impact. Deutsche Bank believes that the first two scenarios are the most likely:
Scenario 1: Copper financing continues but with much tighter audit rules for warehousing receipts. The cost of repo deals are likely to increase, perhaps impacting a small percentage of transactions.
Scenario 2: L/C issuance by western banks will be affected, resulting in a reduction in the number of financing deals. This scenario is possible if the loss incurred on the repo leg of the transaction ( typically the step where a warehouse receipt is exchanged for an RMB loan) by western banks results in a general loss of confidence in the entire system. The knock-on effect would be less L/C’s being issued by western banks. There may be some offset however, from Chinese banks stepping into the void to win market share.
Scenario 3: Copper financing continues, but merchants are no longer able to obtain repo financing. Instead, they sell metal outright to obtain funding.
Deutsche Bank believes that this scenario is possible but at the moment Deutsche Bank dosen’t attach a high probability that all repo financing activity will cease . The imports of refined copper and alloy is mostly via Shanghai, where copper financing is more regulated than Qingdao. In fact, Qingdao has a small share of copper imports but around 20-25% share of alumina and iron ore imports.
Scenario 4: Chinese banks also start to worry about L/C issuance. Copper financing declines significantly. Deutsche Bank believes that this is possible but less likely as end users still need copper imports and L/C financing will be required for real copper demand. However this scenario would have the most severe impact on copper, with an important part of t he credit system effectively “freezing”.
Despite forecasting strong and above trend copper demand for the next three years (4.6%, 4.1% and 3.8% for 2014 to 2016, as well as factoring a significant supply disruption allowance (an average of 6.4% of global demand for the next three years), Deutsche Bank continues to see the copper market in a modest surplus of 300-500kt pa over the next three years. These surpluses are due to the mined supply momentum after a lengthy gestation period of a number of greenfield projects in Peru, Chile and Central Africa.
The concentrate surplus is likely to translate into improving TC/RC’s which will incentivize the restart of idle smelting capacity in their view. The build-up of inventory is likely to weigh on copper price as and Deutsche Bank forecasts and average price of $6,770/t for 2014, $6,650/t for 2015 and $6,500/t for 2016.
The extent of these surpluses is relatively modest however. In their assessment the marginal cost of 6,200/t, measured on an all-in sustaining cost basis, will remain a good support level on the downside. However, Deutsche Bank sees extended periods of +$7,000/t as unlikely.