Tuesday, July 7, 2015

Take that copper!

It's hard not to be excited about the fall in copper prices today, over 5% and dropping as I write. Take a look at the carnage!

Our team has been stalking copper since 2011 when we realized that it was being used in China to skirt their lending restrictions. This was the subject of an interview we did in May 2012 with Funds People magazine (article is in Spanish) where we pointed out the problems with copper prices in Shanghai vs London. Dusting off an old chart from the time, here is what caught our attention - inventories were rising in China and Shanghai copper was trading at a discount to copper in London. This was a big red flag. London is a huge market for copper trading but the use of physical copper obviously would be higher in China. Something didn't smell right.

We were not the only ones looking at this and thinking something was wrong. Standard Chartered did more research on this topic than any other bank I'm aware of and they were coming to the same conclusion as we had, namely that stockpiles were artificially high and thus copper must be getting used for something beyond construction. Sure enough we were right. Copper was being used to obtain letters of credit from Chinese banks. As lending restrictions at the time were being tightened it turns out that credit against commodities as collateral was a great work around. With lending rates in the black market of China being much higher than state owned banks clever importers would bring in copper, obtain a letter of credit, take the money and lend it out into the black market. More sophisticated versions involved arbitraging onshore/offshore Yuan rates and speculating on other investments such as real estate and stock prices.

Zero Hedge has done a great job detailing how the transactions work in China. Please see these articles:



While China may be a huge driver of global growth they have many areas of their markets that remain opaque. As their stock market bursts there will be margin calls on anything that's not nailed down. Expect to see most commodity prices impacted by their continued sell off. We believe copper still has a very long way to go before it bottoms out which is why we've been creating a shopping list for equities in Chile for the last 4 years. Take a look at the U.S. dollar vs. the Chilean peso today. Tell me we are not in an interconnected world!

The dollar is up and because copper is so closely associated with Chile's currency the more copper falls the more the Chilean peso will drop. This is not so different from our observations about oil prices and currencies associated with oil. Chile is a great economy in our opinion. We've been patiently waiting for the current credit cycle to collapse so that we can go in and buy up several things on our wish list in Chile. Seems like we are getting closer. Until then watch out for copper!


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