Part I II Worldbank Presentation 5607 -Frank Veneroso

8/13/2019 Part I II Worldbank Presentation 5607 -Frank Veneroso

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Executive Forum

Reserve Management

The commodity Bubble, The Metals Manipulation, The Contagion Risk To Gold

And The Threat Of The Great Hedge Fund Unwind To Spread Product

To: Global Central Bankers at the World BankFrom: Frank Veneroso

April 17, 2007

Revised as of today May 6, 2007

Introduction

Thank you for this second invitation to speak at your treasury management conference. Icertainly did not expect such a second invitation.

Last year I was asked to speak only because Larry Summers, who was scheduled tospeak, could not make it at the last moment and I was asked to fill in. I chose to speak onthe subject of the global commodity bubble as well as the U.S. housing and housingfinance bubble and their eventual bursting. My presentation was a bit on the histrionicside, and I know it was greeted with a certain amount of amusement. But I certainly didnot expect that it was of enough interest to warrant a second invitation to speak on thesame topic particularly with the more august speakers available such as LarrySummers.

Perhaps I am reading more into this invitation than I should, but it seems to me that theevents that have transpired over the last year must have intrigued some of you with thethesis that we have had a commodity and a housing bubble, that they may be in theprocess of bursting, and that this may have some relevance to central bankers and toreserve management.

Last year, I did not really focus on central bank reserve management, but I thought thatthis year I might direct my train of thought to some reserve management issues. So, inwhat I have to say today, I will try to work towards two assessments: first, the outlook forgold as a reserve asset, and second, the outlook for spreads and the yield curve, which isobviously very relevant to reserve management.

The following paper is very long. So let me give a road map of where I will be going.

In the first part of this paper on the Commodity Bubble, I make the case that, in realterms, we have had an unprecedented commodity bubble in this decade. This bubble hasoccurred because of unprecedented investment and speculation in commodities, largelyby way of derivatives. The far more important engine of this bubble has been leveragedspeculation by hedge funds. Over the last two years prices have climbed even though themicroeconomic fundamentals of commodities have deteriorated. There lies ahead abursting of this commodity bubble. It is now being triggered by deteriorating


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fundamentals and it will be exacerbated by eventual investor revulsion which will reversethe extraordinary fund flows that have created this bubble.

In part two, Metals: A Speculation to the Point of Manipulation, I turn to the leadingedge of this cycles commodity mania metals. In base metals and to some degree in

white metals hedge fund speculation has extended beyond derivatives to purchases of thephysical. This has resulted in several variants of classic market squeezes across themetals sector. These squeezes in the context of a runaway speculative fervor has resultedin increases in real prices for some metals that are far in excess of anything that has everoccurred before for these metals, in particular, and almost all commodities in general.Because of the extraordinary amplitude and duration of these price moves, themicroeconomic responses will be stronger than ever before, generating record surplusesthat will ultimately lead to reversion to the mean or marginal cost. Investor revulsiontoward this commodity sub sector should prove to be greater than for other commodities.A consequent reversal of fund flows and the eventual liquidation of physical stocks heldby hedge funds should lead to severe undershooting of marginal cost in the years to

come.

In the third part of this paper, I consider gold. Golds fundamentals are far better thanthose of base and white metals. Unlike other commodities, there is zero mine supplygrowth in gold. Unfortunately, growth in physical demands for gold in jewelry, small barand official coin has been surprisingly negative over the last decade plus, especially informer gold loving Asia. The flow of gold from official stock liquidation in all its forms,which had been depressing the gold price, has now disappeared, eliminating a formerpotentially bullish factor for gold. The last advance in the price of gold since mid 2005has been driven by funds. Gold and other metals have been especially closely correlatedin this cycle, perhaps because funds have similar portfolios driven by a similarpsychology toward all metals. Therefore, a revulsion by institutional holders fromcommodities in general and the metals sector in particular constitutes a serious contagionrisk to the gold price.

Part I: The Commodity Bubble

Let us first consider the bull market in commodities in this cycle. That is a first steptoward drawing some implications regarding the outlook for gold as a reserve asset.

I will start with a recap of my thesis from last year.

Commodity prices move in cycles. Their cycle tends to be strongly correlated with thebusiness cycle. However, since the end of the 1970s our business cycle expansions, inthe United States at least, have been longer than in the past. The expansion of the 1980slasted eight years. The expansion of the 1990s lasted ten years. Commodity cycles havenot tended to be this long.


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That said, the commodity bull market of this decade has been unusually high inamplitude and long in duration. In fact, by some measures real (inflation adjusted)commodity prices have risen more in percentage terms than they have in any prior half-decade bull market. It would seem that the microeconomic dynamics that have reversedcommodity prices in the past have either been absent or overwhelmed.

The New Era Thesis

In my experience, when a cyclical price trend persists for longer and to a greater degreethan has happened in the past, market participants declare a New Era to not only explainthis unusual persistence but to also justify the persistence of the trend forever forward.

This has certainly happened with regard to commodity prices in this cycle.

There has emerged a host of New Era advocates who share the following commonarguments. The very healthy growth of the emerging economies and the super strong

growth of China and India have made world economic growth different this time. We arein the midst of a new global supercycle in commodity demands that has relegated thefairly short commodity price cycles of the past to a history that is no longer relevant.

The same New Era thinking extends to the supply of commodities. We are most familiarwith such thinking as regards the oil market. The Peak Oil thesis says that all the easy tofind large oil reservoirs with low extraction costs are behind us. Yes, there are smaller,higher cost oil reservoirs to be found and exploited. But declining production from thelarge mature fields we largely rely upon offsets these new sources of output. For all thenew drilling and development we do, we find ourselves simply running fast to stay in thesame place, as decline rates on our old reservoirs pull the ground out from underneath us.

New Era commodity bulls extend this supply side thesis as it applies to oil to many othercommodities. In agricultural commodities, we are facing limits to the expansion ofarable land. In industrial metals the easy to find deposits have been found and, inexisting mines, ore grades are declining, and so forth.

It is my belief that these many claims for a New Era of explosive demand growth andsupply constraints are largely erroneous. This is best argued by looking at individualcommodity markets, for there we can document in detail if trend demand growth hasaccelerated or if rapid supply increases have become impossible. I will do that in whatfollows. We will see that the analysis of individual commodity markets shows clearlythat the New Era hypotheses are wrong. But one can also make a few generalizationsthat are pertinent.

Two decades ago I participated in a huge study of the copper market under the auspicesof the IFC and the other partners in a project called Escondida a project which was tobecome the largest copper mine in the world. We had the resources of the World Bank,BHP, RTZ, and an array of consultants. If I go back to that copper price forecastingexercise at that point in time it becomes very clear that, despite the high economic growth


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in the emerging world in this decade, we are not in a New Era, we are not in a newsupercycle in commodity demands.

Making long term commodity price forecasts is largely an exercise in extrapolation. Atthat time, two decades ago, we were extrapolating based on the economic growth trends

of the prior several decades. The emerging world was growing very fast, though thecontributors to its growth were somewhat different. In those days Brazil was a 7%grower, Mexico a 6% grower, Korea an 11% grower. Their economic growth rates todayare perhaps half of what they were. This is something of an offset to the recent high 9%growth rates of China and India.

But, you will respond, the economies of the emerging world today are a much largershare of the world economy overall. And, to be sure, that is true. But offsetting this isthe fact that the large developed economies were then far faster growers. Japanseconomy grew at a 9% rate in the 1960s and almost at that rate in the 1970s. It now has asecular growth rate of perhaps 1.5%. Europe overall had a growth rate of 4%-5% in the

1960s and 1970s. It now has a secular growth rate of perhaps 2%. For the largest shareof the global economy the attainment of the technological frontier, which implies lowerproductivity rates, plus adverse demographics, has reduced its economic growth ratedramatically. If you take all the economies in the world, valuing GDP based on exchangerates, the overall global growth rate has not significantly changed since the mid 1970s.And so the demand pressures on commodities should not have significantly changedeither.

And, in fact, as the chart below indicates, global economic growth and growth incommodity demands were higher in the period immediately prior to the mid 1970s.Then much of the global economy was still recovering from a prior war ridden epochwhen the disasters of wartime had set back so many economies from a greater potentialmade possible by the interim advance in the technological frontier.


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Mega Speculation and The Explosion In Commodity Derivatives

So if it is not a new era of supercycle demand growth and supply restraint, what has leadto such a high amplitude and long duration bull market in commodities in this cycle. My

answer is speculation nothing more. And speculation on an unimaginable scale.

The latest data provided by the U.S. Office of the Controller of the Currency and theBank For International Settlements provides us with an ever more startling picture ofexplosive growth in commodity derivatives. The data on U.S. bank positions shows alarge increase into mid 2006.

Integrated Oil Update, Mike Rothman,ISI, December 19, 2006

More striking is the data on the same derivative positions of all global banks compiled bythe Bank for International Settlements (BIS).


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Integrated Oil Update, Mike Rothman,ISI, December 19, 2006

Though the six-fold increase in such positions over a few brief years is striking, it is the

magnitude of these positions that is most alarming. From what we know of this datathere is considerable double counting. But, offsetting this, this compilation is incomplete.It excludes the positions of some investment banks who are extremely importantintermediaries in the commodity derivative markets. And it excludes all futures andoptions positions on commodity exchanges, which may add another $2 billion or more tothe global total. Taken all together the global total for all commodity derivatives isprobably much more than $10 trillion.

It is hard to know what to make of this data. But it is noteworthy that several years ago,at the then prevailing lower commodity prices, the entire above ground stock of allcommodity inventories was only in the hundreds of billions of dollars. If only a fraction

of the increase in global commodity derivative aggregates in recent years corresponds toa net long position of investors or speculators, it would appear that this increased demandfor commodity derivative positions has overwhelmed what have been relatively smallmarkets.

No wonder, then, that this cycles bull market in commodity prices has gone higher ininflation-adjusted terms and for longer than in all prior uninterrupted half-decade cyclesin the past.


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Investment Or Speculation?

The question arises, who are these new investors or speculators in world commoditymarkets and what is their behavior?

Investment in commodities today probably refers above all to pensions and endowmentswho have made long term strategic allocations to commodity futures index baskets fordiversification purposes. However, the total assets of all these baskets is somewherebetween $100 and $200 billion up from perhaps a total of several tens of billions at thestart of this decade 7 years ago. These investment positions are quite straightforward;there are few, if any, spread products or options or leverage that would augment thisoverall position. If so, one is hard pressed to explain the increase in recent years incommodity derivative positions in the many trillions of dollars by citing such strategicallocations into commodity baskets.

There is another alternative: speculating hedge funds. It is estimated that the total assetsof hedge funds of all types globally now approaches $2 trillion (up from several hundredbillion 6 years ago) and many of the types of funds who speculate in commoditiesemploy huge leverage. The increase in gross assets of those speculators could accountfor much more of the growth in commodity derivatives. But do they?

We got something of a window on this world at the end of the third quarter of last yearwith the collapse of the hedge fund Amaranth. Apparently, this fund lost perhaps $6billion or more in one commodity U.S. natural gas in a matter of weeks. Themagnitude of this loss and the change in natural gas forward prices at the time implies agross position in that commodity that was at least a small whole number multiple of the$6 billion loss. By contrast, the nominal value of all the U.S. natural gas derivativepositions of all outstanding commodity baskets was not much larger than Amaranthsloss.

Clearly, in natural gas one speculative hedge fund, Amaranth, was many times larger inthe gas forward markets than all the worlds investors in commodity baskets. AndAmaranth was only one hedge fund. According to one compilation there are nowhundreds of hedge funds dedicated solely to the commodity sector, and all kinds of morediversified funds like global macro funds who speculate in commodities. So hedge fundpositions in commodity derivatives outweigh pension and endowment investmentpositions, and by a very large margin.

So if unprecedented speculation is responsible for the amplitude and duration of thiscommodity bull cycle, it can be attributed, for the most part, to hedge funds.

How Investment And Speculation In Commodities Inflates Commodity Prices

In the above discussion there is an implied assumption: hedge fund speculation incommodity derivatives has overwhelmed commodity markets and has driven commodity


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prices way beyond levels justified by fundamentals. Also implicit is the assumption thathedge funds can employ vast leverage using such derivatives, so that limited pools ofspeculative capital can create huge demands for commodities.

I believe these assumptions are valid. But there is a widely held and respectable counter

argument. Derivatives are simply contracts for future delivery between two parties. Tobe sure, a speculator can take a long position in a commodity with only a small margincommitment by going long a derivative contract. But, for his long position, there must bea counterparty short position. The counterparty taking the short position need put up onlya small margin and can apply the same degree of leverage. So the two sides of thecontract balance out. And the leverage employed using a derivative by both the long andthe short balance out. Hence the proliferation of derivative contracts does not influencemarket prices, despite their leverage potential. Because the longs and the shorts basicallyhave the same access to leverage and take offsetting positions.

Since the mid 1990s Fed chairman Allen Greenspan and Treasury Secretaries Robert

Rubin and Larry Summers were pushed repeatedly by Congress to bring the OTCderivatives market under regulatory scrutiny and control. The concern of someCongressmen was that the shadowy world of OTC derivatives could increase the leverageof speculators and thereby the risks to markets and ultimately to economic activity.

Greenspan, Rubin, and Summers fought off these efforts by Congress with unfailingdetermination. There argument was the derivatives simply reallocated risk; they did notincrease risk. And this reallocation spread risk among a greater number of marketparticipants, including participants who were better suited to bear it. Therefore,derivatives were reducing- not increasing- the risks to markets.

This sounds like a solid argument with theoretical underpinnings. But, for many marketparticipants, it just does not seem realistic. We know of too many instances wherespeculators have used derivative contracts to take on very large leveraged positions, andhave thereby exaggerated price movements which ultimately led to crashes.

There are two famous examples. The first is the 1987 stock market crash which resultedfrom the widespread adoption of portfolio insurance which was based on the relativelynew introduction at the time of derivatives and synthetic derivatives on the stock marketsindices. The second example is provided by 1998. In that episode it was not just LTCMwhich experienced severe difficulties; many of the large dominant macro funds at thetime took very large losses in only a matter of a few months. And Bankers Trust sufferedsuch losses it had to be merged into Deutsche Bank. These funds and prop desks hadpushed a whole set of markets to extremes which then all violently reversed in unison. Inmany of these markets, like the fixed income and currency markets, the price distortionswere aided by the use of derivatives and the subsequent crashes were exacerbated by theunwinding of derivative positions.

Many have argued that the explosion in fixed income and forex derivatives in this decade which one sees via the published reports of participating commercial banks- has not


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resulted in market excesses as a result of their explosive growth since the end of the1990s. That is probably correct. For so far, at least. So, the experience of these marketsand their derivatives can be marshaled to support the Polyanna thesis of Greenspan,Rubin, and Summers. But one can do this only if one conveniently chooses to forget thederivative related debacles of 1998..

How does one settle this dispute? By looking closely at the interaction of derivatives, theunderlying, and the price mechanism in specific markets. So let us look at all these inthe commodity space.

First, we must decide on what constitutes the underlying. Commodity derivatives tendto arise through the hedging of the stock of commodity inventories and anticipated futureproduction. Before the commodity bubble of this cycle- when commodity prices wereclose to marginal cost- the total money value of all commodity inventories world widewas on the order of several hundred billions of dollars. Some of this was hedged, givingrise to commodity derivatives. And a small part of future production was hedged, giving

rise to yet more commodity derivatives. Taken together all of these commodityderivatives were comparable to the money value of the outstanding stock of commodityinventories and a little forward production. The worlds commodity derivativeaggregates made sense.

As a result of the bubble in commodity prices in this decade the money value of theoutstanding stock of commodity inventories has doubled or tripled. It perhaps nowapproaches a trillion dollars. But the outstanding commodity derivatives, partly visiblethrough the window of commercial bank books, has gone up perhaps tenfold to 10 trilliondollars or more. Now the commodity derivative aggregates seem to be outsized relativeto the underlying.

Has this explosion in commodity derivatives distorted prices and increased market risk?It is apparent from my use of the term bubble and the way I have framed the above thatI believe it has. Let me explain the process whereby it has.

Roughly four or five years into this decade- and two or three years into this cyclicaleconomic expansion- commodity markets experienced a big bull run. Without going intothe details, I think it is easy to make the case that microeconomic and macroeconomicfundamentals were responsible for this bull move. But once it was underway the superiorperformance of commodity prices attracted attention. Long-term investors like pensionsand endowments began to consider commodities as a new asset class and hedge funds,always looking for fast action to justify their costly 2% plus 20% compensationarrangements, began to chase commodities.

As is apparent from the above chart, the first phase of the commodity bull move occurredwithout huge growth in commodity derivatives. But from the beginning of 2005 onwardthere has been a vast explosion of hedge funds and pensions and endowments who havetried to get longer and longer commodities by way of the purchase of long positions incommodity derivatives. Looking at the pattern of expansion of commodity derivatives


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one can make a prima facie case that the investment and speculative flows intoderivatives. with their huge implied leverage, pushed commodity prices further than theyotherwise would have gone after 2004.

How could this have happened? Initially, before the explosion in commodity derivatives,

the structure of commodity derivatives markets was as follows: speculators tended to benet long, commercial consumers tended to be net short as they hedged some of theirinventory, and producers were mostly net short as they hedged some inventory and somefuture production. The speculators were able to go long commodities by way ofderivatives because commercials, who were natural hedgers of some of their inventoryand some of their nearby future production, were willing to increase the volume of theirhedges.

How did this come about? Speculators wanting to go long had to create a price signalthat would lead to an increase in the supply of these derivatives, since for every longthere must be a short.

Buying pressure by the longs through commodity derivatives raised the price ofcommodities above their marginal cost which is their long run price equilibrium.Commercials, recognizing where marginal cost lay, were encouraged by higher prices tohedge more of the outstanding stock of inventories. They were also encouraged to sellmore of their future production forward.

In past cycles, when commodity prices soared, spot prices tended to rise much morerapidly than forward prices. Hedgers did not forget that the long run price equilibriumwas still marginal cost. As a consequence these markets went into steep forwarddiscounts or backwardations.

But, in this cycle, so great was the buying pressure of the longs in commodity derivativesthat, starting in 2005, far forward prices were pushed up along with spot and nearbyforward prices. When speculators and investors go long derivatives they are going longthe forward price. If speculators want to take on positions that are ever larger relative tothe underlying they have to push up far forward prices further and further in order toinduce producers to sell future production ever further forward- and thereby provide theincreasing supply of derivatives that accommodates the new speculative demands.

In keeping with the unprecedented explosion in commodity derivatives in this cycle, thisentire process has happened in spades. Most striking has been the case of crude oil. Inthe past, whenever crude oil was at marginal cost, the forward market was in a smallbackwardation. When the crude oil price rose sharply the backwardation became huge.In this cycle it has been totally different. As investors and speculators bought more andmore oil by way of derivatives the far forward crude oil price was driven to a hugepremium over the spot price- something that had never, ever happened before. Why?Because this is what it took to get commercial hedgers to generate the unprecedentedcrude oil derivatives supply that rabid investors and speculators now demanded.


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Let us go back to the Polyanna thesis of Greenspan, Rubin, and Summers; in derivatives,for every long there is a counterparty short, and therefore behavior in the derivativemarket is price neutral. To be sure ex post there is always a leveraged short to matchevery leveraged long. But the process is not price neutral. Ex ante the rabid demands ofinvestors and speculators overwhelm the commodity markets and push up the forward

price. And it is only that price signal that brings forward the commodity derivativessupply that ex post completes the identity of longs and shorts, supply and demand.

Does this price impact create a market risk? Of course. How?

If a tsunami of rabid investment and speculative commodity derivative demands hits thecommodity markets, it must drive the forward price more above marginal cost than in anormal bull cycle. The higher the price is driven above marginal cost the more newsupply will be encouraged. These high prices will also lead to a more assiduous effort bycommodity consumers to economize and substitute, thereby rationing demand. Ifunusual commodity derivative demands take prices very high and on a sustained basis,

the resulting surpluses that will eventually take down these prices will be all the larger.

But there is another facet to the increase in risk in commodity markets created byderivative tsunamis. It is the financial risk created by the vast implied leverage ofderivatives. Speculators, by putting up only limited margin, can take on hugeleveraged positions. Pyramiding speculators can employ ever greater leverage as pricessoar. For those leveraged speculators it takes only a partial correction of the price rise towipe them out. In this way hedge funds can fail, as LTCM would have failed without itsbailout, and as Amaranth almost failed a mere few months ago.

The Pollyannas about derivative leverage always emphasized symmetry in the derivativemarkets: for every long there must be a short, the leverage of the longs must be matchedby the leverage of the shorts. But in the commodity markets there is not asymmetry ofbehavior.

How so? The pyramiding leveraged speculators in commodity derivatives must meetmargin calls when the price eventually goes against them. They may not be able to do so.Then there will be failures. There is no parallel to this with regard to hedgingcommercials who are short by way of derivatives. Yes they may be leveraged, but theyhave the commodity in inventory on the shop floor or on the production site or in awarehouse somewhere. Or they have future production secured in the form of extractablereserves in the ground or the wherewithal to produce another crop. Whoever are thedealers the hedgers they have their margin position with, the odds are that they have thestuff to deliver against their forward sale when it comes due; hence, there is no margincall or the margin call will be financed by their dealer.

It is this situational and behavioral asymmetry between the leveraged longs and theleveraged shorts in commodity markets that creates financial risks and the potential forcrash dynamics when derivative leverage creates excessive bull moves in prices. Forthe speculative longs who are leveraged, when the leverage goes against them they get


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margin calls. And when the margin calls come fast and furious they must sell or be soldout. Not so for the hedgers who are short who are carried by their dealers on price risesthat go against them. More importantly, when prices fall such commercial hedgers oftenjust sit with their shorts. They know they have the stuff to deliver when the deliverydue date comes, and they may simply wait until that due date and then deliver their

stuff against their short. So the longs are forced to liquidate. But the hedging shortsmay not be inclined to accommodate them by buying in their shorts. It is this behavioralimbalance that creates crashes.

A Brief Note On Oil

My objective is to get in the end to our topic of reserve management which are gold andcredit spreads. But it is probably worthwhile to touch on the single most importantcommodity first, which is crude oil, before we go on to metals and gold.

The price of crude oil has appreciated almost as much in this cycle as the most bullish ofall the commodities the base metals. So, one may ask, is it a bubble? Two years agothe noted money manager Jeremy Grantham posed this question in an interesting way.He presented a chart of the real inflation adjusted oil price going back to 1875.

He then noted: Over the years we have asked over 2000 professionals for an exceptionto our claim that every asset class move of 2 sigmas away from trend had broken, and notone of the 2000 has ever offered an exception! This should be scarier than the fact thatGMO has tried so hard to find one and failed. But we always have said that intellectually

you can imagine a paradigm shift in an asset class price, even if we have been unable todocument one yet in history. Exhibit 5 shows the price of oil and 1 and 2 standarddeviation bands. If the new price averages $50 and above, it will look suspiciously likethe real McCoy. Chinese growth and supply problems could do it. Its the bestpossibility Ive seen in my career. But the investment desert is littered with the bones ofthose who bet on new paradigms.


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So for Grantham any asset class that moves more than two standard deviations from trendis apparently a bubble and history says that such markets absolutely always mean revert,such bubbles always burst. This happened with the bubble in oil in the 1970s. ButGrantham opens the possibility that crude oil this time could be the first exception.

Why? As alluded to above, it is a popular view (the peak oil thesis) that, in this cycle andmaybe forever forward, the supply of oil will be severely constrained. And that this willbe even more so if there is an adverse geopolitical development in the Middle East thatdisrupts global oil supplies. If oil is the first exception in history to the bursting of allbubbles, this will be why!

Let us look at oils fundamentals. When one looks at the supply/demand data for crudeoil over this cycle it falls within ranges that I would regard as reasonable relative tohistory. Demand growth, which averaged perhaps 1.6% per annum in the prior decade,was elevated in 2004 to a 4% rate by a synchronous global expansion led by the emergingworld and by a power generation shortage in China that led to a transitory need to use

large quantities of diesel to supplement the coal fired power grid until new power plantscame on line. That rate of global oil demand growth has since been tempered. This hasbeen due in part through conservation and substitution (price rationing), as one mightexpect. It has also been due to less reliance in China on diesel for power as the coal firedpower grid expanded. So based on the global demand data, the emergence of China as aneconomic power has not changed the global demand trend by that much. On the otherhand, so far at least, we have not seen any of the severe demand rationing that occurredafter the 1970 bull market in oil which led to a very large outright decline in oil demandin the early 1980s.

On the supply side, the depletion of the large mature oil fields found decades ago that theworld now relies upon and the absence of comparable sized new discoveries has surelyconstrained supply. Global capacity growth has been positive, but it has only risen froma 1% annual rate to only a 3% plus rate this year, despite the high prices that haveprevailed in this cycle. So the fundamentals of oil supply suggest more supply restraintthan in the past. But so far there is no peak oil; high prices still encourage somesupply.

So if one looks at the global oil market, demand growth exceeded capacity growth earlyin the decade by a small margin (2%-3%). Now, in response to the very high oil price,demand growth has come down by two or three percentage points, capacity growth hasgone up by perhaps 2 percentage points, and a buffer of unutilized capacity has slowlyemerged and is gradually on the rise.

In the case of the oil market we are looking at modest changes and differences in thesupply and demand growth rates. This is typical of most commodity markets. There isnothing really shocking about any of the fundamental developments in this sector. Thereis none of the huge increases in primary supply that we are now seeing in base metals, asI will illustrate later.


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That said, I believe that much of the explosion in overall commodity derivatives over thelast half-decade must be attributable in part to investor and speculative long positions incrude oil. This investor and speculation pressure is most apparent in the emergence of asupercontango a premium in the futures and forwards curves that recently hassometimes been several times the cost of carry. Theory says such forward premiums or

supercontangos should not occur because arbitragers should buy the physical and hedgewith a forward, locking in an enormous riskless arbitrage profit. I believe that such asuper contango can exist only if investment and speculative demands in the forwardmarket are so large that virtually all available storage is filled by arbitrageurs, making itimpossible for them to arb away any further such supercontango.

For this reason I believe that investment and speculation in crude oil derivatives hasmaterially inflated the price of oil, even though the supply and demand fundamentals arenot seriously out of whack. The tsunami of hedge fund speculation in commodities isresponsible for much of the amplitude and duration of the bull move in most commoditiesin this cycle. This no doubt applies to crude oil to some degree. But not to an absolutely

overwhelming degree, as I believe is the case in the metals sector.

Part II Metals: A Speculation to the Point of Manipulation without Precedent in the

History of Commodities

Preface

Before proceeding with this section, which is replete with extreme statements about thecurrent state of the metals markets, I believe a reminder to the reader is in order. Adecade ago a famous manipulation of the copper market was revealed. This led to a bigbear market in copper and many class action lawsuits against the perpetrators and dealdealers and banks who were peripherally involved. That these things happen in thesemarkets seems to be forgotten in todays euphoric market environment. But, at thisvery time, after many prior settlements of similar claims with large awards to theinjured, the last such case is now being taken to court. I think it is worth while to quotea recent description of this coming court case and its claims to remind the reader thatwhat follows does not lie outside the realm of plausibility in metals markets.

Last legal action from 1996 copper scandal to go to trialMetals Insider - 3 May 2007

A US federal judge in Wisconsin has ordered a trial next month in a long-runningantitrust lawsuit claiming J.P. Morgan & Co. Inc. conspired with Japanese trading houseSumitomo Corp to manipulate the copper market in the mid-1990s. It is the last legal

hang-over from the 1996 copper crisis with most of the other claims long settled out ofcourt. This action is a consolidated law-suit brought on behalf of around 20 US copper

consumers seeking an estimated $1 billion in damages from J.P. Morgan Chase & Co.,the successor to J.P. Morgan. "We're going to show a jury of good Wisconsin citizens thechicanery and manipulation that went on and how manufacturers of copper wire andcopper rod suffered," Atlanta lawyer James Bratton, who represents Southwire Co. and


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Gaston Copper Recycling Corp, told local media. "We're looking forward to getting abig verdict." The centrality of the allegation against the bank is that it providedfinancing to Sumitomo to artificially inflate the copper price. The bank argued in courtdocuments that its transactions with the Japanese company were proper and did not have

an impact on copper prices. However, its motion to dismiss the case was rejected by US

District judge Barbara Crabb and the trial is scheduled to begin on May 29.

Introduction

In every market bubble there is some cutting edge where the greatest extremes are to befound. In retrospect, the extent of the speculation has always seemed almost impossible,though, amidst the fury of the bubble, very few recognized it for what it was. Thechronicles of bubbles in the past like Charles Kindlebergers, Manias, Panics, andCrashes, and Edwards Chancellors, Devil Take the Hindmost show that, in almost allsuch bubbles, at such a cutting edge speculation is not only unimaginable but involvessome measure of fraud and manipulation.

I alluded to some such behavior in the metals sector in my presentation to you last year,though with little specificity. This year there will be no allusions. I think we knowenough to say that speculation in metals markets in this cycle has gone further than in anyother cycle in history. What we have been undergoing is a speculation to the point ofmanipulation, perhaps involving collusion, across a whole array of related metalsmarkets.

1 I argue that it is as though the famous episode of the Hunts in silver decades

ago has now been taken to a power.

I understand that these are very strong words. To back them up I will discuss a few basemetals where it has become quite apparent that something like this is happening. I willthen touch briefly on a few others as well as the white metals before we get to thesubject of gold.

My reasons for making such an unusually strong claim are many. Some come frominside reports about the activities of hedge funds and others operating clandestinely inthese markets. Some come from analysis that points to large anomalies in these marketsover recent years. And some come from claims and analyses about extreme speculationto the point of manipulation that has fallen into the public domain.

In fact, since I last spoke to you a year ago, a great deal of commentary has surfaced inthe public domain. We have put together a compilation of this commentary which we areattaching as an appendix. In what follows I will avoid all inside information andconfine myself to analysis and a small subset of this commentary that we have culledfrom the public domain.

1Am I going too far with these words? The head of the enforcement at the CFTC just issued a warning:Regulators need more funds to guard against fraud and manipulation. Why this choice of words? Seethe above preface. And see more on this later in this text.


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But let me just say, we have many, many reports from market participants that are morespecific than the statements we have culled from the public domain. Also, many of thesereports are from investment firms who distribute bullish metal market assessmentssupposedly based on facts to their clients when, at the same time, they privately reportmanipulation and collusion as the dominant force in these markets.

In analyzing base metals one has to bring up an all important and rather unsavory featureof these markets: the emergence again and again in most past bull cycles of squeezes orattempted corners. (In this regard, see the quotes from Paul Krugman in a later sectionentitled, The Risk of Revulsion II, Revulsion From A Hamanaka on a Massive Scale.)In the past metal merchants, faced with a bull market environment, often hoardedphysical metals. By taking metal out of circulation prevailing shortages wereexacerbated. This amplified panics by consumers caught short of physical, which in turnfueled further the bull market move. This happened in most cycles in base metals sincethe late 1960s. But in these past cycles such merchants usually sold when the marketshad not yet gone into significant surplus. In effect, they tended to get out when the going

was good.

A squeeze operation like this, by taking metal out of circulation, always distorted thesupply, demand and stock data. As hidden stocks were built, visible stocks declinedfaster and fell further. Market conditions appeared tighter than they really were.

Not only was the stock data distorted, so was the data on demand. We define the demandfor a metal commodity not as the demand for that metal in all the products thatincorporate it which consumers buy that measure of demand is far too hard to calculate.To simplify, statisticians in commodity markets define demand as simply the absorptionof metal by first stage processors. Take for example copper. The primary product acopper cathode is put into a furnace by a wirerod mill. The mill produces wirerodwhich is then turned into wire. And that wire is incorporated in many products thatconsumers buy. Copper demand is defined as the absorption of the metal by a wirerodmaker rather than a wire manufacturer or the maker of final products that embody wire.

But even this concept of demand is hard to calculate for almost all economies. It turnsout it is simply too taxing to monitor the purchases of metals by first stage processors.To simplify yet further statisticians, for the most part, use a concept of apparent demand.Demand is defined for a given country as domestic production plus net imports (in otherwords overall supply) adjusted for the change in visible stocks in that economy. Theresidual produces the estimate of apparent demand.

It follows that, if there are builds of unreported stocks (due to commercial inventorybuilding or merchant squeeze operations), total supply from production and imports willhave to be higher and the residual, which is apparent demand, will have to becorrespondingly higher. So squeeze operations with their typical hidden stock builds notonly portray less inventory than actually exists; they inflate apparent demand relative tothe true level of demand.


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Earlier in this paper I described an almost unimaginable explosion in commodityderivatives due to massive investment and speculation by pensions and endowments andhedge funds. It would not be out of keeping that some of these investment andspeculative demands would have spilled over into the accumulation of physical stuffrather than just derivatives. But, remember, all the physical commodities in the world at

the prices of several years ago only had a total value of several hundred billions ofdollars. At todays prices the value of these above ground stocks is much higher. But itis still a very small fraction of the total mountain of commodity derivatives and probablythe total investment and speculative claims on commodities by way of derivatives. If thisis so, even a moderate spillover of such investment and speculative demands intophysical stuff could involve an accumulation of physical inventories which is largerelative to total inventories and the flows of supply and demand.

Has such a spillover occurred? Yes. There are now commodity oriented hedge fundsthat make it clear in their documents that they purchase physical commodities as well ascommodity derivatives. It has also become fairly clear from detail provided on the

ownership of metal on warrant with the commodity exchanges that hedge funds hold verylarge amounts of these physical stocks a point I amplify on below. So if hedge funddocuments declare that such funds may own physical, if exchange reports suggest theysometimes own very large amounts of visible physical stocks, it is certainly possible theyown off warrant material as well. So the issue is not one of whether we haveinvestment and speculative holdings of physical stuff in the cycle; it is rather a questionof how much and in what form.

Unless the holdings of physical commodities by institutional investors and speculatorstake the form of exchange warrant claims on exchange stocks, there will be no record ofsuch physical holdings. These stocks will be hidden. Increases in such hidden stocksare recorded by statisticians as increases in apparent demands that exceed the increase inreal demands. In effect, just as with our case of the merchant squeezer, the spillover offund speculation into physical commodities may result in an understatement of the truelevel of above ground stocks and an overstatement of the level and growth rate ofdemand. Where markets are balanced, they will appear to be in deficit; where marketsare in surplus, the surpluses will be understated. Given the possible magnitude of suchinvestment and speculation in physical commodities indicated by the new Mount Everestof commodity derivatives, these distortions in the stock data and the supply and demanddata could be very large.

Now, let us put together the historical behavior of merchant squeezers and the morerecent behavior of institutions speculating in commodities including physical. Aquestion arises, have hedge fund forays into physical commodities, and particularly intometals, occurred simply as passive investments or have they occurred with the objectiveof conducting squeezes and corners as merchants and speculators have done in the past.

The answer is clear in many cases the motive must have been to squeeze or corner.Why is it so clear? Because there is considerable evidence that, in the metals markets,hedge funds have taken positions in exchange warrants physical holdings even though


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these markets have been in significant backwardations. And, as our so many of thecommentators in our appendix indicate, these funds have held off warrant material aswell. In a backwardated market holding a forward (which is at a discount to the spot)provides a positive return as one rolls ones future or forward into a successor contract.In the last two years, there have been periods when this roll yield into a significant

backwardation has been extremely high perhaps as much as 20% -30% annualized. Bycontrast, holding exchange warrants and off warrant physical provides no positive rollyield under such circumstances; rather, one must pay the cost of financing plus storageand insurance. Why would any fund hold physical at a considerable carrying costrather than a future or forward with no such cost but with a handsome positive roll yieldinstead? The only reason I know of is to conduct a squeeze or corner operation thatyields other returns if the squeeze succeeds. (Again, see Paul Krugmans comments laterin this paper.)

If hedge funds decide to conduct squeeze plays and attempted corners as merchantstraditionally have but with their far vaster financial resources we face the possibility

of builds of hidden stocks and distortions in our measures of inventory, apparent demand,and market balances that could be far greater today than they were at any point in thepast.

It is my position based on much information that this is in fact what has occurred over thelast two or three years. As I have said above, I am not alone in this regard by any means.Just scan the appendix with our compilation of commentaries on such speculation andmanipulation of metals markets from many market observers. And, as an example, lookat his recent commentary on this very subject by Morgan Bank.

This week we examine the tension in the metals market between (visible signs ofweakness in) industrial trends and the impact of the now super larger and superleveraged commodity funds. We test the water to ask if there is manipulation or collusionof if the sector has inadvertently become a price support and inventory sterilization

mechanism without consciously planning to be.

The author then cites two historical examples where price support was done through theaccumulation of physical commodities: De Beers in the diamond market and a producercartel in tin during the early 1980s.

Excess inventory gives consumers pricing power and low inventory gives producerspricing power. This is something that the tin cartel realized and for years that industrythought that it may have found the holy grail of production, inventory and price controlbut the eventual and inevitable demise of that cartel was a history lesion showing that

such systems cannot last forever, even if they can last for quite some time.

In the current base metal markets it is possible that such a system is operating eitherunintentionally, by default, or intentionally. Whenever there is a possibility thatcommodity funds with huge cash flow decide to make their investments not only via


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futures and options but by holding metals then there is the risk that a crude De Beers typeinventory limitation is in place.

The Nickel Market

On to examples.

Today the price of nickel is close to $50,000 a tonne. Its historical mean is more like$7,000 a tonne. The price of nickel in this cycle has now risen almost 900% from itsprior cycle low. Above I showed Jeremy Granthams chart of the real oil price over130 years. The move in the real nickel price is an even greater deviation from the meanthan was oil in the 1970s. That is really amazing since, with oil in the 1970s, there wasthe very inflationary psychology of the era which fostered hoarding, there was the loss ofroughly 10% of global output with the revolution in Iran, and there was the price supportprovided by the OPEC cartel.

If Jeremy Granthams observation that all such two sigma plus departures from the meaneventually end in reversion to the mean, if this rule proves right once again in regardsto nickel, we will see in the years to come that nickel will be $7,000 a tonne again.

How did the nickel price get to such a lofty level?

The Wall Street analysts will tell you that it has done so because demand is super strongand because of the booming economies of China and India. They will tell you thatsupply growth has been restrained for many reasons. As a result, the market has been inan acute deficit and prices have soared.

On the face of it this argument seems to have some merit. There have been manyprimary nickel projects that have been delayed. Demand for stainless steel, which is theprincipal market for nickel, soared an amazing 16.7% last year.

But people close to the nickel market argue otherwise.

About two years ago there was a meeting of nickel producers and consumers in Portugal.That meeting ended in a dispute between nickel consumers and producers that wasdisorderly to a point approaching pandemonium. At the time nickel consumers claimedthere was no shortage of nickel and that an artificial shortage had been engineered byhedge funds. They claimed that speculation by funds on the LME had divorced the priceof nickel from reality and that the LME had ceased to function as a mechanism for pricediscovery.

These claims have never ceased. You will see in our appendix references by the press tohedge funds that own all the physical nickel.

One of the most interesting complaints has been made by Chinas largest nickelproducing company, the Jinchuan Group a company that is largely owned by the


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Chinese state. Jinchuan says more than once on its website that the LME nickel marketis excessive of speculations and with a suspicion of manipulations, the LME is nolonger a place for fair dealing of metals but a paradise of speculations. It warnscustomers not to be puzzled by deceptive information of nickel stock, conditions ofsupply and demand, as well as price released irresponsibly by a few foreign agencies.

Part of its ire seems to be directed at the LME which allows such shenanigans to runamok. Lots of doubts were aroused in a survey about LMEs fairness, justice andopenness, and also about its role in price discovery.

As I have said, the Jinchuan group is not alone. Speaking about the last run up in thenickel price to its peak the Russian nickel producer Norilsk made the following comment:David Humphries, chief economist for Norilsk Nickel, said hedge funds had moved infor the kill, triggering a violent short squeeze on the futures markets. Implying thatphysical stock is being hidden, ABN Amro notes, The task of the nickel longs is to keepinventories at these critical levels. They will then be rewarded with acute pricingtension.

Since that conference in Portugal two years ago, those who have complained about anunrelenting short squeeze by hedge funds and merchants, often suggested to be operatingin collusion, argue that the market is ceasing to function as a market. This may be true.Recently, the nickel price made a new high above $50,000 a tonne. An LME traderreports it was done on no volume, with the usual comments about the lunacy of themarket.

Nickel's three-month price broke the $50,00 mark at 9am London time on Thursdaymorning when 1 lot traded at this level in a market traders have dubbed "lunatic".

The price of the alloying metal has not traded below $49,200 since the start of thetrading day, after it closed at $49,400 on Wednesday, but volumes have been extremelythin, with only 28 lots having traded by 9:29am on Thursday morning.

"This is lunacy," said a physical trader. "I better close shop and come back when we are

at $40,000 again. The phone has not rung once this morning. But we're heading for afall at these levels. Material is coming from consumers now offering to us. Not smalllittle consumers. The big [stainless] producers."

He said the market lacked natural sellers, and the price surges are on speculative tradingonly.

"It's completely artificial. There is no connection whatsoever between the LME and the

physical market now. The LME has its own life."

The alleged nickel squeezers which encompass hedge funds may have pressured so manyshort side participants out of this market that it has been reduced to the trading of a merehandful of lots on what would seem to be a price pivotal day.


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Let us assume that much of this is correct. Then hedge funds and perhaps merchants aswell have built hidden stocks. The metal is not as scarce as it seems. More importantly,apparent demand has been inflated by the build of hidden stocks. Most statisticians andanalysts assume the nickel market was in a small deficit last year. But, instead, themarket may have been in a surplus rather than a deficit.

Jinchuans website goes far beyond complaints about speculation in, and manipulation of,the nickel market. They provide documentation of a very rapid move towards lowernickel bearing stainless grades and non-nickel bearing types of stainless steel. They citea proliferation of primary nickel projects down the road which they believe will not beneeded. They fret that todays price distortions will lead to permanent demanddestruction for nickel producers and a painful glut when the speculation is over.

And that point may be not far off. Stainless steel demand was up 16.7% last year. Part ofthat was a rebound off a prior year where there was a global stock liquidation. But evenso, it is a growth rate more than four times the past trend. It must have reflected very

substantial stock building in stainless. This is what is now being reported by the stainlessproducers and the service centers that distribute stainless. The very pronouncedinventory cycle of stainless may have now gone so far that a reversal is probablyunderway. MEPS, the industry statistician, reflecting this, is predicting a 4% decline instainless steel demand this year. Add to this the economization and substitution in nickeluse that Jinchuan and many others talk about and a significant decline in nickel demandshould be at hand. For example, the steel giant Posco has just announced that it will use14% less nickel in stainless production this year as it turns to non-nickel bearingstainless.

Is this happening? Apparently it is. In Europe there are excess inventories. TheEuropean stainless producers report falling orders. The price of stainless has fallen from1900 euros a tonne to 1300 euros a tonne in six weeks. Major producers like Outokumpohave announced 10% production cuts.

But the turning point dynamics do not end there. Last year China, looking to bypass highnickel prices and the alleged shortage of nickel, began to access already mined lateriteores in Australia and the Philippines. They used idle blast furnaces to process these ores.The investment involved was minimal, as the ores have been mined and there was ampleblast furnace capacity everywhere in China. Last year nickel output from such lateritesrose from almost nothing to 30,000 tonnes. This year they predict an increase to 60,000tonnes, representing a surprising 5% increase to supply in a mere two years. Someanalysts who have looked at this issue think that production from nickel laterites byChina and Japan could be much higher than 100,000 tonnes this year. In addition, to thisthe world will finally see a significant ramp up in the primary production of nickel frommore traditional sources in 2007 perhaps on the order of 7%. This implies an overallincrease in primary supply of 10% and possibly significantly more.

When I look at all these impacts on the balance a reversal in the stainless inventorycycle, substitution and economization, increases in conventional and non-conventional


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supplies it would seem that the market balance in nickel could swing this year by 15%of demand/supply or more. Such a swing is unheard of. At the same time, adjusting fordistortions in the apparent demand data, the market may have already been in surplus lastyear despite a likely large stainless inventory build associated with that 16.7% rise instainless demand. In effect, the nickel market may already be moving into a vast

unprecedented surplus.

And yet, owing to the LME paradises of speculation and manipulation the nickel priceis still soaring further and further beyond its two standard deviation bubble statusthreshold.

Copper

The price of nickel in this cycle has gone up almost nine times from it prior cycle low.The rise in the price of copper has not been quite so extreme. It rose more than 6.5 timesabove its cycle trough at last Mays $4.07 a pound high. It rose well in excess of five

times in real terms, and is within 10% of last Mays price peak a whole year later. Thisdeviation of the real copper price from trend surpasses that of crude oil in the late 1970sdespite the generalized inflation psychosis of the 1970s, the Iranian revolution that shutdown one of the worlds biggest oil producers, and the support of OPEC, the mostfamous commodity cartel in history. By Jeremy Granthams criteria, copper in this cycleis a two standard deviation bona fide bubble event.

You can divide copper cycles in different ways depending on your choice of endpoints.If ones choice of end points is half decade cycles in inflation adjusted terms, the increaseof the copper price in this cycle was already greater than in any cycle since 1900 once wegot to $1.90 a pound in 2005. By this measure no rise in the inflation adjusted copperprice has ever approached what has happened in this cycle.


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The above refers to cyclical moves in the copper price in real or inflation adjusted termsfrom 1900 forward. I have found a similar analysis of copper cycles in nominal dollarssince the year 1860. This analysis considers longer duration cycles, out to as much as ten

years. This period, starting in 1860, encompasses the Civil War, the First World War, theSecond World War, the Korean War, and the Vietnamese War. Wars tend to consume alot of copper. Wars also spawn generalized inflations, and this period since 1860encompassed the inflations of the Civil War, the First World War, the Second WorldWar, the Korean War, and the persistently inflationary period from the mid 1960s towell into the 1980s. This period also encompassed the advent of electricity andtelecommunications in the late 19thcentury. This was the most important technologicalrevolution and economic engine of those decades. Copper was the material essential tothat New Era industrial boom.

Even though this history since 1860 encompassed all these wars and inflations and a

copper critical industrial New Era the largest percentage increase in the dollar copperprice in any of these past cycles was only 246%.

IN THIS CYCLE IN A MERE FOUR AND A HALF YEARS INTO MAY 2006 THECOPPER PRICE ROSE 575% AMIDST THE LOWEST INFLATION IN THE U.S.GENERAL PRICE LEVEL IN ANY ECONOMIC EXPANSION IN ALMOST A HALFCENTURY.


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Some will say, this must surely be because of a new era of super cycle copperconsumption led by China, India and the emerging world. In fact there is absolutelyZERO evidence for this in the official data on global copper consumption.

Global Copper Consumption

Average Annual Growth

1980 2005 2.3%

1990 2005 2.6%

2000 2005 2.6%


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2006 2.3%

Source: ICSG

In general, when confronted with this data, people simply refuse to believe. It is obvious,they say, that copper consumption in China has been booming; therefore, such data mustbe wrong.

But what has been happening is something that has been going on for decades. As Idescribed above, base metals consumption is defined as the absorption of metal byprimary processors. Since the 1960s the primary processing of copper cathodes has beenmigrating from the first world to the emerging world because such fairly low tech

manufacturing makes more economic sense in emerging economies than in higher costdeveloped economies. Now that China, with its super high investment ratio, is displacingmore and more manufacturing that heretofore had been done in the U.S. and otheradvanced economies, its booming copper fabrication industry is displacing at a dramaticrate this industry in the advanced countries of Europe, the United States and Japan.

World Consumption

2000 2006

Average Growth Per Annum

W. Europe -1.5%

USA -5.5%

Japan -0.6%

China 12.6%

In the end, with all this furious migration of the primary processing of copper cathodes

from the first world to China, the trend in the overall global consumption of copper hasremained basically the same.

If this is so, why has the price of copper soared way, way beyond all historical precedentsin this cycle? Is it a constraint on primary supply unlike the world has ever seen? In fact,that has not been the case either. Yes, a reduction in new investment in primaryproduction and a closure of mines followed the period of depressed prices at the end ofthe 1990s. This resulted in a lagged production response when this global economic


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announced to date results in a supply trend of close to 5% for years to come a rate thatis almost two times the historical average rate.

It should be noted that such projections are based on what has been announced. Whenprices are high exploration budgets rise. Exploration produces results. Existing deposits

become larger, additional investments are therefore made, and surprise expansions tendto proliferate. Also, new low cost projects are found., In the past, at least, theseunforeseeable successes have proved to be the most important engine of supplyexpansion over time.

So what then has caused the copper price to soar? Once again, unprecedentedspeculation to the point of manipulation. In the case of nickel, I gave you accounts of therole of speculation according to Chinas leading nickel producer Jinchuan and a fewanalysts from investment banks. In this case of copper I will provide you with an accountbased on two recent presentations of Nexans, the largest copper fabricator in the world.Nexans operates in 33 countries and accounts for about 7% of all copper wire

manufactured globally. Nexans has laid out its analysis of the copper market in twopower points used in two recent public presentations

Nexans starts their market analysis by noting the difference between official statisticsbased on apparent consumption and real consumption that is, what is going intofurnaces. Nexans believes the copper market has been in an increasing surplus, possiblysince autumn of 2004. Where has this surplus gone, since there has only been roughly a200,000 tonne increase in visible exchange stocks over this period?

February 8, 2007

Who hoovered away so much physical copper?

February 8, 2007


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Again, in a second presentation:April 20, 2007

In our appendix you can find many references from the public domain that correspond toNexans claims. But, we should ask, is there any analytical basis for such a claim that thecopper market, which ICSG official statistics2admit was in surplus last year at asignificant rate of 350,000 tonnes, has in fact been in a larger surplus and for years andwhich has been masked by a hoovering away into hidden locations of more than amillion tonnes by the end of last year?

My answer is yes.

If such a build of hidden stocks by speculators has occurred, it might be discernable intrade data which reflects the flow of metal across borders. We have looked into this. Inthe case of the United States and Canada combined we compared total supply fromimports and domestic refined production with fairly good proxies for domesticconsumption. Provisionally, these respective data series embody a positive residual ofsupply over consumption in 2006. This residual is considerably greater than the rise ofvisible stocks in the United States during the period. The implication is that there mayhave been a hidden stock build of perhaps 100,000 200,000 tonnes in North America

2I realize one must be careful about this ICSG estimate. Since early 2005 ICSG produced initial estimatesof a surplus only to revise them away. Well, well after the fact the initial deficit for 2004 has been revisedup, thereby shifting subsequent year balances in the same direction. Another statistical agency, WBMS,was carrying a surplus for 2006 through November that projected perhaps a 500,000 tonne surplus for the

year. Suddenly there are revisions and, based on the last report I have received, the estimated surplus for2006 including December is now 377,000 tonnes. More striking is the WBMS estimate of a 115,000 tonnesurplus for the first two months of this year. Demand is probably a bit above average in January andFebruary; the seasonally adjusted surplus for these two months combined might be 150,000 tonnes. Thatannualizes out to a 900,000 tonne surplus for 2007, which is huge relative to supply/demand by historicalstandards. Obviously, one cannot reconcile such a large surplus with a copper price of close to $4. I thinkin time we will see efforts being made to tweak and fudge the data toward something that is moreconsistent with the prevailing sky-high price. As I say elsewhere in this report, the copper bulls includingthe mining companies who fund them will look at the statisticians and say, how can you mere bureaucratsestimate a large surplus in the market when the market says otherwise. Hence the tweaking and fudging.


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over the last year. I may add that the same calculations hint toward something similar atthe end of 2005 and the very beginning of 2006.

Last year the import based ICSG apparent demand data on the copper market in Europeshowed an anomalously high rate of copper consumption. They estimated an 8% year

over year increase. If you look back at the first table in this copper section you will seethat, owing to the migration of copper manufacturing out of Europe, this Europeandemand growth rate is usually negative. The analyst Simon Hunt has taken the ICSGdata on European copper consumption and has compared it to a measure of trueconsumption based on reports from Europes fabricators. These two measures ofconsumption correspond over the early years of this decade. Then, suddenly last year,apparent demand based on imports soars relative to the above demand data. Again,implying a build of hidden stocks by someone.

The situation with China is less clear. Last year Chinese imports of refined copper fellvery sharply. As a result, ICSGs estimate of Chinese copper demand showed great

weakness. It is widely argued that a liquidation of hidden stocks by commercials and theChinese Strategic Reserve Bureau was responsible for this. And there is probably sometruth to this.

On the other hand, if one looks at the two years prior, the ICSG demand data, again basedon imports, showed double digit growth in apparent demand. At the same time, all otherdemand indicators suggested that demand growth was much lower. Chinas NationalDevelopment and Research Commission (NDRC), its government affiliate Minmetals,and the data we have on copper semi-fabrication in China all suggest that actual copperconsumption growth was in the single digits. The difference of course is an implied buildin hidden stocks. If one takes the several years combined it would appear that there havebeen hidden stock builds in China over the last several years. It appears that analysts andthe ICSG have inflated numbers on Chinese copper consumption in this most recent cycleand that China may be one of the places where Nexans alleged surplus has beenhoovered up.

We have done some tentative, albeit so far weaker, analyses along the same lines forseveral other Asian countries. Again these analyses point to imports above and beyonddomestic fabrication, implying builds of hidden stocks in these locations.

That is one avenue of analysis that supports Nexans thesis of hedge fund and investmentbank hoovering up of a recent large copper surplus into hidden locations. There areothers.

If there has been a build of hidden stocks in recent years it should have inflated ICSGsconsumption data. But could that be? Since, for the last two years combined, 2005 and2006, ICSG shows a rise in global consumption of less than 2%. Could that feeble a risestill be inflated?


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The answer is yes. As the first table in this section makes clear, on trend global copperconsumption has been a mere 2.5%. But, with the price of copper now far higher relativeto the price of substitutes like aluminum than has ever prevailed before, one might expectaggressive substitution and a growth rate well below trend. Remember, this hashappened before with other commodities in spades. When the oil price rose by a

comparable percentage amount in real terms in the 1970s, global crude oil productionactually fell by a whopping 15% when the global economy was experiencing trendeconomic growth.

From Nexans we get a window on this potential.

February 8, 2007

Nexans tells us that its copper consumption has been flat over the past two years. In thewire sector substitution is more difficult, at least initially, than in the brass mill sectorwhere plastic tubing, thinner tube walls, etc. are options. So if Nexans has been flat,overall industry consumption may have been down. Why has Nexans consumption beenflat? Because much cheaper aluminum is making inroads in wire, as their explosivealuminum consumption testifies.

For last year ICSG reported a surplus in the copper market of 350,000 tonnes. If

consumption of copper over the last two years was a little negative rather than a littlepositive, one gets a surplus of perhaps three quarters of a million tonnes. ICSG canaccount for most, but not all, of its estimated surplus for 2006, implying a possible hiddenstock build on the order of 100,000 tonnes. If the real surplus was higher, so was theimplied hidden stock build.

Let us try another avenue. ICSG has estimates on refined production and mineproduction. Commodity statisticians time and again make errors at turning points. Andone of those errors is a systematic edging of the supply and the demand data to generate abalance that is consistent with prevailing prices. ICSGs significant 350,000 tonne surplusin 2006 is already wildly inconsistent with todays prices which are unlike anything ever

seen before. Could it be that they have been edging down their production data estimate because otherwise they would show an even larger surplus, which would be even moreout of whack with todays sky high prices.

There are many compilations of global mine and refined production from statisticalagencies, metal consultants, etc. We have looked at many of these. In particular, wehave looked at one where, given the business situation of the analyst, there would be abias, if anything, towards a lower, not a higher, number. We have looked at this analysts


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strengths and weaknesses to make a judgment on any likely error. We have found thatthis compilation stands up to detailed scrutiny. It generates a production number that ismany hundreds of thousands of tonnes higher than that of ICSG.

If we plugged this number into the ICSG framework, their 350,000 tonne surplus

becomes a three quarter of a million tonne surplus or higher. If we make both the aboveadjustments to ICSGs refined production estimate and their apparent demand estimate, allof a sudden we have a surplus of over a million tonnes. Of course, the larger the actualsurplus relative to the now standing ICSG estimated surplus, the larger the possibleimplied hidden stock build. So you can see that there may have been a hidden stock buildin 2006 well in excess of a half a million tonnes.

Such possible errors in the official data have further implications for the possibleaccumulation of hidden copper stocks in this cycle. Whatever the underestimate by theofficial statisticians of the surplus last year, it most likely carries back into the prior year.If ICSG has the 2006 percentage changes in demand and supply more or less right but the

level of both are wrong, a much larger surplus in 2006 implies a smaller but stillsignificant surplus in 2005 rather than their now prevailing estimate of a deficit. Thedifference between such a surplus and the official estimate of a deficit corresponds to apossible further hidden stock build.

Therefore several avenues of analysis can provide support to Nexans claim that themarket has been in surplus, that the surpluses have become quite large, and that someonehas hoovered away a million tonnes of surpluses into hidden stock locations.

What can we say going forward? U.S. housing still absorbs 10% or more of copperembodied in final products produced both in the United States and elsewhere in theworld. The trend in copper consumption is being affected adversely for the first time inthis cycle by cyclical factors with the bust in U.S. housing. If substitution was significantin 2004 and 2005, with a much, much higher price signal in 2006 substitution should nowintensify. There is a general agreement that global mine capacity will rise healthily thisyear, and so far this year the outlook is for a higher capacity utilization rate. It is not hardto make the case that the copper surplus will increase by several percent of demand thisyear. If all of the above happens, the copper surplus could increase by 3% or 4% or 5%of global supply/demand of roughly 17 million tonnes plus. If so, we may be looking at asurplus of perhaps 1.5 million tonnes this year. That approaches 8% of supply anddemand.

The copper market has never experienced such a large relative surplus. When it has beenapproached it has always been at deep price troughs. But the copper price is not low. Itremains monstrously high. So projects are now underway that cannot be stopped, andthat ensure yet further net gains in supply going forward. And production processes thatresult in economization and substitution are also underway that cannot be stopped. Forexample, wire makers have found a way to clad much cheaper aluminum with copper andachieve the same functionality with a small fraction of copper consumption andmassively lower overall costs. Initially, manufacturing aluminum wire with a thin copper


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clad proved to be difficult, but this production process has finally been perfected inChina. Production lines to do this started to expand last year. The practice is nowdisseminating globally. We are still in a very early stage of diffusion of this practice.This is typical of the demand rationing process. Such lagged demand responses to thecrazy copper price increase over the last year and a half, coupled with unstoppable

increases in supply, ensure yet higher surpluses beyond 2007.

Should we be surprised? No! Speculation in copper in this cycle may have resulted in abuild of hidden stocks that dwarfs anything that merchant squeezers did in the past. Theresult has been a price distortion that has no historical comparison a six fold rise in thedollar copper price in this cycle versus rises of 246% or much less in all prior cyclessince 1860. Microeconomic logic tells us that such an unprecedented price distortionshould lead to an unprecedented surplus.

What happens if the market goes into a surplus of perhaps 8% of supply/demand and thisgrows and grows because new projects with sunk costs cannot be stopped and

investments that destroy demand are just beginning to take hold? In the end, thecumulative surpluses will become unmanageable for any speculators, no matter how wellheeled they are.

It is not clear what will happen to the hidden stocks that have been hoovered away in thiscycle. I know that in prior cycles, when squeezes failed or when prolonged bear marketswith full contangos took hold, merchants accumulated and then held on to large hiddenstocks of copper and other base metals which they could finance almost costlessly in afull contango market. Something like this might happen, at least initially, to the hiddenstockpiles that have been built in this cycle. But, in the end, even if the speculatorssomehow hold on to their hidden stocks, a mega surplus must be dealt with. At somepoint, it will not be possible for the speculators to simply keep on buying up such asurplus. There will have to be an eventual closing of mines to the point where the marketis, at a minimum, in balance. Aside from depressions, I do not know that we have everseen an episode where so much production capacity had to be shut down to achieve thatend. And to do that will require a copper price below the cash costs of many copperproducers, not just the most marginal ones. Look at the current copper cost curve; thatwill be a very low copper price, indeed.


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Of course, as prices tumble along the way, speculators may have to disgorge their hidden

stocks. I do not believe it is possible to sell hidden stocks of a magnitude that may nowexist and will surely exist in the near future. In prior cycles stock liquidation on a muchlesser scale created powerful undershooting of the mean. This time such stockliquidation dynamics might dwarf those of the past. This means a deeper undershootingof marginal cost than in the past. This means greater pressure to reduce production wellbelow the level of consumption in order to not just bring the market into balance but togo further and absorb the stock overhang.

I think we cannot imagine how severe the industry strains will be when this comes about.

Aluminum

The nickel price relative to the cost of production and past trends is a crazy, crazy price.The copper price, the same. But the aluminum price is not a crazy price. Almost twodecades ago in 1988 it soared to a brief peak above $1.80. So todays price of $1.30looks high, but not necessarily artificially so.

Nonetheless, there is a lot of evidence that the same is happening in aluminum as hashappened in copper and nickel.

In the case of nickel I cited the Chinese nickel producer Jinchuan calling the LME aparadise of speculations. In the case of copper I cited Nexans. In the case of aluminum, I

find it useful to return to Chinese spokesmen.

Formerly Chinas planning commission, the National Development and ResearchCommission (NDRC) may be Chinas most important body responsible for economicmatters. In recent years it has been very focused on reducing the exposure of Chinasmanufacturers to high commodity costs. It has also been very concerned about overinvestment by China in certain economic sectors, including steel and aluminum. So it hasthought a lot about metals prices and their prospect.


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Given that perspective, I find the following statement by the NDRC pertinent: The NDRCsaid: "Possibilities of a steep fall in aluminum prices could not be ruled out ifinternational hedge funds pull out of the aluminum futures market next year." It stressed

that hedge funds' massive buying into aluminum futures was another cause of the bullish

prices this year." China Daily, December 28, 2006

So, for the NDRC, the aluminum price is high today because of massive hedge fundbuying.

Has this hedge fund buying been the passive actions of many investors, or has it been theresult of a concerted effort by a few that mimics the merchant squeezes of the past, but ona larger scale. In recent months the press Financial Times, Reuters, Bloomberg, andelsewhere have provided so much commentary that the latter clearly seems to be thecase. First a note from the prestigious Financial Times.

A battle raged in the aluminium market on Monday between one investor holding a

$1.7bn long position betting that prices will rise against a number of shorts who areequally determined that prices will fall.

Those holding short positions have made no effort to decrease their exposure in themarket and they potentially face significant losses if prices move against them.

Market talk suggests the holders of the short positions have substantial amounts ofaluminium available for delivery to market.

This could wreck the strategy of the investor, thought to be a hedge fund, holding the longposition, which is understood to have maintained its position since mid-December.

Analysts say the position is equivalent to nearly 645,000 tonnes, almost equal to the size

of the LMEs aluminium stockpiles of 695,000 tonnes. At current market prices, it wouldcost $1.7bn to buy 645,000 tonnes of aluminium.

Copyright The Financial Times Limited 2007

Again, you hear the same from Reuters.

One party has maneuvered itself in a position where it could take delivery of almost650,000 tonnes of the metal, or about 93 per cent of total LME aluminium stockpiles. Atcurrent prices, it would cost $1.7bn to buy 650,000 tonnes.

If the demand for aluminium was booming, there would be a clear-cut reason for theconfidence to hold such a position. But demand from aluminium users is not robust, with


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US orders falling and forecasts that production is set to outstrip supply in China thisyear.Still, cash aluminium prices were priced at more than a $80 premium to the benchmarkthree month forward contract yesterday. The premium has narrowed from more than

$100 a tonne on Monday. The aluminium cash price tends to trade at a premium to the

forward price, when demand is strong and inventories are low. The last time aluminiumcash prices were trading at such a high premium to the three-month price, the LondonMetal Exchange launched a probe into the aluminium market about possible collusionbetween market participants. The investigation was launched in August 2003 but wasabandoned the following year after regulators failed to find any evidence of collusion.

However, this time the LME said it could see nothing untoward in the aluminium market.The LME has the power to inspect the trading books of all its members, which are mainlyfinancial institutions, and their clients. But Robin Bhar, base metals strategist at UBS,said: Aluminium cannot be described as a tight market and based on current supply and

demand trends there is no need for cash prices to be trading at a premium.

This suggests that the current premium has been financially engineered by a large fundplayer, who maybe is acting alone or with other players.

All eyes focus on aluminium (Reuters)By Kevin Morrison

If you check our appendix, you will

Documents

Part I II Worldbank Presentation 5607 -Frank Veneroso