Turbulence in the Markets
How Speculators Are Crippling the Copper Industry
By Jens Glüsing, Alexander Jung and Thomas Schulz
Hedge funds and other major investors are always looking for new places to park their cash. Now copper is attracting the hot money, causing the price of the metal to fluctuate wildly. Key industries are warning of the consequences.
In northern Chile, on the high plateau of the bone-dry Atacama Desert, machines have cut a giant hole in the Earth's crust. The crater is three kilometers (1.9 miles) wide and almost 1,000 meters (3,280 feet) deep. It grows larger every day. And as it grows, the Chilean state becomes wealthier.
The mine on the edge of the Andes is called Chuquicamata. It belongs to the state-owned copper mining company CODELCO and is 700 kilometers (435 miles) from the San Jose mine, where 33 trapped miners were rescued last week. Six percent of all copper produced worldwide comes from Chuquicamata, one of the world's largest open pit mines.
Excavators dig through the rock with massive shovels the size of small houses, loading the copper ore onto trucks custom-made for the mine, each weighing up to 400 tons. With their engines roaring, they creep up through the hairpin curves of the road leading out of the pit. The ascent takes 45 minutes.
At the top, the ore is ground into powder, in a process yielding one ton of pure copper for every 100 tons of ore. On this particular day, a ton of copper sells for about $8,100 (€5,844) on the commodities exchanges, according to the current price CODELCO manager Rodrigo Toro sees on his computer screen. Only 24 hours earlier, the price was almost $200 higher. "The market has become very volatile," he says.
Wild Ups and Downs
Toro's office is about 1,200 kilometers south of Chuquicamata, on the 10th floor of the CODELCO headquarters building in Santiago, the executive floor. Everything here is made of copper, from the counter in the lobby to the handrails and the elevators. Metal fibers are even woven into the towels in the bathrooms.
In the past, it would have taken weeks for the market price to move as much as it did on this single day. A price change of that magnitude would have had Toro and his fellow executives deeply concerned. There would have been talk of a warning signal for the global economy. But today no one is surprised by these wild ups and downs.
This year, the price went from $6,400 in February to $8,000 in April, then plunged to $6,100 and is currently rushing back up toward $8,900, which would be an all-time high. The metal has become an object of speculation, and the copper business a playing field for deep-pocketed gamblers. Price movements have less and less to do with the product itself. In fact, the prices are set elsewhere -- in New York, for example.
Going Long or Short
In Manhattan, only one block from Ground Zero, 12 men are sitting at a round table in a windowless room. If it weren't for the countless flashing screens and electronic display panels, they might resemble a group of old men who had gathered to play poker. But these men are copper traders who have gathered at the New York Mercantile Exchange (NYMEX), the world's largest physical commodity futures exchange.
They trade in futures contracts, or agreements that obligate them to sell highly pure copper at a fixed price on a specific date. Each contract represents about 11 tons, with a current market value of roughly $95,000.
Sometimes they go "long," which means betting that prices will rise. Or they take short positions when they expect prices to fall. These traders no longer have any interest whatsoever in the metal itself.
Traders today deal in unimaginable sums worldwide, with securities worth more than $20 billion changing hands every day. Last year, copper futures corresponding to 1.13 billion tons were traded on the world's four largest copper exchanges, in London, New York, Shanghai and Mumbai. It was 71 times as much copper as the industry actually produced in the same period.
Appeal of a New Investment Class
The traders work on behalf of banks, insurance companies, pension funds and hedge funds specializing in commodities. They have all discovered the appeal of the copper business, especially after two US professors in 2004 predicted a bright future for commodities as an investment class of their own. Their paper attracted great attention in the financial world.
It had come at just the right time. In the wake of the New Economy bubble, there was a strong demand for palpable value that everyone could recognize and understand. Finally there was the prospect of an alternative to risky investment in stocks, bonds and foreign currencies, and their derivatives. Since then, more and more capital has been surging into the markets for petroleum, natural gas, sugar, cacao, nickel and aluminum. And copper.
The recent turbulence involving the euro and the dollar has fueled the development even further. The more money floods into these markets, some of which are relatively small, the greater the price volatility. All it takes is for one important player to make a big move, followed by a second and a third player -- not because of some deep insight, but simply out of the fear of missing out on something -- and the entire herd follows in their footsteps. Eventually, one member of that herd suddenly comes to a stop and starts running in another direction, simply because someone has issued a new rallying cry.
This herd mentality causes prices to take off, and they become more and more disconnected from actual consumption. The consequences, however, are very tangible for those who depend on the physical commodity in the real world: the construction industry, for example, which uses various products containing copper in pipes, roofing material and facades.
Warnings from Industry
Copper is also the core component of almost every piece of cable, be it in the form of bell wire or the thick cables that connect offshore wind turbines with the land.
The metal is practically indispensable for producers of electronic devices. Every computer, mobile phone or vacuum cleaner depends on copper. And so does every car. An automobile contains an average of 25 kilograms of copper, at a current value of about €150.
Industry has trouble coping with sharp fluctuations in the price of copper. It is difficult for companies to plan ahead if the prices for their raw materials are constantly changing.
Business leaders like Ekkehard Schulz, the outgoing CEO of German steelmaker ThyssenKrupp, warn that the price fluctuations could have devastating consequences for industry. The Federation of German Industries (BDI) emphasizes the importance of a "safe, reliable and affordable supply of commodities." Without that, says the BDI, "production in Germany would be inconceivable."
Wave of Liquidity
Even professionals can no longer predict changes in prices for aluminum, zinc and lead, or for petroleum and natural gas. The price of nickel, for example, has fluctuated between €7,000 and €40,000 a ton in the last four years.
Price movements are no longer as dependent on the so-called fundamentals. Nowadays, commodities prices are largely a question of emotion. Of course, this doesn't mean that supply and demand no longer play a role for speculators. On the contrary, speculators eagerly follow every piece of news on residential construction in China, ore production in Chile or inventories in London. The problem is that the market only takes notice of news that reflects its mood. Everything else is glossed over. This can lead to grotesque overreactions and extremely volatile prices, to the detriment of consumers and the economy.
Peter Hollands, a British geologist, recognized early on that a deep-seated change was taking place. Hollands, an authority in the copper business, owns a consulting company called Bloomsbury Minerals Economics, tucked away on a side street near London's West End. "We have been living in a new world for the last six years," says Hollands.
Taking Control
Six years ago, a "wave of liquidity" took hold of the market and moved prices in an unprecedented manner, says Hollands. He points to a chart showing two different copper prices (see graphic). One of the lines on the graph is notional. It rises only moderately after 2004 and doesn't exceed $5,000 per ton. It is the result of the traditional factors that influence the price of copper, such as production costs, inventory levels, industrial orders and the effects of currency movements. This line describes the old world, "when copper was still a simple industrial metal," Hollands says, a touch of melancholy in his voice.
The other line shows the actual changes in the price of copper, how it shot up to over $8,000 and has been hopping nervously up and down since then. This is the new world, the world of finance-driven commodities markets. They are no longer shaped by the market and its forces, but by what the market believes -- or what it is supposed to believe.
Nowadays, no one can understand the copper business without factoring in the influence of financial players, says Hollands. "They have taken over control." And the market has capitulated. What has happened is nothing less than a coup that has resulted in a rupture in the millennia-long history of copper.
In the past, when copper became too cheap, producers would reduce production until there was so little product on the market that prices went up again. The mines ramped up capacity, supply expanded and eventually exceeded demand, and the cycle began all over again. Changes in the price of copper were a reliable indicator of future developments in the economy.
The Good Old Days of Dr. Copper
Economists nicknamed the metal "Dr. Copper," as if describing a wise, old colleague who could predict the course of the economy with academic precision. When the price of copper rose, meaning that the commodity was in demand, this could be interpreted as a signal of confidence in the future, and a sign that people were investing again.
David McKiernan still remembers the days when he was dealing with real copper blocks. A veteran copper trader, McKiernan has been working in New York for the last 34 years and now works for Prudential Bache Commodities, one of the biggest players in the market.
McKiernan is in his office in a skyscraper on the East River by 6:30 every morning. When he is not working, a colleague in London, Hong Kong or Hamburg takes over. Only 10 years ago, anyone who wanted to buy or sell metals generally had to put in a call to a trader on the trading floor. The traders were the only ones with direct access to the market.
Everything suddenly changed when the Internet came along. The Web has made the market accessible to almost anyone. Since then, market volume and trading speed have multiplied. McKiernan calls it the biggest change in his career. Given the sums that are involved today, players can clearly influence the market in their favor, says McKiernan. "So if several of them during a period of time act in one direction, the price is going to move."
'Stupid Kids' and Gamblers
There are three groups that control copper futures trading today, each in its own way. The members of the first group behave in the way we imagine common speculators would behave: as primitive gamblers.
Copper expert Sven Müller-Thurau refers to these people as "stupid kids," even though he knows that quite a few of them are highly gifted mathematicians. Müller-Thurau is in charge of the metals and foreign currency business at Aurubis, Europe's largest copper processor. Its headquarters are located in the Port of Hamburg. This is where ships carrying cargos of copper concentrate arrive, and where the greenish-grey powder is processed and refined into marketable copper cathodes that are 99.9 percent pure metal and weigh 50 to 80 kilograms each. When Müller-Thurau once tried to invite the copper traders to Aurubis to show them how copper production works, they graciously declined. "It would only have confused them," he says.
A second group uses copper derivatives in the traditional way. These people, known as bona fide hedgers, want to make sure they will have enough real raw materials available for processing. What they do is essentially the good and sensible form of speculation that has been common practice for generations. It's the way farmers protect themselves against the consequences of crop loss, and the way companies protect themselves against interest-rate and currency risks and, more recently, against fluctuations in the commodities markets.
And then there is the third and most important group of speculators, those who are currently behind market movements: hedge funds with billions in assets, banks like Goldman Sachs, international commodities suppliers like Glencore, and pension funds like CalPERS, the California Public Employees' Retirement System. These players, which are big enough to afford departments filled with specialists, "try to read the market before the others catch up," says Müller-Thurau. "These people set the markets afloat."
From One Side of the Warehouse to the Other
To do that, they use the services of London-based companies like Brook Hunt and the Commodities Research Unit, where dozens of analysts devote themselves to painstakingly analyzing every mining project in the world. They know exactly how high the copper content is in individual deposits, which mines have recently changed hands or where workers happen to be striking at any given moment. They are well paid for their work, and yet even these experts constantly encounter limits in their research.
For example, they can only make vague assumptions as to how large inventories are in the metal-processing industry. They have little more than a rough idea of what happens outside the commodities markets, in the form of direct transactions between producers and buyers. And they can hardly ascertain whether the news that the amount of copper in the London Metal Exchange's registered warehouses has declined by a few tons is simply the result -- as one analyst recounts -- of a forklift driver having moved a pallet of copper cathodes a few meters "for 50 quid."
According to the insider, there are warehouses with a long line running down the middle, marking the division between space allotted to official goods and to unofficial stocks. This highlights how easy it is to deceive the markets.
Big Fish in a Small Pond
China, by far the world's largest copper consumer, is a mystery to the markets. In principle, Western traders are not admitted to the exchange in Shanghai. No one knows exactly how much copper is truly being consumed and how much is being stockpiled there. And no one is willing to rely on official figures.
As the Chinese example illustrates, suspicions of manipulation pervade the copper business. Individual players have repeatedly attempted to withdraw large amounts of metal from the market, thereby creating an artificial shortage in an effort to drive up prices.
A spectacular case that happened in the early 1990s involved Yasuo Hamanaka, a jovial whisky drinker who stockpiled massive amounts of copper in a bid to drive up the price. But the plan backfired and Hamanaka's client lost $1.8 billion.
The copper market is practically tailor-made for such schemes. It is a small pond with a few big fish. The mines are expected to produce about 16 million tons of copper this year, or less than 50,000 tons a day. The oil industry, by comparison, produces about 10 million tons of crude oil a day.
'Cost Trap'
For this reason, even minor shifts in production and consumption are enough to affect copper prices. "In these marginal areas, the effects on the price can be immense," explains Commerzbank specialist Eugene Weinberg. That is especially the case given that investment banks and investment companies are now getting into the business in a big way, buying up gold, silver, copper and even sugar. Some are even also buying warehouse operators so that they can store the valuable goods.
This strategy gives these companies the ability to influence inventories as they see fit, warns Gerd Henning Beck of the Frankfurt-based investment company Lupus Alpha. Besides, says Beck, the physical market, unlike the futures market, is not subject to financial oversight. "This enables the banks to control prices, at least indirectly."
The approximately 570,000 tons of copper stored in the warehouses of the most important metal exchanges, in London, New York and Shanghai, are worth $4.7 billion. With this relatively manageable sum, investors could buy up the world's entire registered copper stocks. Even a fraction of that total would be enough to throw copper's price structure completely off balance.
If the banks have so much control over the copper market, they could even deprive industry of this key resource. The victims would be manufacturing companies, especially metal processors, electronics companies and cable producers. Future price movements would become almost unpredictable, warns a Commerzbank study, noting that this could "quickly turn into a cost trap for companies."
Expensive Hedges
Some companies, like Nuremberg-based auto industry supplier Leoni, are doing as much as possible to prepare for this eventuality. Leoni, a typical mid-sized German company in the metal-processing sector, was founded in 1569 as a small workshop in the Franconia region of northern Bavaria. It produced gold and silver thread for embroidery known as Leonische Ware ("Lyonese wares"), from which the company derives its name. Today Leoni is a company worth billions, and copper is its most important raw material. It processes about 100,000 tons a year, making cable harnesses, wires and stranded wire.
Richard Paglia, who is in charge of copper procurement at the company, has to deal every day with prices that often fluctuate wildly. Today, he says, financial market players play "a fundamental role" in the business, and they are to be blamed for "the permanent volatility" of prices. These fluctuations lead to risks, Paglia adds. In order to limit these risks, the company is forced to engage in costly hedging transactions.
Nowadays, hardly any major industrial company can do without hedging, that is, purchasing futures contracts as insurance against fluctuations in exchange rates or commodities prices. Paradoxically, the banks, while charging their customers handsomely for the service, are also involved in speculation and are thus largely responsible for the fact that the level of volatility has become so extreme. It is a sophisticated business model that allows the financial institutions to essentially double their revenues.
'Speed Limits on a Dark Desert Highway'
Hence the banks can hardly be expected to offer constructive ideas on how to come to grips with the consequences of speculation. Other organizations, such as the US Commodities Futures Trading Commission (CFTC), have addressed the issue instead.
Since the price of oil shot to record highs more than two years ago, there has been a heated debate in the United States over how to regulate speculators, and the CFTC is driving that debate. Ironically, the same agency that was giving financial market players free rein just a few years ago has advocated strict regulation since President Barack Obama came into office.
The discussion centers around tightening the position limit, that is, the maximum number of orders a futures trader can hold. In New York, the limit in the copper business is set at 5,000 contracts, at least in theory. In practice, however, there are many loopholes. The current regulations, CFTC Commissioner Bart Chilton says critically, are about as ineffective as "speed limits on a dark desert highway."
But that will likely change. With its tough new approach, the CFTC is invoking a historic role model. In the 1930s, after the Great Depression, then US President Franklin D. Roosevelt tried to eliminate the root cause of speculation in the commodities market by imposing strict requirements, including position limits. The administration of former President Ronald Reagan, giving in to pressure from the financial industry, weakened the regulations.
Opposed to Regulations
The same lobby is now fiercely opposed to any new attempts to regulate the market. US bankers warn that tighter regulations would deprive the market of liquidity, and that more of the copper trade would simply shift to London. The London exchange has no clear upper limits, and the British don't even disclose which positions market players are taking, in other words whether they are betting on rising or falling prices. Instead, it attempts to influence the market in more informal ways.
This is, in fact, the crux of the argument: It isn't enough to simply establish clear rules in a trading center. Governments can only successfully combat speculators if they coordinate their efforts worldwide and remove the cloak of secrecy from their commodities transactions.
As long as this fails to happen, the price of copper will remain unpredictable and industry will be at the mercy of speculators. Companies will no longer be able to assume that copper will be expensive when it's scarce and cheap when it's available in abundance.
Speculation destroys the basic signaling function that prices have in a market economy, says Heiner Flassbeck, chief economist at the United Nations Conference on Trade and Development (UNCTAD). Although a lot of money moves around as a result of price distortions, speculation doesn't create any real value, says Flassbeck. "The only thing that's created is an illusion of value."
Making Life Difficult for Everyone
In the end, the popular assessment that speculators are the purest of capitalists is by no means correct. In truth, they are the biggest enemies of the market, because they undermine its central mechanism, the efficient balancing of supply and demand. In doing so, they make life difficult for everyone: for industry, which can no longer predict how expensive its raw materials will be; for consumers, who are forced to bear the costs; and, finally, for copper producers, who face more risk when planning ahead.
When the executives at CODELCO in Santiago make investment decisions today, it will be another three to five years before the results become visible. That's how long it takes to develop a new mine or expand an existing mine. The company plans to invest about $15 billion by 2015, but its executives have never been so uncertain about whether their predictions are correct.
One thing is clear: Production costs will continue to rise. Now that deposits near the surface, which are easier to mine, are becoming depleted, mining companies are forced to dig deeper and deeper pits.
Even in the giant pit at Chuquicamata, open-pit mining will likely end in 2018. After that, the mining operation will continue deep underground, in 30 to 40 kilometers of tunnels and galleries that engineers plan to dig into the mountain, at a massive cost.
But what happens if production gets underway just as an influential hedge fund manager is betting on falling prices and other funds follow suit?
CODELCO executive Rodrigo Toro can do without this unpredictability. In fact, he says, he would prefer lower prices if they would only remain relatively predictable and the speculators could be brought under control. "Then we could actually plan ahead."
Translated from the German by Christopher Sultan
© SPIEGEL ONLINE 2010
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