Letter To Shanghai No 1201 - To the benefit of the LME

The LME copper Feb/March spread, which could have been borrowed at $44 contango at the start of last week, on Friday morning exploded to trade at $260 backwardation. At that level, trading would have incinerated any hedge or market-making book. Market gossip pointed to a single trading house sweeping the LME premarket/interdealer session, leaving market-makers very short of nearby liquidity. Although prices have now returned to earlier levels, there is no way this illiquidity has or will resolve in the short term.

I realize that non-LME traders would consider this event as another storm in a very stormy teacup. But there is a lesson here for all commodity markets: although the outlook may be mixed across the commodity landscape, sharp waves of illiquidity can sweep any market, as the money currently attracted to the commodity markets, moving from traditional stock or bond investments, far outweighs the commodity markets' ability to consume the volume of fresh investment dollars. Therefore, if a client wants to be short and cannot deliver, then those shorts must be rolled as far forward and away from cash as possible.

Therefore, if a client wants to be short and cannot deliver, then those shorts must be rolled as far forward and away from cash as possible.

I suspect that many Chinese clients of LME brokers were stopped out of their hedge positions because of Friday’s tightening copper spread. But, large backwardations would attract copper from inventory in China into LME Hong Kong warehouses - if the HK warehouse were currently open. Chinese merchants would have provided the lending liquidity by arbitraging into the spreads and delivering surplus Chinese copper inventory into LME HK.

Chinese merchants would have provided the lending liquidity by arbitraging into the spreads and delivering surplus Chinese copper inventory into LME HK.

With cross-border flows from China by truck into HK and back almost frictionless (no Trump tariffs here), trucking across the border will be measured in hours not days, and the speed at which this copper could be delivered would only be limited by the warehouse's ability to accept the material. In LME terms, should the right pricing appear, delivery from China could be almost instantaneous. Therefore, the added efficiency of having Chinese stocks available to the LME via HK is compelling.

Some may say that the Hong Kong LME warehouses will be too expensive, or that the largest western merchant houses will not use them. That is no matter, the Chinese merchant community will use them, enabling Chinese stocks to swing cross-border and resolve LME market illiquidity when it occurs, which can only benefit the LME in the long run.

Have a good day,

John