Not just gold that glitters

The commodities product group which is normally referred to simply as ‘metals’, is generally broken down into two distinct groups

  • base metals, which are loosely defined as metals that are subject to corrosion or oxidization… and
  • precious metals, which  are defined as those that do not. They are considered as precious and referred to as ‘noble’, in other words they remain shiny over time.

The precious metals group includes gold and silver, along with platinum, palladium, and the rare earth metals. Base metals on the other hand include those such as iron, lead, zinc and copper along with tin and nickel.

Base metals – Copper

Whilst there is no end of choice in the metals futures market as to which metal to trade, let’s look in detail at one of the most popular, which is copper, often referred to either as the red metal or simply doctor copper.

Whilst gold is the ultimate hedge against inflation as well as a safe haven in volatile markets, copper is the most sought after metal for all forms of economic activity and is widely used in manufacturing and construction and in the electrical sector where its applications are both diverse and varied.

As a result copper has always been considered to be a leading indicator of economic growth with rising prices generally signaling increasing demand which ins turn suggests economic growth and demand along with rising inflation; all positive signs of an expanding economy.

Until 2008 the relationship that all commodity traders used to watch was that between copper prices and the London Metals Exchange (LME) stockpile levels. It provided traders with a view of the balance of true supply and demand. These stockpiles were held for physical delivery against futures contracts and at the time proved to be a very reliable indicator, due to the LME’s ability to track the collective inventory of its global network of it’s warehouses on a real-time basis. In other words this information was up to date and not delayed. This offered traders a unique fundamental view on the above ground supply of copper.

The stockpile levels played a vital role in giving traders a view on the true balance of supply and demand in the copper market. Put simply if end users couldn’t get enough of the metal from their regular supplies then the LME stockpile was used to supplement this extra demand. So from a trading perspective if the stockpile went down then copper prices were expected to rise, and conversely if the stockpile rose then copper prices were expected to fall.

However mined copper is now normally shipped direct to the customer and the volumes flowing through the LME warehouses are relatively insignificant as far as global trade is concerned. So old relationship between copper and the LME has broken down and been replaced with a new relationship with the S & P 500, which began in march 2009 and has continued ever since. As copper prices have moved higher, so has the S & P 500 and vice versa, a classic illustration of how connections between related markets can and do change.

In terms of world consumption, China is the largest consumer of copper, and takes delivery of almost one fifth of all the copper mined worldwide, which in turn can lead to distortions in the price of copper, subsequently leading traders and speculators to some misleading conclusions. The problem is twofold:

  • Firstly, with so much of the copper supply consumed by one country, this can distort the true supply and demand picture and….
  • Secondly, over the last few years there have been continuing supply problems particularly in Chile. Chile is the world’s largest exporter of copper, which makes up almost 55% of its total exports. So the supply problems have distorted the price of copper which recently touched an all time high of over $10,000 per tonne.

China’s domination of this commodity looks set to continue for some time to come for two reasons which are very different, but both of which are related to the US dollar.

  1. China needs this valuable commodity as it attempts to rebuild its aged and faltering power grid system, a massive project requiring vast amounts of copper.
  2. Perhaps not so obvious to most, China is now stockpiling copper as a hedge against inflation and the damaging impact that the Federal Reserve is having on China’s huge US dollar reserves, which will increasingly become devalued as the dollar weakens and rises. Copper is seen by the Chinese as a physical hedge in much the same way as for gold or silver. This change in dynamic is yet another reason to watch the price of copper carefully and to view it not just as a commodity, but as a tangible asset and all part of the Chinese plan to diversify away from US Treasuries and into more tangible physical assets such as copper.

In an effort to corner the market China has aggressively been buying its own mines overseas, as well as stockpiling on a grand scale. All this has driven up copper prices but not in the conventional demand led or supply driven way as with most commodities. Indeed in many ways this can be likened to the attempts to manipulate silver prices in the 1970’s or cocoa which was cornered by the delightfully labelled ‘chocfinger’(real name Anthony Ward of ARMAJERO holdings) in 2010 who managed to stockpile sufficient quantities of the physical commodity to make the equivalent of 5.3 billion quarter pound chocolate bars.

Precious metals

Within the precious metals group it is gold and silver which dominate the futures market, but it is important to note that silver is in fact designated as an industrial metal, and not in fact a precious metal at all. Silver has the highest level of electrical conductivity and reflectivity of all metals, and whilst it is used for jewelry and decorative items, it has a much wider and increasing array of applications in industry due to it’s unique properties. However, over the last few years, many investors have turned to silver as an investment, as the price of gold continued to climb towards $2000 per ounce, putting it beyond the reach of many investors.

Gold is the opposite of silver, having a limited use in industry, and representing the ultimate safe haven asset and a hedge against inflation. However, forecasting the future price of gold, as with copper is also complicated by an unusual supply and demand relationship.

Price elasticity

Most markets work on a very simple principle of price and demand known as price elasticity. This is where if price goes up due to over supply, then demand falls, and if the price falls due to lack of supply then demand rises. So supply affects demand a vice versa. One can apply this very simple model to virtually any market or sector one cares to think of such as cars, holidays, clothes, food etc. So price and demand correlate inversely and the markets are said to be perfectly elastic.

Now whilst demand explains the consumer side of buying decisions, what about the relationship between price and supply for the producers? The price supply relationship is the exact opposite of that of price demand. As prices rise so does supply, and as prices fall so will supply – the two correlate directly, which might appear strange at first glance, but if we stop to think it does make sense. If the market can only support a low price, then only the most efficient suppliers will compete, but as prices rise, more suppliers enter the market as even the inefficient producers are able to make a profit. Hence as prices rise, so does supply coming onto the market. If we add these two effects together then the market price is the point where the level of demand will meet the level of supply.

The exception: Gold

So does the same model apply to the price of gold when you are trading spot futures or indeed trading in the physical commodity itself?

The answer is categorically and emphatically no. The reason for this is very simple and very logical. Gold, unlike many other commodities is not consumed, and therefore the traditional models and theories of supply and demand simply do not apply.

There are, of course, several other reasons such as the finite amount available, and the cost of entry to the market, but the key point is that deficits or excesses do not, and cannot affect the market price, for the simple reason that nothing has actually been consumed. In a sense all that is happening in the market is that the commodity is moved from one person’s stockpile ( the mining company ) to another person’s stockpile, the investor. Nothing has been gained or lost in terms of the commodity itself, and unlike James Bond’s adversary, Goldfinger, it would be impossible for one private investor to control the world’s stockpile. Of all the gold extracted from the relatively small number of mines, only a tiny fraction is ever “consumed” in the true sense, with the overwhelming production added to the ever growing stockpiles of governments, corporations and private investors.

So with gold there is always a large stockpile and it never gets any smaller. It is simply the owners of the stockpile who change. So in looking at the market as a whole we need to consider the total supply and total demand, compare one with the other, and not simply the incremental increase or decrease on an annual basis like we do with some commodities.

Let’s consider a simple example based on current estimates from the World Gold Council. Based on their figures the total weight of gold on the market is currently estimated at around 160,000 tonnes with global production at just over 2,500 tonnes a year. Suppose all mining stopped for a year with no new supplies entering the market. This would represent only 2,500/160,000 or 1.5% of the total market – an almost insignificant amount, and remember this is based on a total closure of all the gold mines around the world. If we perhaps consider a more realistic example where total production falls from 2,500 tonnes to 2,000 tonnes, then as a percentage this represents less than 0.3% of the total market. Perhaps now you can start to see why the supply and demand figures for gold, and their relationship to the market price are virtually meaningless.

In addition to the above, there is another reason that the supply and demand analysis (often suggested as the reason for the rise or fall of gold prices) is complete nonsense, and it is this – the figures used are based on guesswork and half truths, not fact. The reason is very simple – much of the gold moves around the world in secret, particularly with the banks reporting or publishing only sketchy details, and most not at all. It is generally agreed that demand runs at around 3800 tonnes per year creating a so called “deficit” of around 1200 tonnes per year or 0.75% of the total stockpile. Hardly enough to move the market.

There is no need at all for supply on an annual basis (excluding private sales) to come into balance with demand on an annual basis. It is not even true that these must balance over any number of years. The reason for this is that a sale out of someones stockpile of gold does not reduce the total amount of stockpiled gold. All it does is shift the gold from the seller’s private stockpile to the buyer’s private stockpile. A market could remain in a “deficit” of this sort forever without the price ever going up (or going down) as buyers and sellers shift the contents of their stockpiles among themselves.

In summary, I hope from the above, that you can understand why I personally place no importance on the figures for supply and demand for gold, which are often debated and discussed in the financial press and elsewhere. In my view they are meaningless and should be ignored.

The gold silver ratio

A valuable tool that many commodity traders use as a quick check on the relationship between gold and silver, is the so called gold silver ratio. This is simply the price of gold per troy ounce, divided by the price of silver per troy ounce, and is used as a general indication of relative value. So if this ratio moves to an extreme, then this may suggest that perhaps one or the other is over or under valued, and therefore due for a reversal. In the last few decades this relationship has peaked at almost 100 in 1991, and currently trades in the 60 to 70 region.

So who trades metals?

The short answer is everyone. The most popular markets are of course gold and silver, but with the recent bull run over the last few years for commodities many other metals are also gaining in popularity, such as copper, along with platinum and palladium. Gold still leads the way as the most liquid and widely traded metals market, and no wonder given the dramatic gains of the last few years.

Why should you trade trade metals?

As with many other commodities, trading in metals was originally a relatively closed market, and only available to those futures traders with a specialist knowledge and deep pockets, with the metals markets generally only trading during normal exchange hours, and large contract size. Now these markets are available to us all, providing diverse trading strategies from simply trend trading, to hedging, and more complex option trading strategies. For the new trader to the metals market, the best place to start is with gold – why? The CME exchage now offers both a mini and a micro contract along with the full size contract. The E micro gold contract with the symbol MGC has an underlying contract size of 10 troy ounces, which is one tenth the size of the full size GC contract which has an underlying of 100 troy ounces, making the micro an ideal place to start trading gold. However, one word of warning. The E- micro is a physical delivery contract, so you need to be aware of this approaching contract expiry, as your broker will generally only allow for cash settlement in your account, and if you are holding this contract, then you will almost certainly receive a warning that the contract will be closed automatically.

The E micro gold is a great place to start with low risk and low margin requirements, and all you need now is the ultimate in technical indicators to tell you when to get in, and when to get out.