How to read the runes of LME inventory

Observing the inventory movement of a metal at warehouses can give a fair picture of its price trajectory in the short term

The prices of base metals diverted from its 2017 upward trajectory, and fell steeply in 2018 following the tariff impositions by the US. Such volatility is an inherent risk in the commodity markets. Whether you are a producer/trader or a buyer of base metals, it is essential to gauge the price movements to avoid being in hot waters.

While understanding the global market and analysing the supply-demand dynamics of a metal is one way to predict its future price movements, observing the inventory movement of the metal at warehouses also gives a fair picture of the trajectory of prices in the short term.

Here, we look at how the London Metal Exchange (LME) prices take cues from the inventory levels at its warehouses. Price discovery at LME is underpinned by a global physical network of about 700 warehouses.

In case of physical delivery contracts, LME is usually considered the ‘market of last resort’.

Inventory = supply

Though the volume of non-precious contracts traded on LME was just about 20 per cent of what was traded on the Shanghai Futures Exchange in 2018, LME is prominent as its warehouses are spread all over the world, unlike the former.

Producers/traders put their surplus in LME warehouses when they cannot sell it in the physical market directly.

Therefore, rising inventory in LME warehouses represents lack of demand in the market for the metal, and prices subsequently fall. Inversely, dwindling inventory implies increased number of buyers for the metal on the exchange, which pushes up the prices.

For instance, when LME inventories of copper were at a yearly low of 2,96,000 tonnes in February 2011, prices hit a record high of $10,170 per tonne. Then, as copper inventory touched a record high of 6,78,000 tonnes in June 2013, the price hit a then multi-year low of $6,637 per tonne.

For each lot of the metal held in an LME-approved warehouse, the exchange issues a warrant, which is a bearer document. When a producer/trader wants to sell the metal stored in an LME warehouse to an buyer outside LME, he/she cancels the warrants issued, and the metal is moved from the warehouse. This means that cancellation of warrants is a sign of rise in demand, and prices go up on such cancellations.

For example, in March 2009, the cancelled warrants of copper in LME grew from 3 per cent to 12 per cent of the total inventory in a week’s time, and in the period, prices rallied over 12 per cent.

Thus, considering the closing stock and the cancelled warrants of a metal at LME warehouses is vital to forecasting the prices. One can check daily reports on the inventory movement of metals on the LME website itself.

Note that the closing inventory includes volumes of cancelled warrants, too, until it is loaded out from LME warehouses. While analysing the inventory, it is advisable to consider the closing inventory after deducting cancelled warrants. The net quantity is termed ‘open tonnage’, which is available for trade on LME. (Open tonnage = closing inventory - cancelled warrants).

Say, a daily inventory report of copper shows a closing stock of 1,000 tonnes, open tonnage of 900 tonnes and cancelled warrants of 100 tonnes. Here, it is more appropriate to consider the open tonnage of 900 tonnes for analysing the inventory, as it represents the actual stock after excluding the stock earmarked for delivery.

Global factors, a caveat

It is equally important that users of the metal look at other factors that also dictate prices in the metals market — mainly, the USD exchange rate. In November 2012, despite a drop in cancelled warrants in copper, prices continued to move up because of a drop in the value of the greenback.

Even now, while inventories across base metals are low compared with a year ago, the market is taking cues from the US-China trade tensions and keeping prices low. For example, though copper’s current inventory in LME is less than 41 per cent over what it was in March 2018, the prices haven’t moved up. In fact, it has dropped 8 per cent to $6,130 per tonne from an average of $6,800 per tonne in March 2018.

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