Copper, Silver and China

Roland Watson
Dec 5, 2005

While we watch gold, silver and other metals foraging onto new multi-year highs, I thought I would be a good contrarian and indulge in some silver speculation of the thinking and not investing kind. These thoughts concern copper and silver.

Now as readers will know, gold and silver have been money for millennia. Indeed, at various points in history, either metal has been used to define money itself. Now if silver has been called the poor man's gold, then copper is most likely to be the poor man's silver.

The one boast copper has over gold and silver is that it is still money. Gold and silver have not been seen in circulating money for decades but copper is still there in the lowest denomination coins we regularly make purchases with. But, as with gold and silver, it will eventually succumb to the same enemy that forced those metals out of the common coin of the realm. That enemy is government sponsored inflation and the intrinsic value of copper content coins will soon stay in excess of the face value of the penny, cent or whatever national currency. It will be all very reminiscent of 1970 when monetary debasement finally forced the last gram of silver out of the half dollar.

But the main arena and debate for copper is in its use as a commodity. Two interesting events dovetailed recently regarding the copper market. One was an article by Frank Veneroso in which he reiterated his view that traders on the long side were manipulating the copper market and that this will lead to a collapse in the price of copper and other base metals. His original thesis back in June can be found here.

By his own admission, no collapse of any long manipulation has transpired as copper continued to advance to new highs. The price of copper in that time frame is shown below. However, Veneroso thinks it is only a matter of time before the alleged longs are burnt with a price collapse.

So what might be the event that primes a bursting of the copper bubble and what would its implications be for silver investors?

That brings us to the other interesting event on the consumer side which is the persistent rumours that the Chinese State Reserve Bureau is heavily short copper to the tune of hundreds of thousands of tonnes and may be facing a massive short squeeze. This is of course bullish for copper if the Chinese government's traders were forced to cover their shorts by buying up the metal in vast quantities.

However, it was an article by the ever-interesting John Mauldin on the copper situation that suggested the complete opposite may come to pass. His article discusses a conversation with a seasoned observer of China and Copper. He basically suggests that the Chinese are indeed short by up to 200,000 tonnes of copper but the positions are spread out over a three-year period. An unwinding of these positions over three years does not sound so painful, especially when it is suggested that China holds about 1.5 million tonnes of copper in reserve. It looks like China can deliver on their contracts.

John Mauldin then indulges in some "wild conjecture" to which I will attach my own meanderings. Will the Chinese authorities stick it to the bourgeoisie traders who are on the opposite side of their short positions by not buying copper for an extended period of months? Mauldin surmises that China could achieve this by tapping their own strategic reserves and watching the unwanted inventories build up across the world. With China consuming 20% of the world's copper, this could be sustained for several months. The effect on the price would of course be negative as demand drops from the main buyer on the global market.

Now combine this with Frank Veneroso's conjecture that the longs are manipulating the situation because:

"The manipulating merchants and hedge funds have created artificial shortages of exchange stocks by accumulating off-warrant material."

In this world of financial musings, we have two stockpiles facing off against each other - those of the Chinese State and those of the merchants and hedge funds. Which will flinch first? If China draws on her reserves, prices drop and the longs are forced to liquidate their positions and sell off their own inventory. Meanwhile, China closes out their shorts at a profit and uses the extra cash to buy even cheaper copper to replenish their reserves. Eventually the price of copper rebounds, as it must in an era of increasing resource deficits.

If there is indeed a manipulation, the price drop will be even more exacerbated, I give you the bone-crunching drop in silver prices last year as an example of rapid unwinding of hedge-fund positions.

However, Frank Veneroso suggests the catalyst may be a downturn in China's economic fortunes. That will indeed happen. One only has to read about the huge amount of corruption and bad debt within the Chinese banking system to see that a major credit squeeze is on the cards there. But will China first and deliberately cause an artificial glut in copper to destroy the alleged artificial shortages? We don't know but the ramification for precious metal investors will be interesting.

What is the correlation between silver and copper prices? At a purely price level, here is the relative performances of the two metals in the last few years.

As we can see there is a high degree of correlation between the prices as the commodity bull market has progressed onwards and upwards. One thought that seems contrary to the chart is that since a lot of silver production is a by-product of copper mining, ought not this demand-insensitive silver cause a price drop when it is dumped on the silver markets by copper mines running at full capacity?

The answer would be "yes" if silver demand remained static, but as we know the world's increasing appetite for silver is consuming any inelastic supply from base metal mining. Indeed, one may be so bold as to suggest that the recent 16-month retrenchment in silver prices may be due in part to the excess silver coming out of copper mines across the world.

But that is by the by, the main question is what will happen to silver if the price of copper drops precipitously? Since every metal seems to be interconnected in this great metals bull market, a temporary drop in silver prices is almost assured. One only needs to look at the large and simultaneous drops in silver and copper prices in April 2004 to see an example of that. However, unlike that drop, it is copper that has been racing ahead and not silver in the last 16 months and so we suggest that silver has less to lose than copper in percentage terms.

The only other question is who is the tail and who is the dog when it comes to wagging? With world copper production worth over 45 billion dollars per year (based on $1.50 per pound and a 14.5 million tonne production) and silver coming in at less than 5 billion dollars (based on $7.50 an ounce and 20,000 tonnes of mine production), it is apparent that the silver tail will not wag the copper dog.

The reason for copper influencing silver not just at the mining level but at the price level is due we think to copper being a more important barometer for the health of the booming commodity market than silver. In other words, if copper sneezes, every other metal catches a cold.

But then the supply and demand equation comes into play. If silver demand remains at a faster pace than now depressed copper and with copper mines throttling back in production, we anticipate that silver will come out of the blocks faster than any other metal.

If China were to cause an artificial glut in copper, that should not affect overall silver demand, as it is only the source of copper that has changed, not the amount consumed. In that light, we anticipate a sharp rebound in silver prices.

So, in conclusion, we must emphasise that we are talking about a copper-silver relationship in the context of an alleged copper stockpile manipulation. If there is no such manipulation, we fall back on Frank Veneroso's warnings about a collapse in Chinese copper demand due to a credit/currency crunch similar to the one Asia experienced in 1997. We anticipate that particular scenario will be negative for silver unless the financial contagion spreads worldwide into a monetary crisis.

In that dire situation there are few places to run to except the safe haven of precious metals.

December 3, 2005
Roland Watson
email: newerainvestor@yahoo.co.uk

321gold Inc