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Summary of "Hedging China Trust Default with Copper"

Core Content

This report from BofA Merrill Lynch Global Commodity Research analyzes the copper market dynamics and the impact of China's trust sector on global commodity prices, particularly focusing on copper and market hedging strategies. The analysis spans from 2013 to 2015 and includes insights on supply, demand, price trends, and macroeconomic factors influencing the market.

Main Points

Copper Market Overview

• Historical Supply Issues: For over a decade, copper supply has been disrupted, supporting fundamentals. However, 2013 was an exception with miners like Anglo American and Collahuasi delivering strong production.
• Market Rebalancing: Copper is expected to have a small surplus in 2014, suggesting it is fairly priced at $7,013/t or $3.18/lb.
• Future Outlook: The copper market is projected to shift into deficit beyond 2017, with a structural slowdown in China's economy likely to limit price upside.
• Balance in the Global Refined Market: The global refined copper market is expected to remain balanced in the coming quarters, with prices unlikely to fall below $6,500/t or $2.05/lb in 2014.

China's Copper Market

• Inventory Build-Up: China's copper imports surged in January 2014, indicating a restocking cycle. However, copper prices fell on the LME due to weak commercial demand and shipments booked in 2013.
• Market Tightness: The Chinese copper market is less tight than the World ex-China market, as evidenced by price differentials that do not incentivize imports.
• Credit Concerns: The report highlights concerns over China's credit growth and the potential for trust defaults in the second quarter of 2014, which could reduce commercial copper purchases and impact LME prices.
• Policy Implications: The Chinese government may use trust defaults as a tool to curb moral hazard in the credit market, potentially leading to a credit crunch.

Hedging Strategy

• Copper Put or Put Spreads: The report recommends buying copper puts or put spreads to hedge against potential downside risks due to China's trust defaults and soft macroeconomic data.
• Volatility Trends: Copper volatility has fallen, and the put skew is less pronounced, which supports the hedging strategy.

Key Information

Price Forecasts

• 2014 Average Copper Price: $6,750/t or $3.06/lb for 2Q14.
• 2015 Forecast: $7,313/t or $3.32/lb.
• 2013 Forecast: $7,127/t or $3.23/lb.

Risk Factors

• Downside Risks:
  • China's economy decelerates faster than expected.
  • Problems on the money market escalate.
  • Unreported inventories exist on the zinc market.
  • Mine production increases.
• Upside Risks:
  • Strong restocking through the supply chain.
  • Stronger than anticipated demand growth.
  • Supply squeeze continues, especially on the scrap market.
  • Increased scrap supply.
  • Chinese steel production stronger.
  • Production disruptions.

Charts and Data Highlights

• Chart 1: Miners delivered strong production in 2013, leading to a rebalancing of the copper market.
• Chart 2 & 3: Highlight that mine supply underperformed for over a decade, with production often below expectations.
• Chart 4: Treatment and refining charges recovered in 2014, indicating smelters gaining more pricing power.
• Chart 5: Smelters capture a slightly higher share of the copper price.
• Chart 6: The copper market is expected to switch into deficit beyond 2017.
• Chart 7: China's copper stocks fell steadily in 2013.
• Chart 8: Prices have held up, raising expectations of a rally if China restocks.
• Chart 9: China's copper imports reached record highs in January 2014.
• Chart 10: Refined copper production tended to rise.
• Chart 11: Price differentials suggest the Chinese market is better supplied than the LME.
• Chart 12: China's copper imports are expected to subside in the coming months.
• Chart 15 & 16: Copper volatility has fallen, and the put skew is less pronounced.

Conclusion

The report concludes that while copper fundamentals are stable, China's trust sector and credit growth pose a significant risk to the market. The potential for trust defaults could lead to reduced commercial demand and impact LME prices. To manage these risks, hedging with copper puts or put spreads is recommended, especially given the declining volatility and balanced market outlook.