Copper: worth its portfolio weight?

A barometer of long-term commodity demand, copper prices are more than three times the level of a year ago, but forecasts vary widely. How are portfolio managers reacting to the uncertain price outlook? By Kathleen Kearney

Copper and other base metal derivatives are forecast to attract greater interest from funds in the coming 12 months, despite signs that the four-year bull run in metal prices is losing steam amid poor performance at many funds. Still, portfolio managers say sustained real demand growth and above-average price volatility should make copper and other base metals an attractive investment in 2007.

"There is no reason why funds will pull out of metals when prices are where they are," says Duncan Letchford, portfolio manager at Galena Asset Management in London. "You will see more people come into the markets, as regards funds from a metals point of view. In the short term, you could argue that we could still see higher prices," says Letchford (see box, page 32). "But in the medium term, it is very likely you will see copper prices slightly lower - let's say by about 20% - probably through the course of next year." Three-month copper was trading at $7,477 a tonne at the close of trade on the London Metal Exchange (LME) on October 25.

Market strategists in east Asia are also positive on this asset class, although industry players are generally more cautious in their approach, largely due to the heavy losses suffered by small end-users in the past year. "There is still good upward momentum in the market and the economy as a whole," says Zhu Bin, director of research at Nanhua Futures in Hangzhou, China. "We have not yet seen a large increase in (physical) supply, even though prices are high and stocks in the warehouses are relatively low."

Despite all the positive sentiment, the market is changing, and investment and trading strategies will need to change as well, adds Zhu. But a price knock of 20-25% is just a bump in a long-term uptrend, says resources specialist, Victor Hugo, director of Vega Capital Asset Management in Johannesburg. "The macro drivers are telling us we are going to see four more years of strength across the base metals board. The clever money is already climbing in on a two- and four-year outlook."

Meanwhile, volatility in three-month copper on the LME fell from above the 50% range at the end of August to close to 40% at the end of October, still a relatively high level. The widening bid-offer spread also indicated players' overall jitters.

High volatility and high prices may be reasons why the LME has brought out its mini contracts. The exchange will launch a small-size, cash-settled, electronically traded monthly futures contracts, initially for copper, aluminium and zinc. The contracts, to be launched before the end of November, will be equal to five tonnes, and the first tradable month will be December. Existing copper contracts traded on the LME are equivalent to 25 tonnes, which for copper would mean "you are putting up an initial margin of $20,000-25,000 per contract, which discourages a lot of people," says a Hong Kong-based banker.

Changing conditions

The same high prices and volatility were no doubt also major reasons why funds of all types have been active players in the market. Most funds do not appear to have changed their strategies in the past four to five months, content possibly with the reasonably high volatility. Despite that advantage, the performance of many funds has been relatively dismal, showing gains of less than 5% over the previous 12 months, well below the price gains of the underlying assets.

Funds of funds with a weighting in commodities have had mixed results in the past year, and it is difficult to know whether a continuation of this strategy of diversification will benefit them down the road. One of the better long-term plays was the SAM Macro Trading Fund, which has returned 14.3% in the 11 months since its inception. Atlas Capital Group launched the SAM Macro Trading Fund on September 30, 2005, which is currently invested in 15 hedge funds with the following allocation: bonds 26.1%, currency 25.3%, equity 23.1%, commodities 13.7% and cash 11.1%.

There has been a proliferation of listed commodity funds in recent years, with a wide variety of strategies. There are, for example, nearly 100 exchange-listed, commodity index-linked funds with active and passive strategies, although some are cautious of them. Galena's Letchford says: "You should be careful of index-linked products, generally speaking, because in a downturn they are bound to underperform, and the cost of carry is going to be very expensive."

Many of these commodity funds have only about a 20% weighting in base metals, especially those that track the broad indexes, such as Commodity Research Bureau indexes, the Rogers International Commodity Index (RICI) or the Dow Jones - AIG Commodity Index. The latter comprises futures contracts on 19 physical commodities and has been consolidating in a broad sideways trend over the past year, gaining just 2.5% over the past 12 months.

Other funds track just the energy, agriculture or metals segment of a commodity index, such as those which seek to replicate as closely as possible the metals segments of the RICI.

Getting value from structures

Structured funds can be one of the more dynamic ways to tap base metal markets. Good timing and an appetite for volatility are required. The BNP Paribas Energy - Base Metals Secure Growth fund, managed by Harewood Asset Management, is one that has done very well over the past 12 months, with a gain of 76% since its launch 16 months ago.

"The fund is a composite of a zero-coupon bond that cost roughly 75% of the fund value at launch and a very, very highly geared option on a portfolio of commodities," says Christopher Darbyshire, London-based manager at BNP Paribas, parent of Harewood Asset Management. The notional portfolio is composed of oil (30%) and base metals: copper 20%, aluminium 20%, nickel 15% and zinc 15%.

"We hit a sweet spot in terms of the pricing," says Darbyshire. "We had such large backwardation that if you linked the price of the option to the forward price - which was very low - you got a huge upside on it. The reason we went down that route was that options on commodities at that time were extraordinarily cheap, so our fund could afford 340% gearing on the upside on that portfolio. At the end of five years, if that portfolio doubled in value, investors will actually get a return of 340% or more. It is very important to stress that, because those options are very cheap, we got very good upside, but the beauty of a structured product is that you get your capital back at the end, so investors didn't put any capital at risk."

But with its high gearing, the fund is very volatile, with about 28% volatility over the past 16 months. BNP Paribas launched another similarly structured and weighted fund with lower volatility and with much less positive results and if it were to launch a third fund, he would rethink the entire structure, says Darbyshire.

Other banks in Asia, though, often find that they have trouble selling base metals-centred funds to private clients. "They often prefer a product which offers a mix of precious metals and energy, because they think they understand these better," says the head of structured products at a US bank in Singapore. "That is not necessarily the case."

In addition, the backwardation in base metals makes it difficult to put together new structured products for retail clients. "The picture gets slightly more murky when there is backwardation which people don't understand," says the banker. "They think that the backwardation curve suggests that the price will fall in future, when in fact that is not likely to be the case."

Another problem is that the curve for base metals such as zinc and nickel is not well defined beyond one-and-a-half to two years, and after that the spreads widen around the longer tenures, he adds.

Meanwhile, the mining companies themselves seem to be shunning futures, as a result of the prolonged periods of backwardation in copper prices, and bearish price forecasts from some quarters. BHP Billiton and other Australian miners report that they are not hedging using futures, believing that their business offers them natural hedges.

Others are choosing different instruments and strategies at this stage of the cycle. Jiangxi Copper said last year that it would look into trading options on the LME. The company reported a loss of 248.3 million renminbi ($31.5 million) from futures trading in the first half of 2005.

And then there are pension funds, which have restrictions on their investments in derivatives, but have sought structured products with embedded call options, giving them low-risk potential exposure to base metals, says David Thurtell, London-based analyst at BNP Paribas.

The key question for many investors is whether the strong liquidity, healthy open interest and high volatility of the past 12 months will continue next year. Market conditions in 2006 have certainly not been as favourable as last year. Higher prices in 2006 pulled some investors and speculators back into the market, but many also stayed away due to high volatility.

Turnover on the LME in the first half of the year rose 29.4% year-on-year to 46.9 million contracts. This followed a record year in 2005, when total turnover rose by 9.3% to a full-year record of 78.6 million lots, worth $4.5 trillion. Assuming the trend continues, boosted by new products, and 2006 is another record year, can we envisage three record years in a row?

In Shanghai, changes in market conditions have been very similar. Turnover on the Shanghai Futures Exchange - which lists contracts in copper, aluminium, natural rubber and fuel oil - soared to 9.52 trillion renminbi in the first nine months of the year, a 98.96% rise over the year-earlier period). Natural rubber and copper showed the biggest increases - nine-month trading volumes were 3.9 trillion renminbi and 2.77 trillion renminbi, respectively.

Many commodity sectors have traditionally been seen as difficult to understand, highly volatile and having a tendency to drift incomprehensibly downwards for years, before racing upwards. Given the performance of base metals in the past 12 to 18 months, it seems little has changed.

WHERE NEXT FOR COPPER PRICES?

Copper prices have been climbing over the past five years. The exuberant phase of the rally in the metal began in early 2005, and three-month copper on the London Metal Exchange repeatedly hit 16-year highs in the 10 months to October 2005.

Then, in November last year, on rumours that a trader acting on behalf of China's Strategic Reserve Bureau (SRB) had sold copper short, speculators plunged into the market, driving the price to record high levels. While the SRB was believed to be unwinding its position in the final weeks of last year, funds continued to piggyback on real and perceived Chinese demand. Supply disruptions and a rising tide of new investment in commodity derivatives, including base metals, sent copper to a record intra-day high of $8,800 a tonne in May.

Long periods of backwardation in copper prices, whether as a result of the physical supply shortages or producers hedging their positions, have made it difficult to forecast the future price trend. And while backwardation appears to be easing, there is still a good bit of uncertainty in the market.

The near-term price trend, in particular, is uncertain, because commodity prices gyrate within nine-month cycles. However, longer term, copper and other base metals will definitely rise, says Victor Hugo, director of Vega Asset Management in Johannesburg. "I believe we are going to see copper double again. Looking at the chart, copper should rise to $12,500 a tonne in the next two to three years unless there are shocks to global growth on a sustained or serious basis," he says.

But funds and strategists should take note: there are price bears out there. "We see copper falling to around $6,000 a tonne in 2007. This is a significant fall, but prices are still very high," says David Thurtell, analyst at BNP Paribas, who expects a further drop. "Over the next four to five years, mine supply and smelter supply will increase, and we see the copper price falling to $4,200 a tonne," he adds.

The most likely cause of a possible decline in copper and other base metal prices would be the copper market moving back to surplus in 2007 from the current tightly balanced supply and demand situation, say analysts.Despite predictions that China demand will remain strong, a projected slowdown in the US and German economies led by a slowing housing market is likely to bring a fall in demand from two of the world's largest consumers of copper, say analysts.