Metal mania


It has taken the Shanghai Futures Exchange (SHFE) only a decade to become the world’s largest commodities exchange by number of contracts, or lots, traded last year. With 434.86 million contracts transacted in 2009 across just eight futures contracts, the SHFE bested previous incumbent the CME Group to become the largest commodities exchange last year, according to data collected from various sources.

The SHFE offers both ferrous and non-ferrous base metals futures, but its leap to become the world’s largest commodities exchange has been helped mostly by its copper contracts. China is the world’s largest importer of copper, consuming up to 40% of the world’s total demand, according to the Metals and Minings Institute, a research division under iron and steel trading operator And the SHFE, being the only metals futures exchange in China, has become a benchmark price-setter in the country with the potential – currency constraints and contract enforceability concerns aside – to become the price-setter for Asia’s metals industry.

The SHFE has also built up new contracts, such as the launch last year of reinforcement steel bar (rebar) futures. Indeed, it is the only exchange in Asia to trade rebar steel futures, with a total of 161.6 million lots of rebar amounting to 1.33 billion renminbi traded (amount includes both buy and sell) last year. In terms of contract volume, it outsized copper contracts, which totalled 81.2 million lots but amounted to larger turnover of 3.31 billion renminbi.

The SHFE has also branched out into precious metals by offering gold futures in January 2008. This also meant that, for the first time, its membership was opened up to banks, which for now are only permitted by their regulator, the China Banking Regulatory Commission, to trade gold futures.

As well as trading commodity futures contracts comprising base metals of aluminium, copper, zinc, ferrous steel contracts of rebar and wire rod along with gold, the SHFE also trades fuel oil and rubber contracts. But it is restricted to offering futures contracts with options still not available. 

According to the SHFE’s undated strategic plan 2008–12: “The SHFE’s goal for the period from 2008 to 2012 is to develop to become a major futures market in the Asia-Pacific timezone that hosts the trading of bulk commodities, such as base metals, previous metals, energy and chemicals. The long-term goal of the SHFE is to develop to become a regulated, efficient, transparent, comprehensive and internationalised derivatives exchange.”

But it was the trading of copper futures that fuelled the exchange’s ascent to the world’s top rank last year, with a total of 81.2 million lots traded. This compares to 26.5 million lots traded by the London Metals Exchange (LME) during the period with a contract value totalling $3.4 trillion.  However, while the LME trades lots in 25 tonnes each, the SHFE trades in smaller five-tonne lots. In terms of tonnes, that gives the SHFE 406 million tonnes compared with the LME’s 662.5 million tonnes. But just like other base metals such as aluminium, liquidity for copper futures concentrates on the three-month contracts, which are physically deliverable into five copper warehouses in Shanghai.

China, which imported a total of 5.67 million tonnes of copper ore and refined copper in February, is today only producing 30.1% of its total refined copper consumption domestically and relying on imports for the remaining 69%, according to Metals and Mining Institute. Several market participants tell Asia Risk they expect China this year to reduce import of refined copper to 2–2.5 million tonnes, from 3.19 million tonnes in 2009.

Metals market participants say copper prices traded on the SHFE and the LME are being followed closely by copper traders and investors alike, which have access to both the SHFE and LME either directly by trading as a member on both exchanges, or indirectly through being the clients of other futures brokers. Some are even  trading the spreads between the SHFE and LME copper contracts.

For example, three-month July copper futures on the SHFE were quoted at 60,600 renminbi per tonne on April 23, while on the LME three-month contracts were quoted at a selling price of $7,700 per tonne. Zhang Hao, an analyst at Citic Newedge Futures, a Shanghai-based futures broker joint venture, says to determine whether there is an arbitrage opportunity between the SHFE and LME copper contracts, his team looks at the ratio between the price on the SHFE, divided by that of the LME. If the ratio is between 8.1 to 8.2, it would indicate the SHFE copper price is high and investors could consider selling on the SHFE and buying the same maturity contract on the LME. Such a threshold is predicated on a worst-case scenario when the investor has to take the risk of physical delivery – and the additional transportation costs, taxes and administration fees involved with physical delivery from LME’s closest warehouse to China, located in Busan, Gwangyang in South Korea, on top of the foreign exchange rate of around USD/RMB, at 6.8.

“If such ratio declines before the contracts’ maturity, then an investor could consider squaring off his positions on both the SHFE and LME to take profit,” Zhang says. “For example, if the LME three-month contract is trading at $7,000/tonne and on SHFE three-month copper is trading at 56,000 renminbi – giving it a ratio of eight – then an investor can long LME three-month and short the SHFE three-month. Once this ratio narrows to 7.5, for example, that SHFE contract rises to 56,250 renminbi and LME contract grows to $7,500, then the investor can take profit of 3,150 renminbi per tonne.”

However, such sizeable pricing differentials only occur “three to four times” a year, Zhang adds. In China, 31 state-owned enterprises had been given the approval to trade commodities and equities futures listed on foreign exchanges, but since 2007 the State Council has ordered the securities watchdog, the China Securities Regulatory Commission, to stop giving out further approvals.

Since the renminbi is only convertible under the current account and not the capital account, any physical traders that have custom clearance documents could buy and sell foreign currency to trade these physical commodities and commodities futures, so long as they could prove that such trades on the foreign futures exchange could help them to hedge market risks related with physical market transactions.

But a problem arises if a financial trader wants to trade the SHFE and LME spread, because if he suffers from the losses on the LME side of the trade, he would not be able to use the gains on the SHFE trade and convert the renminbi to buy US dollars to finance the losses on the LME leg. In fact, foreign participation on the SHFE remains limited at best. JP Morgan is the only foreign entity that has membership on the SHFE through its joint venture, JP Morgan Futures Co, established with Chinese futures broker, Zhongshan Futures Brokerage, in December 2007. Some 80 of the exchange’s 386 members are futures brokerage firms; with metals and chemical corporates such as Chinalco, CNOOC, Sinochem International accounting for the bulk of the remaining 20%.

LME – global benchmark

Liz Milan, LME Asia managing director, appointed to head the exchange’s first overseas office in Singapore, says copper arbitrage trading related with physical traders between SHFE and LME is actually beneficial to the volume of LME. She adds that currently the LME still accounts for 64% of global copper futures trading.

“We have not seen volumes of our copper or aluminium contracts dropping, instead we have seen continuous growth in our volume. We don’t feel we are losing share to the SHFE, instead together we have helped increase the whole pie of copper trading globally,” says Milan. “So we don’t see the global benchmark price that the LME has is in any way threatened, because SHFE’s price is still a regional-set price, not a global price.”

It is exactly the growing opportunities in Asia that has led the LME to opening an office in Singapore. The LME currently has warehouses in Malaysia, Singapore and South Korea. And by maintaining a presence within Asia, the LME aims to gather more market intelligence about what its members are trading in Asia, and potentially look into strategic alliance or developing new contracts that could be complementary to the existing ones trading on the LME.

Today, net open interest levels at the SHFE stand at 8% – far short of the LME’s 80% – indicating deeper liquidity in the copper market remains with the LME as well as the London exchange offering participants the ability to trade out to as long as 10 years forward across a full forward curve. “The open position percentage is evidence that SHFE traders are very retail,” says Milan. “The LME is more wholesale-driven – the fact that we have large contract lot sizes (trading 25 tonnes lot versus SHFE, at five-tonnes per lot) indicates a more professional market.”

Meanwhile, Simon Grenfell, Deutsche Bank’s head of commodities for Asia in Singapore, says he has not seen much interest from foreign corporates with operations in China referencing SHFE contract levels when discussing how to devise their corporate hedging strategies, and metals forward prices listed on the SHFE still remain relevant only to the Chinese domestic market.

“If you take a very large consumer of steel, for example, a car maker that might have operations in and outside China, they would take a holistic approach to their risk management,” he says. “They would look at the overall global steel or aluminium demand. While some of this demand would be driven by the China operations, [Chinese companies] would hedge at a treasury level out of Europe or US.”

Rutie Zhang, director of commodity sales, Asia Pacific, at Société Générale in Singapore, adds while globally metals pricing in the physical markets would mostly reference to the LME, in China most refined metals such as copper and zinc would reference to their domestic exchange, the SHFE. Others, such as alumina prices, are determined by the negotiated prices between the buyers and sellers. For example, Chalco sells alumina that is referenced on the published price it sets each month. Zhang adds the SHFE is relevant to metals traders for short-term hedges such as within three months. Both local trading houses or multinationals need warehouses of an exchange as a last resort for delivery in case of being hit by a market downturn.“Warehouse is important even for producers during market downtime when all buyers are on the sidelines, waiting for the next market trend,” Zhang says. “By delivering into a warehouse they have stock in hand to get back their principal and working capital [during the interim, through either selling through the futures exchange or pledging them to banks for a loan]. To them, a warehouse is a very important function of an exchange.”

This contrasts with the metals consumers, he says, who might find the SHFE less useful.  As corporates’ budget cycles are usually planned on an annual or multiple-year basis, the limitation of the SHFE – where most of its liquidity is concentrated on the third-month contracts, which in turn makes it a momentum-driven market – makes it less useful for these end-users to get an effective hedge.

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