Warning Signs for Copper Market

Warning Signs for Copper Market

By CAROLYN CUI And TATYANA SHUMSKY

As analysts and investors seek clues to the strength of the recent rally in commodity prices, some are taking a closer look at the copper market, where warning signs are emerging.

Copper prices have almost quadrupled after a two-year rally, largely driven by the belief that China, the world's largest copper user, has an insatiable appetite for the metal.

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Imaginechina/Zuma Press

A Chinese factory worker monitors the production of coiled copper tubes at a copper products plant in Nantong city.

.But Chinese buyers are now facing the double whammy of higher copper prices and the government's aggressive moves to tighten credit. Moreover, evidence has recently surfaced of previously unreported copper stockpiles, a sign that much of the purchased copper hasn't been put to use. The stash is estimated by people in China and several Western banks to be around one million tons, or about 15% of the country's annual consumption.

Copper is closely watched and has been given the nickname "Dr. Copper" because it is a proven bellwether for the health of the global economy. Since the metal is used in myriad industries, a strong demand often indicates that the overall economy is expanding.

Since reaching an all-time high of $4.6230 a pound on Feb. 14, copper's rally has stalled. At one point, the metal was down 11% from its high, though it has clawed its way back and closed at $4.4950 Friday on the Comex division of the New York Mercantile Exchange.

Official commodity inventories aren't readily released by China's government, forcing industry watchers to resort to other means—either physically scouting warehouses themselves or finding government sources—to try to determine just how much copper has actually been used.

The task has become even more daunting recently because companies and individuals have been hoarding commodities of all types—from cotton and copper to cooking oil—betting that prices will rise. With little insight into the stockpiles, analysts tend to overestimate China's real strength of consumption.

In late March, the market got a rare glimpse at the size of the potential copper overhang when the China Non-ferrous Metals Industry Association, a government-backed trade group, indicated the levels across the country could be as much as one million tons.

"The risk is that you end up with this overhang, which finally finds its way back" onto the market, said Leon Westgate, a London-based analyst at Standard Bank, who took a field trip to China last month to scout warehouses. He said he saw a glut of copper in warehouses just along the coast, which he estimates at about 700,000 tons. That "intensified" his negative feelings about copper, he said.

Most analysts still believe that China's long-term demand for commodities remains robust because of the economy's enormous size and blistering growth, but many agree that the country's successive rounds of interest-rate increases and moves to clamp down on speculation will have a negative impact on copper and other markets in the short run. Some speculators will be forced to sell their copper as a result of higher financing costs, while consumers are likely to keep their inventories low to save capital.

"The risks now appear, for the first time in quite a while, to be skewed to the downside," said Stephen Briggs, senior metals strategist of BNP Paribas.

Much of copper's surge since the middle of last year has been driven by the widely held belief that demand will exceed mining output this year, and that China will be forced to bid up prices to feed its growing economy.

.If Mr. Westgate and others are right, China is sitting on enough copper to completely offset any expected deficit. The International Copper Study Group, a Portugal-based intergovernmental organization, estimates that copper demand will exceed production by 435,000 tons this year.

It "raises the prospect of a balanced market, or even a small surplus," Mr. Westgate said.

Mr. Westgate focused on so-called bonded warehouses, storage facilities where trading houses park their goods before paying duties and officially moving them in or out of the country. The fact that much of the newly discovered copper is sitting in these types of warehouses is particularly worrisome, because the metal is just one step away from being sent into the global market. In his March 28 report, Mr. Westgate said that these warehouses were so full that some copper was being stored outside them.

Still, some analysts think the sentiment is too bearish. Given China's voracious demand, the copper stockpile at bonded warehouses can be consumed in 23 to 26 days, said Credit Suisse analyst Ivan Szpakowski, who estimated Chinese copper usage in 2010 at 9.5 million tons. China's underlying demand for copper remains robust, as indicated by the solid growth in industrial production, electricity usage and fixed-asset investment, he said.

That demand isn't reflected right now, some argue, because copper consumers—companies that make everything from brass door handles to copper wiring for iPods—are keeping their inventories low to save capital as the government tightens its credit policies. At some point, these companies will step back into the market, said Alan Williamson, a commodity strategist with Trafigura Group, a commodity-trading firm.

Some of the stockpiled copper might have already found its way back into the market. During the first two months this year, China exported 42,600 metric tons of refined copper, eight times the amount a year earlier.

"This is very unusual," said Deng Hong, a copper analyst with Maike Futures, a brokerage affiliated with Maike Group, China's largest metal importer.

Since the beginning of this year, copper inventories at designated warehouses of the London Metal Exchange have risen 17%, a sign that some copper is moving from Shanghai to London, where prices are higher.

"We expect there will be a continuous flow of copper into London" from China, Ms. Deng said.

Write to Carolyn Cui at carolyn.cui@wsj.com