LONDON, April 5 (Reuters) – The good news for the London Metal Exchange (LME) is that its nickel contract is trading again after last month’s chaotic suspension.
Average daily nickel volumes inevitably fell sharply in March compared to February, but were only 2% lower than March of last year, which is not bad considering the shutdown six-day trades and the subsequent stop-start return. Read more
The bad news for the LME is that most trading appears to have been a massive rush for the exit door. Nickel market open interest plunged to levels last seen in 2013.
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The scramble was equally dramatic in China, where open market interest in the Shanghai Futures Exchange nickel contract is the lowest since April 2015, which was only the second month of trading after its launch.
Nickel prices are still strong and large short positions are weighing on the market. The rapid decline in participation risks opening a liquidity void and a volatility trap.
The wild nature of nickel makes it a special case, but high prices are leading to broader risk removal from the industrial metals sector as even the biggest players struggle to meet the cost of funding positions.
Indeed, Goldman Sachs warns that several parts of the commodity complex risk falling into a self-perpetuating volatility trap.
BEWARE OF THE TRAP
As defined by Goldman Sachs, the global nickel market is already here.
“A lack of risk capital reduces market participation, lowers liquidity and exacerbates volatility, and further discourages potential lenders and investors, reinforcing lower participation and higher volatility,” so the bank describes a volatility trap. (“A physical market under financial constraint”, April 3, 2022)
Traders have obvious reasons to reduce their nickel risk exposure. Take your pick from trade cancellation by the LME, eye-watering margins or the prospect of increased regulatory scrutiny, both in London and China.
But it raises the question of what the exodus means for prices and trading in the days and weeks ahead. LME three-month nickel is around $33,500 a tonne, nearly $10,000 higher than at the start of March.
The outsized short positions accumulated by Chinese nickel and stainless steel producer Tsingshan are subject to standstill agreements, but they are still there. Read more
Resolving this positioning tension will be more difficult in a market with low liquidity.
You can begin to understand why the LME has introduced price limits and why it believes it can count on “broad support to maintain daily price limits for the foreseeable future in order to (…) minimize the potential for price movements messy”.
These price movement caps have been rolled out across all deliverable contracts on the exchange, which speaks to the wider dangers.
Open interest on LME aluminum and zinc contracts also fell sharply following the nickel crisis.
This is partly a ripple effect as positions were liquidated to meet nickel margin calls. But aluminum and zinc are becoming increasingly difficult to trade as such as supply chain strains emanating from the Ukraine crisis have driven up prices and volatility. Read more
The only major metal in the LME that has not seen a sharp reduction in open interest is copper.
But Doctor Copper has his own risk-averse story to tell.
LONG CONVICTION, SHORT POSITIONING
The LME copper contract was already subject to special measures after going wild in October last year.
Open interest fell over the next three months, falling to a decade low in January, which explains why there was little immediate reaction to the nickel debacle.
However, open interest in the LME copper market has been declining since 2013, albeit with strong fluctuations around the first pandemic hit in 2020.
Open interest on CME copper has also been on a downward trend since 2017. Speculative flows on the investor-friendly US exchange were conspicuous by their absence even as the price hit all-time highs above $10,000 the tonne.
Copper is typical of a “long on conviction but short on position” market, according to Goldman Sachs.
The bank notes that while the S&P GSCI Commodities Index has risen 125% since October 2020, investment in the Bloomberg Commodities Exchange has risen only 7% on a price-adjusted basis over the same period.
The contrast to the China-centric bull market of the late 2000s is stark. At the time, fund money was flowing into the complex, both directly and via long-only passive index funds.
However, too many investors bought near the top of the cycle only to see metal prices fall inexorably in the first half of the 2010s.
Since then, commodities have largely disappeared from the radar of the investment community, which has limited the flow of venture capital into the sector.
So has the withdrawal of many banks from the commodity finance and trading space over the past 10 years.
Just as metal producers have failed to invest in new production capacity to meet the rapidly rising demand associated with energy transition trends, the financial community has failed to invest in the capacity to trade the resulting higher prices.
It’s not just Goldman Sachs that worries about what it calls “the deeper mismatch between financial and physical market risk.”
Bank of England Governor Andrew Bailey believes wild commodity markets are the most fragile area in terms of pressures on the financial system.
“We cannot take resilience, especially in this part of the market, for granted,” Bailey said at a March 28 event organized by the Bruegel think tank in Brussels. Read more
Bailey said the cost of commodity-related activities will inevitably reflect increased price volatility and changing risk for everything from aluminum to gas to wheat.
“We need to watch very closely to make sure the dramatic change in the cost of risk doesn’t cause market failure,” Bailey said.
It may be too late for the nickel.
The question is how many other metals can avoid falling into the same trap.
The opinions expressed here are those of the author, columnist for Reuters.
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Editing by Barbara Lewis
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