China drives base metal growth

The announcement by French bank Natixis in May 2012 that it was shutting down its base metals trading business was a powerful signal for the industry. Natixis is one of just 12 category one members of the London Metal Exchange (LME), the so-called ring dealers allowed to trade directly on the open-outcry floor of the world’s largest non-ferrous metals exchange.

The French bank earned $120m from all its commodities businesses in 2011, according to estimates by JPMorgan equities analyst Kian Abouhossein, who focuses on global investment banks. That is dwarfed by the US giants in the commodities business such as Goldman Sachs, Morgan Stanley and JPMorgan itself, which generate between $1bn and $2bn per year from commodities.

Waning appetite

Mike Camacho, newly appointed head of commodities for Europe, the Middle East and Africa (EMEA) at JPMorgan, and also the bank’s head of metals, says the number of banks genuinely active in the market has perhaps halved over the past five years. And he expects it to shrink further.

“The cost structure continues to go up and you need to have a large industrial scale business to operate successfully, so banks may need to consider whether to scale up or move out, leaving perhaps a niche precious metals desk that is part of their foreign exchange business,” says Mr Camacho.

Commodities bankers mainly attribute this decline to regulatory changes since the crisis, including tougher measurement of market risk for capital requirements, heavy position reporting requirements and limits, and the obligation to use central clearing and (in the US) swap execution facilities (SEFs) with higher margin needs. Those banks that remain are gaining market share both organically and through acquisition.

JPMorgan bought Sempra from Royal Bank of Scotland in 2010, adding physical trading capabilities in Europe and Asia to its existing franchise, which was strong in derivatives and in the North American physical markets. Deutsche Bank is another growing presence, with its commodities revenues growing by about 15% to more than $1bn in 2011, according to Mr Abouhossein. Deutsche hired a listed commodities trading team from UBS in May 2012.

“We are perhaps getting past the point where the number of banks exiting the market is a good thing for those that remain. Most metals markets are still liquid on average, but the capital and margin management requirements have caused a decline in the number of consistent market-makers. That can lead to liquidity being trapped in pockets, with high price volatility at certain times,” says Simon Grenfell, global head of metals sales and origination at Deutsche Bank in London.

Growth business

This is not to say that metals trading is unattractive. When MF Global fell into bankruptcy in 2011, its head of commodities, Fred Demler, found plenty of interest in acquiring his commodities teams, and in particular the top-ranked metals brokerage operation.

“I must have received at least 20 phone calls from banks, futures commission merchants, voice brokers, hedge funds and merchant trading houses. We wanted to find a deal that would keep the team together,” says Mr Demler. Most, if not all of the top sales executives and dealers, as well as many in the professional staff, had individual offers pending, so time was critical to agree a transfer.

In the end, the metals team was acquired by US commodities broker INTL FC Stone, originally an agricultural commodities specialist that has expanded dramatically over the past decade. Mr Demler is now FC Stone’s head of LME metals, and the firm was awarded LME ring dealer status after the transaction. This highlights another trend, the growth of non-bank commodities brokerages.

These non-bank brokerages are still subject to the regulatory efforts to bring over-the-counter derivatives trading onto exchanges and SEFs, as well as other aspects of the Dodd-Frank Act in the US. But they do not have the legacy asset portfolios that are weighing down many of the largest banks. Mr Demler says many of the potential buyers who approached him were not suitable homes for his team compared with what FC Stone had to offer in terms of the right staff and infrastructure.

“The LME is more complex than other futures markets, because there are market-making and credit line aspects to the business, it is a global not a regional market, and requires a team structure to deliver value to clients. There is a very varied client base including funds, financial institutions and corporate hedgers from the blue-chips to the smallest scrap dealers and merchants,” says Mr Demler.

Asia's rise

Another fast-growing brokerage that has LME ring dealer status is Marex Spectron, formed from the merger of UK-headquartered on-exchange commodities broker Marex and energy, environmental and freight broker Spectron in 2011. Managing director and global head of sales Gavin Prentice says brokerage volumes can benefit from the rise of high-frequency trading. He estimates algorithmic trading very roughly at 5% to 10% of total commodity fund activity today, but believes that could increase to 20% or 25% over the next two years.

“With the Volcker Rule and other regulations there will be an increase in commodity hedge funds overall, as proprietary traders leave the banks,” says Mr Prentice.

However, the dominant theme for metals desks is increased consumption in Asia, where Mr Prentice estimates metals market volumes have grown by 15% to 20% per year over the past five years. China is now firmly established as both the largest and the most important marginal consumer of metals worldwide. According to Max Layton, head of metals research at Goldman Sachs, Chinese demand accounted for 8 million of the 20 million tonnes of copper produced in 2011.

“Chinese copper consumption growth of 8% equates to an extra 600,000 tonnes of copper consumption, whereas 3% is about 240,000 tonnes. That compares with a global production deficit of 200,000 tonnes last year, so China is clearly the swing consumer,” says Mr Layton.

All eyes on China

Unsurprisingly, China-watching is a favourite pastime for traders in the metals markets and beyond. Shengzhang Luo is the deputy general manager of Maike Metals, the largest Chinese copper importer which trades about 1.5 million tonnes of metals per year, of which 900,000 tonnes are copper. He is confident that Shanghai could become a global centre of commodity trading within three years, and believes this is important for China, given its high raw material needs.

“Chinese factories and traders already prefer the Shanghai Futures Exchange [SFE] to the LME, because they find prices on the SFE better reflect the Chinese domestic supply and demand situation,” says Mr Luo.

For now, however, foreign access to the SFE is restricted, and speculative activity appears to dominate. In 2010, trading volumes were up 400%, but open interest only rose by 10%, suggesting that the vast majority of transactions were day-trading rather than producers or consumers buying commodities for delivery or hedging.

That means the LME continues to be the heart of global metals trading, with a market share of about 80%. But with the exchange up for sale, there could be a seismic shift in the pipeline. The Chicago Mercantile Exchange – which accounts for most of the other 20% of metals trading – the Intercontinental Exchange and the Hong Kong Exchanges group remain in the running. Most ring dealers are represented on the LME’s board and are unable to discuss the bid.

Short-term uncertainty

While the long-term growth of Asian markets is in little doubt, a sell-off of about 10% to 15% in much of the metals complex in 2011 is a reminder that the development of the metals market will not be linear. The China domestic picture is crucial, says Mr Layton, who estimates that the quantity of copper consumption re-exported as finished goods could be as low as 5% to 15%, mainly in the form of consumer durable goods.

“About 40% to 50% of Chinese copper demand comes from the construction industry, about 20% for aluminium. Lead is an exception because it is almost all used in the auto and motorbike sector, but much of that production is also for the local market,” says Mr Layton.

Mr Luo is relatively bearish on Chinese metals demand in the short term, suggesting that the economy, especially the property sector, “is experiencing a hard landing. Consumption is quite sluggish, and is likely to go down further over the next one or two years.”

Mr Layton says the government’s drive to build more affordable social housing may pick up the slack in the private residential market, although the timing of that new wave of construction is uncertain. And the rest of the world cannot be completely ignored, nor can financial factors.

Mr Camacho of JPMorgan says the low interest rate environment and a contango (upward sloping) futures curve have encouraged clients to hold aluminium stocks in warehouse because they expect the cost of financing will be more than outweighed by the gains from the higher future sale price.

“A continued oversupply of aluminium could steepen the curve. The risk to the other side is that consumers, who are at historically low stocks, could need to bid up an inventory if economies rebound, particularly in Europe. The curve in that case is likely to flatten,” says Mr Camacho.