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ETPs: A tale of two metals

Metal ringsThe soar-away price of gold has seen gold exchange-traded commodities leave other metals in the dirt. But India's plan to spend $1.7 trillion on infrastructure over the next decade might help narrow the gap, writes Nick Fitzpatrick.

In fairy tales, people move to big cities like London to seek their fortunes in gold. But in recent years, copper has been in demand too, at least for thieves. Cases of copper wire theft from rail stock have shot up.

The price of copper has increased dramatically over the past decade. Other industrial metals prices have also risen.

Yet sales of exchange-traded products based on industrial metals lag gold considerably. It may be a cliché, but copper, lead and tin just don’t shine like gold and silver.

Precious metals and industrial metals have different drivers, with the former typically acting as a hedge against currency devaluation caused by quantitative easing.

Nevertheless, the prices of industrial metals have in fact been pushed up, maybe not to gold’s dizzy height, but steeply by demand from the emerging markets over the past decade.

Also, high extraction costs and labour unrest have dented supply, and limited supply is a key driver of metal prices. For example, a lack of usable copper ore has lead copper miners to use new and more difficult extraction methods. The same is true of oil and the dangers of this were illustrated most catastrophically with the BP Gulf of Mexico oil spill in 2010, which saw 11 people killed.

In case you’ve missed the way commodities have behaved over the past 30 or 40 years, here’s an overview courtesy of Daniel Ung, associate director at S&P Dow Jones Indices, who says that the last time commodity prices were very high was in the 1970s, when consumption of commodities in the OECD peaked. Demand fell a lot afterwards and resulted in a drop in real prices and underinvestment.But from 2000 onwards, prices started to pick up again due in no small part to the emerging-market demand and decline in easy-to-reach supplies.

Prices were hit by the financial crisis but bounced back quite quickly, Ung says, thanks to the stimulus programme that China introduced in 2009 with the main aim of stimulating infrastructure investments in the country.  

Over the past decade, the price of copper has risen from $1,800 (€1,388) per tonne to $8,000. At the same time, the amount of recoverable copper ore fell by half in the ten years to 2010 compared with the prior decade, even though growth in ore reserves remained constant, according to Barclays.

The broader commodity index has done well. The DJ-UBS Industrial Metals Total Return Index – which comprises, copper, nickel, aluminium and zinc – returned 260%, or about 6.9% a year, between January 2000 to the end of October this year.

However, industrial metals may now lose some of the fuel that has been lifting them, and the main culprit is China.

“China is very interested in base metals as it is by far the biggest single buyer of a variety of metals,” says Ung.

Growth is forecast to be slower for China. At the same time, it is rebalancing its economy. “As China rebalances its economy by shifting from exports and infrastructure investments to domestic consumption, so there is the possibility there will be less demand for commodities, such as copper,” Ung adds.

The effects are likely to be felt most keenly in copper markets. China has been responsible for 40% of global refined copper demand in recent years. Demand from China for the metal grew five times faster than the world average for the 11 years to 2011.

With all the emerging-market demand for industrial metals over the past decade, it might be thought that sales of industrial metal-based exchange-traded products would have done better. These include exchange-traded commodities (ETCs), which track single commodity types, and exchange-traded funds (ETFs), which track broader commodity indices.

Yet they have lagged gold considerably and despite responding well to quantitative easing programmes like other risk assets have done, they have seen only limited inflows.

Although the third quarter of 2012 saw better investor sentiment drive net inflows globally for industrial metals, the sector only gained $81 million in new money – small compared with gold which saw $7.7 billion worth of inflows, according to figures from ETF Securities, an ETC and ETF provider.

Whereas commodity-based exchange-traded products had a total of $207 billion in assets at the end of the quarter, gold accounted for a record $151 billion of that.

The price of industrial metals increased, pushing up the sector’s assets by $123 million. In the quarter, copper increased 7.7%, for example.

But what next? Will slower growth in China diminish cash metal prices and exchange-traded products based on them, both in terms of returns and sales? Could commodities go back into a depression as they were between the 1970s and 2000s?

The answer could be that, as commodity prices are so sensitive to sudden demand, other high growth emerging markets could fill the vacuum.

For Ung, Brazil and India could become greater centres of gravity for commodity prices over the next decade. Supplies are tight enough that any increase in demand from big countries like those will have an influence, he says.

“In my view, this is particularly true for India which has so far lacked public infrastructure investments to support private industries. If India were to invest more, this would inevitably support the prices of many industrial metals, including copper.”

The lack of Indian infrastructure is a situation that could change considerably. India has announced that it will spend $1.7 trillion on developing infrastructure over the next decade in key areas such as power, roads and railways. Structural support for individual industrial metals could be on the way.

Meanwhile, metal prices are fluctuating, as with volatility in broader assets. Commodities tend to be cyclical: if investors are confident, commodity prices will benefit and this pattern was reflected in September when commodity prices increased after the Federal Reserve announced another round of quantitative easing.

Nicholas Brooks, head of research and investment strategy at ETF Securities, says: “Commodities have great structural prospects but in the short-term they are cyclical and so there will be less interest in commodities when economic growth is slow.

“But the opposite is also true and when investors feel more comfortable commodities may come back strongly.”

The outlook for industrial metals is positive if other high growth emerging markets can pick up the slack caused by China. But in the meantime, the metals will bounce along like other risk assets, occasionally benefiting from quantitative easing.

Meanwhile gold, having a reserve currency status that other metals, apart from silver, cannot attain, continues to shine.

©2012 funds europe