Lofty Copper Prices Remain at Risk

The copper bears have come out of hibernation in recent weeks.

Measures aimed at cooling China's economy, the continued worries about the finances of some European countries, and concerns about rising oil and food prices are all being touted as serious threats to the global recovery. While these factors aren't new, their collective importance has grown to the point where even the most confident of copper bulls is admitting the market could be due a pullback.

Prices already have retreated more than 8% after more than tripling over two years, following an economic downturn that crimped demand in key consuming markets such as housing and construction. Prices peaked in February at a record $10,190 a ton. Tuesday, three-month copper traded on the London Metals Exchange stood at $9,321 a ton in afternoon kerb trading. Only the weak U.S. dollar has prevented a further decline.

Inventories in global warehouses are rising, and stockpiles in China, the world's biggest copper consumer, have rapidly increased, particularly in bonded warehouses, where the traditional practice of purchasing dollar-denominated copper as a means to get credit has been well-used of late. Anecdotal evidence from physical traders and analysts is that Chinese investors, including farmers and property developers, are buying copper and using it as collateral for loans.

Standard Bank analyst Leon Westgate estimated that about 700,000 tons of refined copper is sitting in bonded warehouses—exempt from China's 17% value-added tax and equivalent to roughly 40% of the country's net refined copper demand. Physical traders active in China estimate the figure could be as much as four times higher, imported over years.

Stocks in these bonded warehouses may now start to haunt their owners, given that China's foreign-exchange regulator has tightened rules on repatriating foreign currency from the re-export of the metal.

As a result, accumulating stocks may be sold and consumed domestically, cutting demand for imports in the process.

To be sure, China's voracious appetite for copper hasn't completely disappeared. Barclays Capital analyst Xin Yi Chen said that while copper imports in April may be lower due to the new import regulations, this could help bring China's domestic copper market into balance.

Copper consumers already have reacted to the high prices by seeking to substitute copper with alternative, cheaper materials, such as aluminum and plastics.

There's a growing concern among industry participants that copper prices may tumble.

"Will the weaker dollar (a good bet going forward) provide the next boost for the group, or will investors sell as they start discounting the somewhat moderating growth outlook?" said MF Global analyst Ed Meir. "We suspect it will likely be the latter, since energy is the big wild card here and will contribute to higher inflation readings, in turn meaning that the upward rate cycle now in place in a number of countries will likely be accelerated."