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 dropped sharply in March relative to February but were only 2% below those of March last year, which is not bad considering the six-day trading halt and subsequent stop-start return.
The bad news for the LME is that most of the trading appears to have been a mass rush for the exit door. Nickel market open interest has plunged to levels last seen in 2013.
The stampede has been equally dramatic in China, where market open interest on 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 big short positions hang over the market. Rapidly dwindling participation risks opening up a liquidity vacuum and a volatility trap.
Nickel’s wildness makes it a special case, but high prices are causing a broader risk retreat from the industrial metals sector as even the biggest players struggle to cope with the cost of financing positions.
Indeed, Goldman Sachs warns that multiple parts of the commodities complex are in danger of falling into a self-perpetuating volatility trap.
MIND THE TRAP
As defined by Goldman Sachs, the global nickel market is already there.
“A lack of risk capital lowers market participation, driving down liquidity and exacerbating volatility, and further discouraging potential lenders and investors, reinforcing lower participation and higher volatility,” is how the bank describes a volatility trap.
There are obvious reasons for traders to wind down their risk exposure to nickel. Take your pick from the LME’s cancellation of trades, eye-watering margins or the prospect of enhanced regulatory scrutiny, both in London and China.
But it begs the question of what the exodus means for price and trading in the days and weeks ahead. LME three-month nickel is around $33,500 per tonne, almost $10,000 above where it was at the start of March.
The outsized short positions accumulated by Chinese nickel and stainless producer Tsingshan are subject to stand-still agreements but they are still there.
The resolution of this positioning tension is going to be harder in a low-liquidity market-place.
You can start to see why the LME has brought in price limits and why it feels it can count on “broad support for retaining the daily price limits for the foreseeable future so as to (...) minimize the potential for disorderly price moves.”
Those price move caps have been rolled out across all the exchange’s deliverable contracts, which attests to the broader dangers.
Open interest on both the LME’s aluminum and zinc contracts has also fallen sharply following the nickel crisis.
This is in part a spill-over effect as positions were liquidated to meet nickel margin calls. But both aluminum and zinc are becoming more difficult to trade in their own right because of the supply-chain stresses emanating from the Ukraine crisis that have lifted prices and volatility.
The only major LME metal not to have seen a sharp reduction in open interest is copper.
But Doctor Copper has its own story of risk aversion to tell.
LONG CONVICTION, SHORT POSITIONING
The LME’s copper contract was already in special measures after turning wild in October last year.
Open interest fell over the ensuing three months, dipping to a decade low in January, which is why there was little immediate reaction to the nickel debacle.
However, LME copper market open interest has been sliding since 2013, albeit with some sharp fluctuations around the first pandemic hit in 2020.
CME copper open interest has also been trending lower since 2017. Speculative flows on the investor-friendly U.S. exchange have been conspicuous by their absence even as the price has rallied to all-time highs above $10,000 per tonne.
Copper is typical of a market “long on conviction but short on position,” according to Goldman Sachs.
The bank notes that while the S&P GSCI commodities index has risen by 125% since October 2020, investment in the Bloomberg Commodities Exchange is up by only 7% on a price-adjusted basis over the same period.
The contrast with the China-centric bull market at the end of the 2000s is stark. Back then fund money poured into the complex, both directly and via passive long-only index funds.
However, too many investors bought in near the top of the cycle only to watch metals prices grind inexorably lower over the first half of 2010s.
Since when commodities have largely dropped off the investment community’s radar, which has constrained the flow of risk capital into the sector.
So too has the withdrawal of many banks from the commodities finance and trading space over the last 10 years.
Just as metal producers have failed to invest in new production capacity to meet fast-rising demand from 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 worrying about what it calls the “deeper mismatch between financial and physical market risk.”
Bank of England Governor Andrew Bailey assesses wild commodity markets as the area of greatest fragility in terms of stresses on the financial system.
“We can’t take resilience, in particular in that part of the market, for granted,” Bailey told a March 28 event held by the Bruegel think tank in Brussels.
Bailey said the cost of doing commodity business will inevitably reflect the heightened price volatility and change in risk for everything from aluminum to gas to wheat.
“We have to watch very closely to ensure that the step change in the cost of risk doesn’t cause a market failure,” Bailey said.
It may be too late for nickel.
The question is how many other metals can avoid falling into the same trap.
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