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China Caused Copper's Crash - But Not The Way You Think

When prices for the red metal plummeted Wednesday morning the mainstream assumed Dr. Copper was simply waking up to the reality of slowing growth in China. Since China consumes 40% of the world's copper, a slower China had put copper into oversupply.

Well, it seems China was to blame – but not for that reason.

Play detective for a moment.

Wednesday's sell-off started at 1am UK time, late evening in North America – after almost all western metal traders had turned off for the night. In an hour, copper on the London Metal Exchange fell more than $400 to less than $5,389 per tonne.

When the price fell below the key support level of US$5,500 per tonne a wave of stop-loss sell orders were unleashed around the world, compounding the effect.

And this all happened in a global market made anxious by oil's collapse and during the first quarter, when copper demand in China is weak because consumers and traders don't want to hold big piles of copper over the looming two-week Chinese New Year holiday. Those factors made a copper decline 'make sense', further fueling the slide.

And who would have benefitted? Hedge funds holding cheap puts, which are options giving the buyer the right to sell copper at a set price. Before copper's crash these options were out of the money. With copper significantly lower the options turned profitable – and the same Chinese hedge funds that had pushed the price down made a quick killing.

It would not be the first time Chinese funds staged a Bear Raid on copper. Last March they pulled a similar move, selling massive quantities of copper over three days to push the price down. The episode rattled traders but the price returned fairly quickly.

It makes sense. With China so dominant in the copper market, they are better positioned to pull off such manipulations. They know when physical buying is strong and what price would make China's Strategic Reserves Board start buying. And there are a large enough force to actually change prices when to their benefit.

As the Financial Times put it: "Dealing during illiquid hours, their aggressive tactics can have speedy ramifications given the increasing presence of high-frequency traders and black-box funds that sell or buy based on preset instructions."

Copper starting correcting the crash quickly, rising to $5,625 by the end of the day. That's still more than 12% down since the start of the year, but commodities as a grouped have been hammered.

Looking ahead, despite bearish predictions in the fall the copper market now looks pretty tight, after several disruptions shifted the market. Rio Tinto lowered forecasts for its Kennecott mine by 10,000 tonnes, BHP shaved 150,000 tonnes off its Escondida outlook, and Glencore reduced guidance from Minera Alumbrera by 50,000 tonnes, among others.

As a result, just three months ago Macquarie predicted a 400,000 to 500,000 tonne copper surplus in 2015. Now the leading commodities forecaster sees balance or even a deficit.

Copper won't be the most exciting metal in 2015, but it will do just fine. Unless these Chinese traders have another big pile of even cheaper puts they need to ditch.

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