Copper Chinese Foundations

A recent article on the Financial Times Alphaville highlights a growing concern for the copper market: Chinese land developers are using copper to finance development deals, but the copper market in China may be drying up.

Here's how it works:

1. Interest rates in China are rising steadily, causing borrowing issues for land developers in China.
2. Just like any other business, the land developers look for ways to cut costs.  In this case, that means finding other ways to finance and fund their projects.
3. Copper has been on a tear lately; the iPath Dow Jones-UBS Copper Total Return ETN (JJC) has moved from lows below $18 at the end of 2008/beginning of 2009 to over $60 in the beginning of 2011.
4. Instead of taking out loans at the Bank of China, land developers are buying copper in bulk in the hopes that its value will rise enough to cover development costs.
5. More than just buying in bulk, the developers are using deferred-payment plans which offset the initial cost of the bulk copper.

The problems begin to arise when there is a surplus of copper in the Chinese market, as the article notes.  Copper warehouses are getting so full that some supply is being stored outside the warehouses (nevermind that copper corrodes).

This creates an interesting relationship between copper prices and the profitability of land developers: a significant rise in copper significantly affects both the bottom-line and future growth prospects for developers than choose to speculate and finance through the “economically-intelligent” metal.

Check out this graph of China Housing and Land Development, Inc. (CHLN) versus the JJC over the past months (note the change in correlation  beginning in 2011):

The article also points out the discrepancy developing between the Chinese and European commodity markets.  Normally, materials seek higher prices regardless of location, yet recently prices for copper in China have dropped and copper is still flowing their direction.  If markets are at all efficient (worth debating some other time), then prices may be kept at bay through the arbitrage in this market.

Im a believer in “the other yellow metal”, and considering the fact that less and less of this stuff is being pulled from the ground each year, combined with the increasing demand from emerging countries for housing needs, to me means that copper – in the long term – is going nowhere but up.  However, if the Chinese government tries to stem alternative funding sources, the copper market (at least in China) may be in for a significant setback.

Also see commentary from Trader Mark over at FundMyMutualFund.com, who always has great analysis and thoughts on the markets.