Base metals prices, as measured by the LME Index, have fallen by 35% since their peak in early March and by almost 30% over the past three months, Macquarie Research reports. Being the last base metal left trading above the marginal cost of production, the developments in copper have been particularly interesting of late, and so far the price declines (since their respective peaks) have been in line the declines in the other base metals.

The $2,800/t ($1.27/lb), or -31.5% fall in the copper price to $6,085/t ($2.76/lb) over the past three months has been strongly correlated with US dollar appreciation of almost 14% over the same period. This makes sense in that the rise in the US dollar makes it more expensive for non-US dollar denominated copper consumers. However, Macquaruie believes the correlation over the past three months is likely to also reflect the fact that both variables are being driven by macroeconomic developments.

Copper prices have been driven lower by deterioration in the outlook for demand growth in most countries over the past three months; however the downward revisions appear to be larger for European and Chinese demand, which were previously expected to hold up relatively well compared to the US. The downward revisions to European outlook have placed upward pressure on the US dollar relative to the Euro over the period, together with the upward pressure coming from the general ‘flight to safety’.

There is no doubt that the deterioration in global demand expectations is resulting an increase in the likelihood that the copper market will move into more significant surplus over the next six months. The Macquarie view is that copper will be in surplus of 470,000 t in 2009 (note this assumes almost 870,000 t of losses relative to plan).

In the very short term however, it is interesting to note that LME copper has fallen by 10.7% over the past week while the SHFE has been closed. If SHFE copper prices hold up relatively well next week then the arbitrage will open up and Chinese traders may buy LME copper to deliver into SHFE, keeping LME stocks low for the time being. Regardless, the copper arbitrage points to a pickup in Chinese imports over the next two months.

Furthermore, the US bailout package (just passed) and anticipated Chinese government fiscal/monetary stimulation by end October/early November may provide temporary support to prices.

Indeed, copper may be vulnerable to short covering rallies around the anticipated downward trajectory over the next six months. The view that copper may be susceptible to temporary short covering rallies comes from the fact that the there has been apparent build up in short positions has taken place over the past three months.

See http://macq.wir.jp/d.ut?t=CVdqxnl4f