Few cheers for physical base metal products from analysts

THIS year’s annual London Metal Exchange (LME) week was abuzz with the news that physical exchange-traded commodities (ETC) for base metals are going to see the light of day. After plenty of speculation in both the press and the markets, ETF Securities confirmed what many had assumed and announced that it was preparing to launch physically backed industrial metal ETCs.

According to ETF Securities, these new products are still subject to approval from both the regulator and the London Stock Exchange (LSE) but will include physical aluminium, copper, lead, nickel, tin and zinc, as well as a basket of all six metals. However, a scheduled launch date or timeline has yet to be announced.

The interest and excitement surrounding the statement is symbolic of the demand for new methods of getting exposure to the Asian growth story and the recent rally in base metal prices. Indeed, a physical ETF for industrial metals already exists in the US – BI Physical Commodity Fund, operated by Basinvest, was launched in May 2009 and now has $42m in assets under management. Earlier this week it was revealed that JP Morgan had sought regulatory approval from the US Securities and Exchange Commission to launch a physical copper ETF.

Although the precise structure of these products is not yet known, metals analysts are sceptical about their potential. First, high storage fees are likely to deter would-be investors. Storage costs in LME warehouses are high – for aluminium the published rate is $146 per tonne, which equates to a 3 per cent annual charge at current prices. The alternative is to store the metal more cheaply elsewhere but this exposes you to credit risk because it would be held outside the exchange system. In addition to warehousing costs, investors would also have to pay insurance and financing costs as well as a performance fee. Standard Chartered’s Dan Smith calculates total charges for holding physical aluminium would equal 5.5 per cent a year while copper would cost 2.5 per cent.

Second, Goldman Sachs analysts led by Joshua Crumb don’t think physically backed base metal products will impact the market beyond the short-term. This is because speculators have no incentive to hold once the forward curve flips into backwardation – where the futures contract trades at a premium to the spot price.

“Even if an ETF were to buy sufficient material to drive the market into shortage, it would then shift the forward curve into backwardation and there would be an arbitrage to sell the storage-paying ETF and buy lower priced futures, releasing the material right back into the market to ease the shortage,” Crumb points out.

However, he warns the ETF’s structure could exacerbate short-term volatility – if it is constructed as a closed-end fund this would remove supply. Even if it were open-ended, if it launched in a tight market like copper, then there would be the potential for short-term volatility, since the provider would need to build working capital.

Although little is known about these products at the moment, the sense is that investors will lose out in a backwardated market because they can’t benefit from the roll yield. But providers benefit regardless of whether it is in contango (the opposite of backwardation) or backwardation.

Physically backed base metal ETCs will certainly receive their fair share of attention when they actually launch but investors are unlikely to get a better deal than they would in the futures market.