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Aspects of Copper Price Volatility

ICSG Seminar, Lisbon, October 2007

Alan Williamsonalan.williamson@trafigura.com +44 207 009 1702

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Trafigura

Trafigura is a USD50Bn a year commodity trader

Second largest independent non-ferrous metals trader

Third largest independent oil trader

50 offices in over 35 countries

Galena Asset Management

Subsidiary of Trafigura

Leveraging off group information

Proprietary research into supply and demand

3 Main Funds, cUSD600m under management

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Structure of presentation

Recent price history

Who are the funds involved in the commodity markets?

How do we track what the funds are doing?

What is the impact of fund activity on metals prices and volatility?

Other factors affecting prices and volatility

The US dollar

Arbitrage between the LME and other exchanges

The role of non-visible stocks

Summary and conclusions

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Long run trends in copper prices

In nominal terms current copper prices are unprecedented

but in real terms we have been here before

The surge in prices 2002-07 has been unusual (outside war)

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Nominal price Real copper price (2007 money)

c/lb Nominal and real copper prices

Source: CRU, Trafigura

USD/tonne

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Why have prices surged so dramatically?

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1970 1974 1978 1982 1986 1990 1994 1998 2002 2006

%yoy

forecast

average = 3.8%

Global GDP growth has been exceptionally strong

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67

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Stocks:Con Ratio LME Cash

weeksUSD/tStocks have been depleted

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MtICSG forecasts for 2006 copper mine output

The supply side has struggled

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1999 2000 2001 2002 2003 2004 2005 2006 2007e

GSCI-DJ-AIG Other indices

USD

Billions

and the funds have poured in

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Types of funds involved in the metals markets

Hedge funds

Over 10,000 active funds (more than the 8,600 US mutual funds)

Current assets around USD1,500Bn (US mutual funds cUSD9,200Bn) Have a variety of investment styles, across asset classes

Can be long or short

Commodity Trading Advisors

Current assets cUSD180Bn Are largely driven by technical factors (charts, momentum)

Can be long or short

Pension funds

Traditionally were purely index investors (GSCI, for example) Not particularly price sensitive

Almost always long

Other (arbitrageurs, specialists, Chinese general public)

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Growth in hedge funds has been enormous

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Assets under management (RHS) Hedge funds (LHS)

USD BillionsNumber

Hedge fund business has increased 10x in recent years

Over 10,000 hedge funds with cUSD1,500Bn under management

Main sources of funding are high net worth individuals and Fund of Funds

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Hedge fund strategies

Arbitrage seek to aim from asset mis-pricing

Convertible arbitrage between bonds and equities

Fixed income arbitrage between bonds of different maturities, grades etc

Risk arbitrage where different assets are pricing in different risk probabilities

Derivative arbitrage between a derivative and the underlying asset

Emerging markets - buy equity/debt in emerging markets

Event driven

Distressed securities - buy debt/equities at discount Merger arbitrage between acquiring company and target company

Global macro aim to profit from changes in global economy

Fund of funds - mixes and matches hedge funds

Income - primary focus is yield

Long/short equity - low volatility by offsetting positions across markets

Market timing - attempts to pre-empt changes in market/economic conditions

Multi-strategy - mixes and matches different hedge fund strategies

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Characteristics of macro hedge funds

Aim to benefit from changing global economy

Can take positions across asset classes, but often specialise

Use derivatives to gain leverage and maximise gains

Are very well researched

Look for various investment opportunitiesCyclical play (near the top or bottom of a cycle)

Changing fundamentals / end-use applications

Look for value in commodity / equity trades

Can run positions / trades for very long, or very short time periods

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Macro funds can shorten bear markets

In traditional cycles (the 1980s) inventories needed to fall to critical levelsbefore prices would take off

This changed in the 1990s as funds moved to anticipate the fundamentals

This ensured the bear market ended sooner than it otherwise would have done

Risk/reward means this is more noticeable in bear markets than bull markets

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Excess inventories - all metals (LHS) Base metal prices (RHS)

price rise on lowinventories

price rise despitehigh inventories

weeksIndex

"Excess" metal i nventories and prices

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Commodity Trading Advisors (aka Managed Futures)

Like hedge funds the growth in CTA business has been tremendous

Long term average returns of CTAs have been 13.6%pa

Little correlation with equities or bonds

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Assets under management

USD Billions

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Characteristics of CTAs

Can be technically driven or discretionary 90% technically driven (charts, momentum)

10% discretionary Allocate across asset classes

Foreign exchange 40%

Financials 30%

Softs 14% Metals 9%

Energy 7%

Allocation across LME metals

Al 41%, Cu 27%, Zn 15%, Ni 10%, Pb 4%, Sn 3%

Account for 15-20% LME turnover

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CTAs in the copper market??

2005 to May 2006 CTAs long as prices supported by 40 day moving average

Momentum wanes in summer 2006 and CTAs switch to short positions

Early 2007 momentum turns higher and CTAs switch back to long positions Currently still long

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Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07

USD/tonne

LME copper 40 day moving average 200 day moving average

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Pension fund interest in commodities

Few pension funds have explicit mandates to invest incommodities, but this is growing

Dutch pension fund PGGM in 2000, now 4% of USD76Bn funds Stichting Pensioenfunds in 2001, now 2.5% of USD190Bn funds

Ontario Teachers, Missouri State, Harvard University, Novartis have followed

Investment decisions are based principally on asset class

allocation considerations not supply/demand Long run rates of return equal to or greater than other assets

Low correlation with equities and / or bonds

Returns/investment decision can be influenced by what happens in energy

Are generally passive investors: historically have invested in indexproducts or fund of funds

Increasingly looking to enhance returns

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How much is invested in the commodity sector?

Fund interest has boosted commodity prices and increased volatility

Best estimates suggest USD145Bn in index products, USD40-50Bn inbase metals

No immediate sign of investor appetite for metal exposure waning as aresult of US sub-prime worries

Continues trend to more active management

CTAs and Prop

Desks, 36%

Hedge funds,

37%

Commodity

index funds,

27%

cUSD50Bn spec. money in base metals in 2007

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GSCI-DJ-AIG Other indices

US

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illions

Investment in commodity indices

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How do we track fund activity?

Very little hard data available

LME open interest

Rising open interest and rising prices = fund long position building

Falling open interest and falling prices = fund long liquidation

Rising open interest and falling prices = fund short position building

Falling open interest and rising prices = fund short covering But other factors (producers/consumers) also impact the open interest data

CFTC Commitments of Traders reports

Comex copper, aluminium, gold and silver

Nymex platinum and palladium

Anecdotal evidence the funds are buying . the funds are selling

Replicate the funds run simple technical models

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LME copper open interest and prices

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Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07

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LME copper open interest LME cash copper

'000 lots USD/tonneLME copper open interest and prices

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CFTC Commitments of Traders data

Most analysts follow the CFTC CoTs data

The non-commercial + non-reportable positions are considered aproxy for speculative involvement in the markets

But there are huge problems with the data that make it difficult to read,particularly for copper

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Speculative position on Comex - LHS Copper price (3mths) - RHS

'000t c/lb

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Influence of funds on prices

Macro hedge fund

Can be long or short (and sometimes long and short at the same time)

Positions often counter-cyclical (picking turning points)

Effect is to dampen/shorten the cycle (particularly bear markets)

No long term impact on prices

CTAs

Can be long or short Positions tend to follow market trends

Effect is to exacerbate/lengthen the cycle

No long term impact on prices

Pension Funds and other index investors Almost always structurally long

Effect is to raise long term prices

Also has a significant impact on short term spreads as positions are rolled

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Index fund investment

S&P GSCI has cUSD80Bn invested in commodities

Currently copper has a 3.98% weighting

= USD3.18Bn = c400,000t copper

DJ-AIG index has cUS40Bn invested in commodities

Currently copper has a 6.19% weighting

= USD2.48Bn = 310,000t copper

Other indices have cUSD25Bn invested in commodities CRB has a 5.88% weighting in copper

S&P Index has a 3.39% weighting in copper

Rogers International Commodity Index has a 4.00% weighting in copper

Deutsche Bank LCI has a 0% weighting in copper = USD660Mn = 85,000t copper

Total index fund investment = USD6.32Bn = 795,000t copper

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Influence of index fund investment in copper

800,000t of long position building has undoubtedly boosted copper prices

Quantifying the impact is difficult given other influences the level of stocks,strength of demand, other speculative interest in the market, the US dollar etc

But clearly while index funds remain long, copper prices will be higher, forlonger, than in previous cycles

LME Stocks '000t

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USD/tonne LME copper stocks and 3 month pri ces 1994-2007

2004-5

1994-2003

2006-7

Stocks.consumption relationship moving

further out - higher price for a given stock level

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A weak dollar is good for copper! Discuss

Conventional wisdom has it that a weak dollar is good for commodities

This should be through marginal changes in supply and demand

A falling dollar lowers non-US prices, stimulating marginal demand, cutting production

Lower supply and higher demand = rising US dollar denominated prices

The impact should be higher with prices close to costs of production

The funds knowing of this relationship will buy in advance

This relationship is particularly important for gold

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Platinum Tin

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Correlatio n coefficien t weekly return s 2000-2007

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The role of the dollar in determining copper prices

The view that the dollar drives copper prices is unfounded empirically

In 2002-3 copper and the dollar were positivelycorrelated

Since 2004 there has generally been a negative correlation, but is this causalor coincidental?

If the copper market moves into oversupply expect copper to fall irrespectiveof what the dollar does

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3m rolling correlation coefficient - copper vs the dollar

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The influence of multiple exchanges on price volatility

For many years the only copper arbitrage was between LME and Comex

Arbitrage difference was narrow as both contracts were liquid and nearby warehousing

facilities ensures that metal could easily be moved to settle contracts

Activity has declined as increased volatility has seen risk/reward deteriorate

as has the decline in US copper consumption and production

This has now been surpassed by the LME-Shanghai Futures Exchange arbitrage

Wide arbitrage reflecting lack of close warehousing facilities (higher freight costs)

exacerbated by Chinese import/export restrictions and taxes

Making prices volatile due to a lack of clarity on why metal is flowing to China

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LME-SFE arbitrage

Shanghai prices are a function of LME prices, local supply and demand for physicmetals, and local speculative activity

This can be further affected by raw material prices and the forward structure on

both exchanges Huge differences in LME and SHFE prices can develop that require physical

shipment to correct

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SHFE cash LME cash SHFE cash post taxes

USD/tonne

LME and SHFE cash p rices LME-SHFE arbi trage

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Jan-06 Jul-06 Jan-07 Jul-07

USD/tonne

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Chinese imports and SFE-LME arbitrage

Early 2006 arbitrage was against imports weak demand and stock overhang

Stocks were run down through H1 2006, causing the local market to tighten

By late 2007 Shanghai was trading at a significant premium to LME

Traders began shipping copper to China in record quantities

Eventually pushing the market into oversupply, arbitrage disappeared

Excess stocks now being worked off / exported / accumulated by SRB

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Monthly net refined copper imports SFE-LME arbitrage

$/tonne

Shanghai at premium to LME

Shanghai at discount to LME

Chinese market beginning to adjust '000

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2006-07 movements in Chinese unreported stocks

2006 Chinese imports fell sharply despite ongoing increase in real demand

Chinese supplies of 3.58Mt and consumption of 3.95Mt implies stock drawdown of 370k

Market perceived lower imports to be bearish, erroneously believing demand to be wea

2007 Chinese imports rose sharply as favorable arbitrage encouraged shipment

2007 supplies of 4.75Mt and consumption of 4.50Mt implies stock build of 250kt

Market perceived rising imports as bullish, erroneously believing demand to be stronger

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2000 2001 2002 2003 2004 2005 2006 2007Refined output Net imports

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Chinese copper suppl ies and consumption

ConsumptionDestocking

Stock building

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(Remember China is the key driver to copper prices)

For much of the last 3 years the markets have been sanguine about US growth,correctly being more interested in China

This changed in August, the markets fixating on US debt problems

This created some good buying opportunities, particularly in equities

If US debt worries ease, expect attention to go back to China

R2 = 0.1061

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US GDP growth and copper prices 2005-Q3 07

R2 = 0.9203

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Chinese quarterly GDP growth

Chinese GDP growth and copper prices 2005-Q3 07

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2007 Chinese stocks up, Chilean stocks down

H2 2006 collapse in US demand led to an unexpected rise in Chilean copper stock

Much of this was then exported in H1 2007, most to China

Markets took this as bullish (lower surplus in H2 2006 and higher deficit in H1 200

But should be market neutral as it is merely relocation of existing inventory

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2003 2004 2005 2006 2007Codelco strategic stockpile Other Chile

'000 tonnesInferred Chilean stocks of copper back to normal

Stock change calculated as production less exports less consumption

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The role of stocks in determining copper prices

Basic economic theory has it that stocks influence prices

But in reality information flows lag and it is difficult to know the true stocksituation

R2= 0.7218

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Total reported ind ust ry stocks (weeks consumptio n)

Copper inventories and prices

current

c

LME Stocks '000t

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USD/tonne

current

LME copp er stocks and the cash-3m

backwardation 1994-2007

B i d k d f

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But movements in unreported stocks can dwarfmovements in reported stocks

Movements in copper stocks, 000t 2006 and 2007

H1 06 H2 06 H1 07 H2 07e

Exchange stocks 5 86 -21 20

Other reported stocks -16 34 -21 0

Total reported stocks -11 120 -42 20

Chinese stocks -210 -170 250 0

Chilean port stocks -69 168 -134 40Other unreported stocks -100 100 -50 40

Total other stocks -379 98 66 80

Total stocks -390 218 24 100

Market balance Deficit Surplus Balanced Surplus

Prices Up Dow n Up Dow n

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Summary and conclusions

Copper prices have surged higher as the fundamentals have been incredibly tight

The funds have had and will continue to have a huge impact on commodities

But we need to differentiate between the funds macro funds, CTAs and long

only index investors

Macro and CTA influence is transient, long only investors should keep priceshigher for longer

The impact of the dollar in driving copper prices is overstated

The China factor production, consumption, stock movements, speculative activitand arbitrage is exacerbating copper price uncertainty and volatility

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