The year of the Chinese metal bear has its negative impact

The collapse in metal prices this year is all about China.

That much is now common knowledge. Chinese demand growth fuelled the boom years. Chinese slowdown, particularly the slowdown in construction activity, has caused the bust.

But China is also the source of an entirely new driver of lower prices in the form of massive speculative short selling.

Open interest and volumes have surged across all the industrial metals contracts traded on the Shanghai Futures Exchange (SHFE).

Indeed, such has been the intensity of the bear attack that the country's own producers are now calling for the authorities to investigate what is going on.

But just what is going on?

There is no year of the bear in Chinese astrology which is a shame because for metals this has decidedly been the year of the Chinese bear.

As early as January London Metal Exchange (LME) copper plummeted to what where then six-year lows under the weight of spill-over selling from Shanghai.

In the frame were previously little-known Chinese investment funds such as Shanghai Chaos, a gift to headline writers everywhere.

While Western analysts were still trying to fathom what a Chinese growth slowdown would look like, such local players evidently took the view that it was going to look a lot more ugly than just a "slowdown".

That view looks highly prescient with hindsight although whether the Chinese funds made money is a moot point, given the fact that copper spent the next four months rallying from the January lows.

Come the middle of the year, though, the Chinese bears were back on the attack, selling commodities as a proxy for a negative view on Chinese growth which couldn't be expressed on the local stock exchanges after the Chinese authorities effectively banned short-selling of equities.

NEW PLAYERS IN TOWN

But something has appreciably changed again over the last month or so, suggesting a whole new category of Chinese bears has entered the market.

All the major SHFE metals contracts have seen the same mushrooming of open interest and trading volumes as prices have been falling, a classic sign of short-selling.

The arrival of new players, however, is most evident in a contract such as aluminium, which has previously been shunned by Chinese investors, at least partly because it's a metal that China doesn't need to import because it produces more than enough to meet its own demand.

Total open interest on the Shanghai contract has more than doubled since the end of September, hitting an all-time record high of 803,620 lots on Wednesday.

Total aluminium volumes have averaged 492,000 lots per day so far this month. They averaged 274,000 lots last month and just 79,000 lots in the first eight months of 2015.

The Shanghai aluminium price has sunk to record lows below 10,000 yuan per tonne, far lower even than the trough of 13,665 yuan seen at the worst of the Global Financial Crisis in December 2008.

As analysts at Macquarie Bank nicely put it, "the question is whether the typical Chinese investor had a sudden realisation that aluminium is not a great market or a new type of investor has emerged with an interest in metals". 

Their tentative answer is that "many of the named entities that have increased shorts on SHFE through this period are organisations that cater to retail investors as well as institutional clients (and) there is a possibility that a certain proportion of the tide of shorting may have come from this direction."

The fact that no-one seems sure of where all the selling is coming from implies that it's not coming from entities previously on the metals markets' radar.

Some sort of retail crowd surge seems to be at work, injecting another layer of complexity into the already complex world of Chinese market price behaviour.

If true, the inference is that Shanghai trading is going to be become more volatile since, again to quote Macquarie, "crowd momentum will be stronger but wallets will of course be shallower".

SPECULATORS VS PRODUCERS

Of course speculators, particularly short-selling speculators, have long been a bug-bear for producers outside of China.

U.S. producer Alcoa, for example, has made no secret of its distaste for what it feels is the increasing financialisation of the LME aluminium price.

In a Feb. 6 2015 letter to the exchange Alcoa called for greater transparency on "non-physical" trading, arguing that "the LME is at risk of becoming increasingly irrelevant to physical market participants if LME prices become increasingly driven by the financial community rather than market fundamentals."

It's the first time, though, that Chinese producers have felt the same way and their response has been swift.

The state-controlled China Nonferrous Metals Industry Association has asked the local regulator China Securities and Futures Commission to investigate "malicious" short-selling.

"Malicious" is a highly loaded word when it comes to Chinese markets. It was used repeatedly by the authorities to justify their clamp down on short-sellers in the July equities rout.

Indeed, the very news of a possible investigation has generated a strong recovery rally right across the SHFE metals suite.

FOR BETTER OR WORSE?

So too have reports of various attempts by major Chinese metal producers to support prices.

Chinese zinc smelters have already stated their intention to cut output by 500,000 tonnes next year. Nickel producers are due to meet on Friday to discuss something similar.

Both nickel and aluminium producers have asked Beijing to buy up surplus metal, an emergency measure last used during the depths of the 2008-2009 Crisis.

The speed and scale of response is surprising by historical standards and the interesting question is whether it is the massed bear attacks on domestic prices that has focused so sharply Chinese producers' minds.

If they have, there will be plenty of Western producers who will be quietly grateful for whoever is behind the short-selling in Shanghai.

An even more interesting question is whether, after getting their first taste of industrial metal markets such as aluminium, the new generation of Chinese speculators will want more of the same.

In which case, this may be only the first year of the Chinese metals bear.